Making Sense: 2023 Market Outlook

Amy: Hello, everyone and welcome to the First Citizens Wealth Management Making Sense series, where Chief Investment Officer, Brent Ciliano and Director of Market and Economic Research Phillip Neuhart help you make sense of what's going on in both the markets and the economy. I'm Amy Thomas, a strategist at First Citizens Bank. This is our final presentation for 2022, so we're focusing on our 2023 Market and Economic Outlook. Just a reminder, the information you're about to hear are the views and opinions of First Citizens Bank and should be considered for educational purposes only. If you have any questions about any of this information, please reach out to your First Citizens partner. And with that, Brent, we are ready to go, so I'll turn it over to you.

Brent: Great, well, thank you, Amy, and good afternoon, everyone. I hope all of you are well. Well, Phil, we are basically at the end of another year, and what an event-filled and volatile year it's been. Rampant multi-decade high inflation, deep and protracted global supply chain issues.

Phil: We had a war in Ukraine and other geopolitical issues in Asia. We have monetary policy tightening rapidly here in the states and abroad as well. All of that's pushed risk assets down, the S&P 500 down 25% peak to trough. And fixed income sold off too. The aggregate bond index peak to trough down 17%.

Brent: Yeah, so as the calendar is about to turn from one year to another, Phil and I wanted to highlight some of the areas in focus.

Phil: So what are we going to cover today? So first, there's so much we could cover. This is going to be 50 in focus, but in the interest of time, we've narrowed it down to five.

Brent: That's right.

Phil: Five in focus. And then of course, we want to cover our views as well.

Brent: Great, so before we do that, Phil, why don't we take a huge step back? And Amy, if we can go to the next page, and let's talk about the broad global growth environment. Big picture, what we're looking at here on the left is projections from the IMF. On the right is broad Wall Street consensus. And I think without getting into the pedantic details, Phil, what's clearly evident is that as we shift from one year to the next, broad global growth is slowing and growth in the United States is also slowing materially.

Phil: Yeah, so when we go through this presentation, it's in the context of slowing growth, everything we're saying today. Our next 12-month recession probability remains 60%. So we are still odds-on recession. We think it's shallow for a number of reasons that we have discussed in detail, but we do think odds-on recession next 12 months. So what do we want to focus on in terms of the five in focus?

So first, if we flip a head, Amy, we're going to touch on the path of inflation. We, and everyone, is tired of talking about inflation, but you just can't ignore it, how critical it is for the markets. And speaking of that, what is the Fed and market participation's reaction function to inflation? Just this week, the Fed highlighted the degree to which, look, they're staying aggressive. They reminded the market of that. What's that reaction function?

Brent: Absolutely, and as we said basically on almost every WebEx, the labor market and consumers remain resilient right across the board in the labor market, and job growth looks robust and continues to remain robust. Also, we talked about the underlying health of corporations: balance sheets, PNLs, cash flows for corporations, revenues, earnings remain incredibly strong. So if, God forbid, knock on wood, we do enter a recession, they're in better shape today than they've been. And then the one thing that none of us could forecast is what we don't know.

Phil: Right. The unknown.

Brent: The unknown, for sure.

Phil: Absolutely, so let's jump right into point one, which is the path of inflation. We won't dig into this chart as much detail as we have in the past, but if you believe consensus, really high inflation that we're seeing today is going to continue to moderate. And we've started to see some moderation in the reported data. It remains far too high but is coming down. Of course, we always note that consensus has gotten it wrong. The black diamonds are where consensus was in March of 2022, but still, moderating inflation still elevated. But this is certainly good news if it comes to fruition.

So we flip ahead, what are the causes of inflation and what are some reasons maybe for inflation to continue to moderate? Well, one, M2 money growth on the left side, we're going back to the early 60s here. Unbelievable expansion in money growth. Why was that? Fiscal stimulus. Monetary stimulus. Just unbelievable. Look at where it is compared to 2008, the financial crisis. Just shocking. With that benefit of hindsight, of course, we've had elevated inflation.

Now, what's interesting is if you plot into money growth on the right side with core CPI, which is consumer price index, excluding food and energy. Think of it as sort of core inflation. And you lag CPI 13 months, CPI does tend to track M2 money growth, and M2 money growth has collapsed. Why is that? Fiscal programs rolling off, Fed tightening. This is a good indication in the future and one of the reasons that economists, and we do think inflation moderates, maybe not the pace we want.

Brent: Right.

Phil: But there are reasons to think it moderates. In the details, if we flip ahead, a real concern in terms of inflation levels has been owners' equivalent rent. And we won't dig into it. It's kind of a unique measure, what we'll say, in terms of how the government measures cost of housing. What you tend to see is if you lag a Zillow rent index, so this is real world rent, so you let, you lead that 9 months versus owners' equivalent rent, owners' equivalent tent tends to follow that Zillow rent index. Their index has turned over. So we get a lot of questions from clients, well, what's going on underneath the hood that might indicate inflation turning over? Well, this is something, right?

Brent: And it's an incredibly high percentage of the inflation data. You're talking 25% to 30% of that index is primary owners' equivalent rent. So if in fact, this trend does turn out this way, you're certainly going to see a big impact on inflation.

Phil: That's right, and something that hasn't even shown up in the owners' equivalent rent data at all yet. So certainly something potentially in the future. So when might the Fed start hiking? Right, we talked about the Fed's reaction function. Fed is very aggressive. They're reminding us that they want to stay aggressive every chance they get. If you look back all the way to the 1970s, you've not seen the Fed pause over the overnight rate hiking of the Fed funds rate until it exceeds the level of inflation. Right, so the gold bars here exceed the gray bars every cycle.

Brent: Right.

Phil: Right. Look at the far right, where we are today. So recent CPI, Brent, 7.1%. The top end of the Fed's range, 4.5%. At some point, that gold bar needs to get above this rate bar.

Brent: Right, right.

Phil: You know? If you, there's a reasonable chance that happens sometimes late in the first half of the year. Why is that? The Fed's saying, "Look, we think we're going to get just north of 5%, the market thinks they're going to be a little below 5%, let's call it 5%." And inflation starts to moderate to that sub-5% level. So that's where the Fed really has a green light to pause hiking.

Brent: Right, and when we're talking, you know, broadly, that pivot is not really until we get into potentially at the earliest the summer of next year, when we have that crossover inflection.

Phil: And remember, just because the Fed pauses does not mean they start cutting.

Brent: That's exactly right.

Phil: So, so.

Brent: They said very specifically that they're going to keep rates higher for much longer.

Phil: That's right. So why might the Fed pause even while inflation is higher than their target? Well, that's because Fed policy operates on a lag. In fact, the Fed has even mentioned the word lag in recent statements from the FOMC. Here, we're showing the Bloomberg Financial Conditions Index. When this index is below zero, that means conditions are tightening. Right, tighter financial conditions. Right, this is what the Fed wants to see. What you'll notice, the first Fed hike, that first arrow, you saw conditions tighten leading into that because markets were looking ahead. They realized the Fed's going to start to hike. But really, the lower lows didn't happen until a lag. And the Fed knows this, markets know it. It's one of the reasons that there's a chance, reasonable chance, that we have a recession—60% in our view—because the impact of Fed policy tightening does not hit the economy immediately. It takes a lag, and you do see that in the data.

Brent: So let's shift gears and let's talk about the labor market. Phil, I am constantly blown away by how resilient the labor market has been. We saw 263,000 jobs created in November. We revised up the previous months, October to 284,000 jobs, 6-month moving average still in excess of 300,000 jobs.

Phil: Initial jobless claims, very low.

Brent: Absolutely. Unemployment rate stayed at a low 3.7%, you know, only 0.2% above the lowest level in more than 50 years. So the underlying resiliency and the degree of job creation is just incredibly robust. And if we look more deeply under the hood and you look on the next slide, Amy. On the chart on the left, when we look at nonfarm payrolls, it's been, you know, a road to recovery for sure. But pre-pandemic, we were at 152.5 million jobs in February of 2020. We are now officially a million jobs above that level, at 153.5 million jobs. Now, if I drew a trend line through that series, Phil, we'd still be a couple hundred thousand below. But again, significant recovery in the amount of employed folks. And I guess importantly, on the right-hand side, when we look at average hourly earnings, very very consistent average hourly earnings ticked up a little bit to 5.1%. Again, compared to the long-term average, Phil, we're more than 60% above the long-term average. So consumers are employed, and they're making good money.

Phil: And it's a very tight labor market, right?

Brent: Absolutely.

Phil: Participation has been stubborn to come back. We have a huge, many, 10 million job openings right now in the economy. So while it's recovering, what's pushing wages higher is the tightness.

Brent: Exactly, exactly. And what's critically important, because we are a consumption-driven economy, is consumer spending. And the gold line here is good spending. The gray line is services spending. And again, in nominal terms, Phil, consumers continue to spend almost double the 20-year average as it relates to spending in both goods and services—certainly coming down from the pre-pandemic levels and post pandemic, but still robust spending.

Phil: And you mentioned these are nominal levels. So one may say, well, what about inflation? Well, if you look at the first three quarters of this year, real PC, real personal consumption, did grow. So you did see growth even in nominal terms. One thing of note, we did recently receive a retail sales report that disappointed. So I think there are some cracks forming.

Brent: Yeah.

Phil: The consumer cannot withstand high rates forever, but as long as the labor market's strong, they're certainly stronger than they would be otherwise.

Brent: And that could be potentially the impact of what the Fed is doing in tightening financial conditions. It's starting to impact the economy, which is what they're looking for.

Phil: Absolutely.

Brent: So let's shift gears and let's talk about corporations and what you can see on the left-hand chart. You can see S&P 500 debt to equity, right? So as it relates to the amount of leverage, as it relates to larger companies, while it is ticking up a little bit, we're coming from very, very low levels. And when you look at that right-hand graph, when I look at the amount of earnings before interest and taxes and look at that interest coverage on that debt that's out there, very, very robust coverage. So even though you have a little bit of a tick down, we're starting from a very resilient place as it relates to balance sheets for corporate America.

Phil: So if we have a recession, of course, corporate America is going to feel it, but the starting point does matter.

Brent: And so when we look at the next slide, Amy, and we look at the graph on the left and we look at aggregate last 12 months, sales and revenues for S&P 500 companies, look at those last handful of bars. Just incredible growth. And so even if I adjusted that for inflation, still well above the trend growth rate as it relates to revenues for S&P 500 companies. And then when I look at the graph on the right there, what I look at, last 12 months net income, look at that incredible recovery in net income of post the pandemic. It's almost too good to believe. And again, if I were to draw a trend line through that data series, well above trend as it relates to net income.

Phil: And you get a feeling some of those earnings were pulled forward.

Brent: Right, exactly.

Phil: Right. So, so let's talk about the next item and the five in focus, and that's the unknown. So, so, one, investors tend to be anchored by the present. I'm guilty of this. We all are. It's called recency bias. Where we sit tends to be where we think we're going to stay. And of course, unfortunately, is we're repeatedly surprised by unforeseen events. Coming into this year, look at where the 2-year Treasury yield was.

Brent: Yeah.

Phil: Was it pricing all these Fed hikes? No, it wasn't.

Brent: I expected a war in Ukraine and the turmoil that we have from a geopolitical perspective. You couldn't have predicted that unless maybe if you worked for the CIA or FBI, maybe you knew. But by and large, we're constantly surprised by unforeseen events that we can't predict. But I think the most important thing when we think about all this is that as investors, we have to keep a cool head because we've been dealing with a wall of worry for the last 50 plus years. So look at the events on this chart. There was always something that, in a vast majority of these, no one predicted these things to occur. But a long-term, thoughtful investor that stayed the course has seen their money compounded almost 11% rate for these greater than 50 years. So again, there's going to be something that comes up next year, maybe in '24, that none of us predicted. At the end of the day, it shouldn't really affect our broad policy in how we think about investing.

Phil: That's right. So let's turn to our views and what we're watching for 2023. So, so first, five reasons why you need to stay invested. We’re going to cover some of the positives out there in the marketplace. Secondly, we want to cover our S&P 500 price target, which is now a 12-month forward price target.

Brent: Exactly, and I think the other things that we're thinking about is we see much more balance, not only over the next decade but next year as it relates to the difference between stocks and bonds. And we're going to get deep under the hood as it relates to that. And something that we've preached all the time is diversification matters. We believe that diversification will matter very much in 2023 and the decade to come. And it's been a very volatile year, Phil, for both stocks and bonds. Just because the Roman calendar shifts from one year to the next, volatility doesn't magically disappear, and volatility tends to cluster. And we think volatility is here to stay for stocks and bonds in '23 and beyond.

Phil: So let's jump into reasons to stay invested. Well, there's one big, long-term reason we'll talk about it—

Brent: Right.

Phil: But some of the more micro reasons and we've talked about this before, so I won't dwell on it, but returns post-midterm elections tend to be pretty good. In fact, the 12-month return following midterm elections since 1950 have been positive in the lower right here, in every instance, not an enormous sample, but in every instance and up 15% on average. So there's something about getting past that uncertainty. Additionally, if you look at sentiment lows, right? So here we're just showing University of Michigan consumer sentiment lows. We hit a very low level last summer, have bounced back from there. We'll see if that low holds. But what's interesting is the old adage, you sort of buy when others are running for the door. If the average 12-month return, if you bought at sentiment lows, is almost 25%. The average 12-month return at sentiment highs, on average, is 4%.

Brent: Right.

Phil: So in other words, when everyone's feeling good, returns looking forward tend to be lower than when people are not feeling too great.

Brent: And it ties into what we've always been saying, Phil, is that the markets are an expectational pricing mechanism. They bid themselves up or down in anticipation of what's to come. Not exactly what's in front of us at the moment.

Phil: Right, and turning to reason number three, the Fed. Right? So 6 months following the last Fed tightening, the Fed hike, the end of a tightening cycle tends to really be a good period for markets. Now we aren't there yet.

Brent: That's right.

Phil: But there is reason to believe we're there at some point in the first half of next year. Markets, much like with the midterms, like getting past that uncertainty of a Fed tightening cycle.

Brent: Yeah, and reason four is likely going to be top of mind for investors, as we turn the calendar into 2023, because we've talked about the probability of a recession being 60% for next year. Many market participants believe that there could be a recession, you know, first quarter, first half, second half, it's all over the place as it relates to timing. But what we're looking at here is S&P 500 returns post-recessions. Let's focus on the 12 recessions that we have seen post World War II. On average, Phil, they've lasted about 10 months and the results for equities in a recession have been mixed. Fifty percent of the time we've seen a positive result, the other 50% of the time we've seen a negative result. Has been askew, when it's been positive, median observation has been positive 16.6% return. When it was negative, median expectation -1%, 1 and 1/2 return. So there is a skew there. But what I would focus on and what I think we've highlighted before with this slide is look at the returns for the S&P 500 1, 3, 5 and 10 years post-recessionary periods. You've seen performance being positive, 92%, 100%, 100% and 100% of the time 1, 3, 5 and 10 years post with very robust cumulative returns. So again, while we don't know what the outcome is going to be, if, in fact, we do end up in a recession, but post recessions equity markets have done very, very well.

So another reason, the fifth and final reason is something that we've covered all the time is, it is virtually impossible, Phil, to time markets. And what we're looking at with this graph here is the last 30 years of returns for the S&P 500 and, and there we're looking at a period of 1992 through 2021, which is roughly 30 years or about 7,500 trading days. And we are looking at a hypothetical $10,000 investment back in 1992. Had you invested in the S&P 500 and just sat with that over the last 30 years, you would have had almost 20 times your money. When you miss the 10 best days out of those 7,500, you ended up with less than half of that money. Truly incredible. And if you miss the 20 best, you're looking at almost 3/4 less. Right, so the important thing is that callout box. When I look at more, almost half of the S&P 500's best days occurred during a bear market. Another 28% of the S&P 500's best days occurred in the first 2 months of a bull market when nobody knew it was a bull market. You put that together, Phil, you're looking at 76% of the S&P 500's best days occurred when you'd likely not want to be an investor. So again, it's time in the market, not timing markets, that prove to add value for clients over the long term.

Phil: Right. So we talk a lot about micro reasons to stay invested. But in the end, this is the takeaway.

Brent: Exactly.

Phil: It's very difficult to time markets and staying invested pays off in the long term. So let's turn ahead to our price target here. One thing of note, we are rotating to a next 12-month price target that will roll through time. And in the past, we've had a year-end price target. The problem is, as you reach the end of a year, it becomes really—

Brent: You're forecasting a month.

Phil: It's not very valuable. So we're trying to keep it, our eyes on a 12-month forward. We're showing here a bear case and bull case. We'll emphasize the base case throughout the year, but wanted to show you a construct here. In the bear case, you're talking 3,100 on the S&P, base case 4,100, bull case 4,500. So that bear case, depending where the market's selling on a given day, something like 20% down from current levels, the base case is low to mid single-digit growth. So, so modest growth at best and bull case is a double-digit gain. But you'll notice there's more downside to the bear case than upside to the bull case.

Brent: That's right.

Phil: It's good old-fashioned asymmetric risk. We are facing a lot in this economy.

Brent: Yeah.

Phil: When you look at what's driving these various cases, we will not get into the details here, but you're really looking at earnings a couple of years down the road. And what you'll notice in the bear case, as you'd expect, earnings on net down, right, the multiple what's your price to earnings? What you're willing to pay for a dollar of earnings is lower, likely, in the bear case and the base case, some modest earnings growth after some initial revision growth down the road and the PE multiple stays basically in line. And the bull case is Goldilocks. That is where you get earnings growth, revision, very little revision

Brent: Those analysts are right, right?

Phil: Right, and growth beyond that. And then, of course, multiple expansion.

Brent: Yeah, and I think it's important when we look at the bear case here, you and I have highlighted this I think the last three or four WebExes, where we talked about valuation implied levels of support, where you look at earnings. Where they roughly are right now, are likely to end the year at about $224 per share. That average PE multiple that we've seen as range anywhere between 14 to 15 times. As you get to a low, mathematically, you work together. We've been talking about a level of between 3,150 and almost 3,350 for quite a while. In that bear case, again, if things were to not go right is right around those levels.

Phil: That's right.

Brent: So let's talk about one of our main views, which we believe that the balance between stocks and bonds is going to matter not only next year, but we think for the full decade to come. So let me unpack this a little bit more on the next slide, because you really have to see how truly incredible the decade that ended 12/31 of 2021 was. So to your point that you mentioned earlier, Phil, we saw unprecedented fiscal stimulus, more than $5 trillion. More than $5 trillion of monetary policy stimulus. In 6 of those 10 years, we are at the zero bound in Fed funds. Right, and additionally, we saw just incredible loose financial conditions. All of that came together to really drive risk asset returns. Over that decade, what is also very interesting is that inflation averaged 1.9% versus the long-term average of 3.2%, almost 40% lower inflation over that decade. When I looked at volatility, right. And if I look at something like the VIX index, which looks at the volatility of the S&P 500 implied, you saw volatility running at about 17.1 times versus the long-term average of almost 20. So much lower volatility. That created a Goldilocks environment where, for the decade ended, US stocks that we're talking about, large cap, mid cap and small cap all together annualized at an incredible 16.3%. To put that into perspective, the long-term average is 10.8%. So you're talking about annualizing at more than 50% per year above that long-term average. Taxable bonds did about 2.9%, so respectable but nowhere near where risk assets were. So if we roll all of this forward and we get a little bit more underneath the hood on the next slide and we think about expectations, let's talk about not just the level of returns for stocks and bonds. I want to talk about the difference between those two.

So when we look at the first thing that we just talked about, which is the decade just ended, 16.3% for stocks, 2.9% for bonds. When I look at that difference Phil, of 13.4%, that was in the top quartile of largest spreads between US stocks and US bonds that we've seen post-World War II. So just an incredible difference. Every percentage point or every dollar that you were in stocks versus bonds over the last decade mattered an awful lot. So let's take a look at what we might expect for the next 10 years. And this involves a little bit of explaining. What we're looking at here is consensus expectations of the top six firms out there over the next decade. Right, and I don't want you to focus so much on level. I want you to look at the difference between the two. But to get into that number, when I look at US equities at 7.6%, there's a handful of forecasters that are expecting US stocks to do 9%, 10%, 11%, and there's some forecasters that are forecasting 5%, 6%. So that variance, that gapping between what forecasters are looking at for the next decade for US stocks, is very broad.

Phil: Right.

Brent: But if you average them together, you're sitting at about 7.6%. For US bonds at 4.7%, the spread between the vast majority of forecasters is very, very tight, only about 0.2% between the highest forecast and the lowest forecast. So very, very tight. So if in fact, these forecasters are right, which we know there's a lot of variance as to what expectations are versus what actually happens, the spread between stocks and bonds over the next decade of 2.9%, if that were to happen, that would be in the top quartile of lowest spreads that we've seen post-World War II. So again, tale of two different environments, what we've seen and what we're expected to see. So if I then take this to the portfolio context and look at a hypothetical portfolio of an 80/20 stock-to-bond portfolio or a 50/50 stock-to-bond portfolio, again focusing on the decade that ended 12/31 of 2021, you can see an 80/20 portfolio of almost 14% and a 50/50 portfolio of 10%. First of all, in nominal terms, very robust returns regardless of what you had. But that spread between the two, you got almost 40% more being in an 80/20 portfolio than you did in the 50/50 portfolio. If I take what forecasters are looking at over the next decade, again, wide-ranging views, you can see that that spread between two portfolios is much, much tighter. Again, understanding that there's a big variance between what folks are forecasting.

Phil: And I think, you know, what I'm hearing is, is lower expected returns when trailing was 16.3%. That's pretty, that's a layup. Right, and tighter returns versus bonds and equities. I mean, maybe you could take a moment. This, of course, is conceptual, right? We're only using US equities and US AG bonds. It's not what our portfolios certainly look like and could vary from our portfolios.

Brent: Absolutely and when we're building portfolios for clients, you know, global multi-asset portfolios, that includes capitalization ranges, large, mid, small, value, core, growth, international exposure, satellite exposures, trying to build a thoughtful, diversified portfolio using our 3-year forward-looking assumptions to make sure that as things are happening, as we go over this next decade, to make sure that our clients are thoughtfully positioned. But again, the ultimate takeaway, do not focus on these levels of returns. Understanding to your point that the expected returns are going to be lower over the next decade for stocks, a little bit higher for bonds, and the spread between the two will likely be much tighter than what we saw over the last decade.

Phil: That's right. And speaking of that fixed income, as we flip ahead, unbelievably more expected return of fixed income than a year ago. So 2-year treasury, for example, is yielding 73 basis points at the end of last year, on December 7, at 4.26%. Look at the aggregate bond, 1.75 to 4.36%. So, Brent, you know, as you mentioned, saying that the spread between stocks and bonds is going to tighten is not a very controversial statement when bonds are yielding much more than they were end of last year.

Brent: Absolutely.

Phil: So let's turn ahead. That's sort of between return generating, risk managing assets. We also believe diversification within a balanced portfolio will matter more in 2023 and beyond. So in your sort of illustration, you were showing just US stocks and US bonds. But of course, there's a lot of asset classes outside of large cap US stocks.

Brent: It's funny, you and I have talked to so many clients and when we talk about the concept of diversification, everybody nods their head, yep, diversification makes sense. But when you actually go through life and you go through market experience, diversification, when it actually occurs, doesn't always feel good, right? So what we wanted to do is kind of give you a very long-term example of how it doesn't always feel good, but maybe it turns out the right way. So let's take a look at a period of time that starts all the way back in 2000 through 2002. Right, that was a technology, media, telecom bubble. The S&P 500, and let's talk about what we're looking at here. One, the S&P 500, you know, hypothetical investment in that index and then a diversified 60/40 portfolio, an underdiversified portfolio just to be illustrative here, just large cap and small cap, US stocks, a little bit of international and some core fixed income. In that period of time when the S&P 500 sold off, 37.6%, a diversified portfolio protected you, but you are still negative. So many clients are like, well, that's great. I'm glad I have diversification, but I still lost money.

Then you fast forward after that incredible bear market and you had a very robust period of growth from 2003 to 2007, where the S&P 500 did 83% and a diversified portfolio trailed the S&P 500 by a whopping 20%. And you could see with that little, you know, not so smiley face. I know I made money, but I didn't make as much as an investment in the S&P 500. Eh, I feel okay, but I'm not really happy. And then you have the Great Financial Crisis hits, and again markets sell off 37%. Diversified portfolio down 17.4%, eh, I had this diversification. I still lost money, Phil, what's going on? I don't really see the benefits that I thought that I could. And then again, post the Great Financial Crisis. When equity markets recover, we see one of the more incredible runs for the S&P 500 that we've seen in decades, where you see almost a 259% cumulative return for the S&P 500. A diversified portfolio trailed the S&P 500 by almost 100% and the client's sitting there going, geez, I didn't make as much money.

And then you have 2018 that comes, and the S&P 500 is down 4.4% and the diversified portfolio actually lost more than the S&P 500 and clients were really unhappy. I lost more money than the S&P 500. How can this diversification be beneficial to me? So if I pull this almost 20 years together and I geometrically link all this together, the total return over this period of time is almost 147% for the S&P 500, 166% for the diversified portfolio. So at the end of you not feeling good almost at any point in time in the cycle, you actually ended up with almost $20,000 more money in the diversified portfolio than that 100% stock portfolio. So again, diversification when it's actually happening in client portfolios, rarely feels good, but adds value over time.

Phil: That's right. So let's dig in to the S&P 500 and where we've stood and where we stand today. So first, we're looking at, it's called the cyclically adjusted PE ratio. It's a lot of words. We'll call it the CAPE ratio. This is basically a measure of a valuation, what price you're willing to pay for dollar of earnings, but earnings looking over a longer-term period. So this is sort of a smoothed ratio. What you'll notice is end of last year, how elevated it was, 38.6, not quite the tech bubble highs, but very expensive market. Now, this ratio is not a very good predictor of near-term returns. I guess it was coming into this year, but that's the exception. But longer term, if you flip ahead, Amy, it is a pretty good predictor of long-term returns. So here, if you plot cyclically adjusted to the CAPE ratio on the x axis and the 10-year annualized real return, this is real return on the y axis, you can see the more expensive you are, the lower expected returns. Now, that does not mean we're calling for a negative decade because we aren't. But lower expected returns in the S&P 500 are certainly something you'd expect given where valuation was at the end of last year.

Brent: And we highlighted this exact same thing back in our 2022 outlook.

Phil: Right.

Brent: As you showed in the previous slide, coming down from that, you know, second-highest level of all time, you would expect that as valuations fall, you would likely have, you know, not only volatility, but lower expected returns going forward.

Phil: That's right. And inflation plays a role, as you can see on the next slide. So we've been in this 1 to 2% inflation environment before the last year or so. We're moving likely to a 2 to 3 or 3% to 4% sort of trend inflation. Hopefully it's the 2 to 3 and not the 3 to 4. We'll see. Clearly, the days of just extremely low structural inflation might be behind us. And what you see here, as you look at that price-to-earnings ratio, the market tends to be cheaper, 2 to 3, 3 to 4, and by the way, happens to be about where the market is trading today. And it's around 17.4 times. This is sort of more return to normality. The exception to the rule, as you can see in these bars, is that 1 to 2. But there is reason to think that the extreme PE ratios we might have seen in years past are now moderating to more of a long-term trend level.

Brent: And I think it's a great tie-in because we're not looking for a cataclysmic decline in multiples to something significantly below where we are today to your point about normalized environment. So does that mean, Phil, that we should get out of stocks and be done with it? Because valuations were coming from a high point? We're going to continue to see volatility. Valuations are falling in. Multiples are falling. No, this lends itself to that point of diversification. And what we're looking at here is what a lot of investors will talk about when we talk about periods of valuations falling and expected returns falling. It's that lost decade that appeared that occurred from the end of 1999 for a full decade all the way through 2009. And what you can see on the graphic here is that the S&P 500 for an entire decade annualized at a -1%. But as you start to look at other asset classes, things like mid-cap stocks, mid-cap value stocks, small cap, small-cap value, non-US stocks, both developed and developing aggregate bonds all returned on average between 4 to 10% per year, more than the S&P 500. So again, it's not a case of saying, "Oh my god, this is over. Get out of US large-cap stocks." No, it's just adding diversification to the portfolio that can help. And as we look at where we've been this year, it might not feel good because almost everything up here other than inflation has a negative sign on it. But when you look at what's happened year to date with the S&P 500 being down about 16%, mid-cap stocks almost 5% better, mid-cap value stocks, almost 10% better. Same thing with small and small value. Even international stocks are now doing better than US large-cap stocks. And again, while it hasn't felt good in fixed income, fixed income still providing diversification relative to US large cap stocks. That diversification has already started, and we believe that not only continues into 2023, but will continue for the next decade.

Phil: That's right. And we mentioned, as we flip ahead, the concept of volatility and why we think 2023 we see continuation of recent volatility. So here we're showing percent of trading days in the S&P 500 with greater than a 1% move up or down. And you can see this year has matched previous highs. The other thing you'll notice is that volatility tends to cluster. In other words, you tend to see a few volatile years together. There are reasons to think that we have volatility next year. Why? Uncertainty around the Fed, uncertainty around inflation, geopolitical risk. So certainly we hope that's not the case, but we likely bounce around. So you look at something like our price target, the base case, let's say, it's very unlikely we just move to the base case in a straight line. What's more likely is we have downs. We might have some ups, we have some downs. What we do think is a bumpy ride to get there. And speaking of volatility, fixed income has certainly seen it as well. And as we flip ahead, as we mentioned, look, the worst year for the aggregate bond index back to the 1970s, we have on-record peak to trough a 17% down, certainly an outlier. We also had 2 consecutive years of declines in fixed income. That's the first time since the late 50s. And we have now, at least in the data we have seen 3 consecutive years.

Brent: Right, knocking alright.

Phil: And yields are up. That means expected returns are up. So certainly, hopefully that portends better return. But again, the volatility we have seen within fixed income is likely to continue as well.

Brent: And I think as we look to wrap up our views, I think first of all, number one, understand that we are constantly looking forward in the way that we build portfolios using our 3-year forward look ahead, constantly making sure that every single quarter we're reevaluating what to own, when and how much. So regardless of what happens, to your point, Phil, more volatility in either stocks or bonds, having more diversification in the portfolio and looking forward, not backward. We believe will put our clients on the right path for whatever the markets throw at us.

But at the end of the day, when we think about potentially more volatility or thinking about the unknown things that we cannot forecast or plan for, we think that for yourself, your family, your business, that planning should be core and centric to everything that you do. You really can't invest and build a portfolio unless you know where you're really going. So at the end of the day, whether it's planning for a rising interest rate environment, thinking about as we're heading into the end of the year, tax considerations not only for now but in the future. Thinking about your retirement planning, thinking about borrowing and using leverage thoughtfully, protecting your assets as it relates to insurance or the things that you need to consider if you own a business. We think all of that is going to matter a lot, not only next year but as we head into the next decade. So again, a lot to think about. Phil and I will constantly be bringing your views and insight every single month. But from Phil and I, we want to thank you for putting your faith and trust in us and allowing us to participate in your financial success, not only now, but in the future. So with that, Amy, let's wrap it up, and thank you so much, everybody, for your time.

Amy: Brent, Phil, thank you so much for sharing your thoughts on the year ahead. On behalf of all of us here at First Citizens as Brent mentioned, we want to thank you for trusting us to bring you this information. Your trust in us is something that we never take for granted. We hope you have a great rest of the year and we, and a happy holidays. And we hope to see you again in 2023.

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