2022 was a challenging year in the US markets, and we are thankful to have performed well for our investors. Despite the broad market’s steep decline, we are pleased that a majority of the SG Capital Management strategies posted positive performance in 2022, and all SG Strategies handily beat their benchmarks. Our risk management successfully provided capital preservation during the downdrafts, while our individual stock selection drove the gains in our portfolios. Our strategies were resilient in 2022, and December was another great example.
Our focus on bottom-up fundamental analysis led to the alpha contribution we achieved throughout the year. We believe the fluid market and fundamental environment continues to favor our active management approach, and we are hopeful that we can continue to post strong results in 2023, regardless of the broader market performance.
2022 BIG PICTURE MARKET ENVIRONMENT:
US equities suffered some of their steepest losses since 2008. The simultaneous collapse of both the stock and bond markets was likely the result of the Federal Reserve’s aggressive policy to fight inflation. The US Federal Reserve, along with central banks around the world, issued an unprecedented series of large interest rate hikes in attempts to combat stubbornly high inflation. The high CPI and PPI numbers were likely fueled by an economic recovery driven by accommodative monetary and fiscal policy, a surge in oil prices and other commodities, as well as supply chain disruptions that resulted from the 2020 Covid crisis.
The sustained 2022 downdraft was speckled with bursts of investor optimism, but the few sporadic market rallies were fleeting. Through the second half of 2022, both increasingly negative economic data and positive indicators of peaking inflation drove flashes of investor hope that the Federal Reserve would have to pivot from its aggressive interest rate hikes. However, as the Fed restated its commitment to hold interest rates high, concern mounted in the fourth quarter over a seemingly inevitable recession and a deteriorating corporate earnings outlook.
LOOKING FORWARD: ENTERING 2023 CAUTIOUSLY OPTIMISTIC
Fundamentals were resilient in 2022, but we do not think this will last into 2023 as financial conditions continue to tighten and global demand weakens. Consumers and corporations are poised to cut discretionary spending. In 2022, companies had pricing power, and could pass higher prices along to customers which boosted overall sales growth and profit margins. However, as demand weakens, we believe additional price increases will be difficult, and sales growth for many industries will be pressured.
Through the third quarter of 2022, corporate earnings were relatively healthy, providing some support for stock prices. While the earnings for the S&P 500 companies only fell 1.2%, the index ended the year down -18.11%. The S&P 500 P/E multiple started the year 21.3x and ended at 17.4x as the risk to future earnings became discounted, and higher interest rates increased discount rates. The multiple that investors were willing to pay for future earnings accounted for 95% of the Index’s decline. Meaning, the stock market losses were driven primarily by multiple compression and not earnings deterioration.
Going into 2023, P/E multiples are more reasonable than a year ago, but we think earnings have more downward revision risk. Interest rates, inflation expectations, and Federal Reserve policy could continue to drive P/E multiples in either direction in 2023, while we believe corporate profit estimates will generally be revised lower through the year. We think it’s likely that management teams in many industries will set a lower bar for profits in the upcoming earnings season. Our job will be to determine if the bar was set low enough as we move through the year.
We are optimistic heading into 2023. Similar to the last few years, we believe the current environment favors our fundamental focused investing style. As companies have been plagued by unprecedented macro and geopolitical shocks, it has been difficult for them to accurately predict both demand and costs. The result has been greater earnings surprises as management assumptions have been wrong. This is an optimal environment for us as we take advantage of the inefficiencies that are created by this fundamental business volatility.
As economic conditions have changed for the worse, our research effort is more focused than ever on balance sheets and competitive advantages. Higher interest rates and slower demand can separate companies that are well managed from those that have weak balance sheets or poor market share positions. We believe this environment creates a more favorable backdrop for individual security selection, SG Capital’s specialty.