Wed. Feb 1st, 2023

5 surprising investing ideas for 2023

Key takeaways

  • Equities are my top pick by asset class for 2023, partly based on valuation dynamics that historically have pointed to better odds of upside than downside.
  • High-volatility stocks could outperform other equity groups for the year, based on the combination of low valuations and the past performance of high-volatility stocks in periods when leading economic indicators weakened.
  • Emerging-markets equities show the potential to be an outperforming region, provided the US dollar continues to weaken versus other currencies.
  • Mid-cap stocks may outperform large caps in 2023, since poor fundamentals appear to be largely priced in as of the beginning of January.
  • Materials—especially metals—look even better than energy at the start of 2023, based on supportive valuations and this industry group’s past performance in periods of weaker manufacturing data.

Conventional wisdom points to many reasons investors might want to stay cautious as we enter 2023, including an inverted yield curve, potential for recession, a hawkish Fed, a war in Europe, and a trend of earnings revisions to the downside. Added to this mix is continued uncertainty about the future rate of inflation.

While I’m cognizant of these and many other risks, my approach is to look at the market data through a historian’s lens. When I do this, I see most of the leading economic and market indicators that I track in continued decline. Historically, the lower these numbers get, the better the odds of a future market advance—not because the news cycle is improving, but because markets have priced in so much negativity.

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For this reason, I believe it’s too late to be bearish on the markets. At the start of 2023, I’m looking for bullish ideas by asset class, stock factor, market cap, region, and sector/industry group, searching for situations in which I believe fundamentals have heavily discounted a downturn. Based on this analysis, some of the best potential opportunities I’m seeing are among the badly lagging segments of 2022.

1. By asset class: Stocks could see upside

Staying the course in equities may be a prudent move in 2023, partly because valuation spreads—which measure the difference in valuation between the most-expensive and least-expensive stocks—looked historically wide at the end of 2022, recently reaching the top quintile, a level not seen since 2020 and only one other time since the Global Financial Crisis. Going back to 1990, this quintile produced a higher average return than any other.

Chart shows average next-12 month S&P 500 returns in quintiles. Chart shows that historically, when valuation spreads are in the top quintile, next-12-month S&P returns have averaged 19%.

Combo valuation spread measures the average percentile rank of the earning yield spread and the book yields spread. The spread is the difference between the 25th and the 75th percentile. Past performance is no guarantee of future results. All data measured monthly. Sources: Haver Analytics and Fidelity Investments, as of 11/30/2022.

Just as important, this valuation-spread quintile produced a higher risk-reward ratio—as measured by the upside-versus-downside range of outcomes—despite having the lowest odds of positive earnings growth.

Degrading earnings trends remain a worry for many investors, although perhaps they shouldn’t. A look at S&P 500 index performance going back to 1963 suggests that stocks rose 65% of the time over the next 12 months when aggregate earnings contracted.1 The lower the prior-year returns, the higher the odds of a market advance the following year. This is because stocks often discount bad news in advance.

When earnings trends degrade, multiples like price-to-earnings ratios often expand to cushion the blow. Once again going back to 1963, multiples expanded in 89% of 12-month periods when earnings contracted the previous year. At about 15 times forward earnings, multiples for the S&P 500 at the end of 2022 were in line with valuations seen in the past when earnings contracted the previous year. They did not look historically high.

Chart shows historical S&P 500 odds of price-to-earnings multiple expansion in quartiles of future earnings-per-share growth.

Past performance is no guarantee of future results. Analysis based on the price-to-earnings (P/E) multiples of the S&P 500 measured monthly since 1963, and arranged in quartiles of 12-month forward per-share earnings growth. Sources: Haver Analytics, Fidelity Investments, as of 9/30/2022.

Lastly, I see the 20%-plus move lower for crude oil prices in the latter half of 2022 as an encouraging sign for stocks in 2023. I believe this could result in improved consumer spending and, in some cases, lower costs, which have yet to be fully reflected in quarterly earnings reports. Going back to 1970, the S&P 500 index produced a 14% return, on average, in the 12 months following a 20% decline for the price of crude.2 Of course, energy prices also could rise from here. We’ll be watching energy prices closely all year.

2. By stock factor: Volatility could outperform

Higher-volatility stocks may be poised to lead if we see an upward trend for equities overall. Volatility hasn’t been a great factor to own over time. Over the long term, its returns have been roughly on par with the market, but with greater risk. That said, volatile stocks in the S&P 500 index rose after periods in which their valuations were especially low versus the broader market. Since 1991, when the volatility factor has been in the cheapest 40% of its historical range, it has outperformed the market by 3.6% over the next 12 months, on average.3

Many investors argue that it doesn’t make sense to buy high-volatility stocks, which tend to be cyclical (or economically sensitive), because leading economic indicators (LEIs) have weakened. This logic may seem persuasive, although it’s not consistent with history. When the year-over-year change in LEIs has been the worst—in the bottom 40% of its historical range— volatility has outperformed the broad market by 4.5% over the next 12 months.

Chart shows high-volatility stocks' next-12-month average relative performance after year-over-year changes in leading economic indicators.

High-volatility stocks are the top quartile of stocks in the S&P 500 based on standard deviation, measured monthly, since 1991. Relative performance is measured by quartile versus the S&P 500. Leading indicators are measured by The Conference Board Leading Economic Index. Past performance is no guarantee of future results. Sources: Haver Analytics and Fidelity Investments, as of 11/30/2022.

Higher-volatility cyclical stocks have also performed well following past periods of credit-spread tightening. Notably, option-adjusted spreads widened to a 2022 high in October, then narrowed later in the fourth quarter of 2022.

3. By market cap: A focus on mid-cap stocks

Mid caps present a potential opportunity with meaningful valuation support based on 2 different measures: Both the relative price-to-book and the relative price-to-earnings of mid-cap versus large-cap stocks are at bottom-decile levels not seen since the early 2000s.

Chart compares the Russell Midcap index to the top 200 stocks in the Russell 1000, showing median stock to median stock price-to-book and forward price-to-earnings percentile ranking versus history.

Past performance is no guarantee of future results. P/E is price/earnings and P/B is price to book. Data for each is measured monthly and compares valuations of the Russell Midcap Index versus the top 200 stocks in the Russell 1000 since 1990. Sources: Haver Analytics and Fidelity Investments, as of 12/15/2022.

The fundamentals of mid caps are currently, by any measure, worse than large caps, although this hasn’t mattered much historically, as mid caps with relatively poor fundamentals still have outperformed in many past periods.

Valuation has been much more predictive than fundamentals. Going back to 1990, each quartile of lower relative valuation versus the overall S&P 500 proportionally increased the odds for mid-cap outperformance versus large caps. At top quartile levels, the odds and alpha both look compelling to me. Said differently, the poor fundamentals look likely to be priced in.

Chart compares the Russell Midcap index to the top 200 stocks in the Russell 1000 index, showing average next-12-month relative performance in relative valuation quartiles based on forward price-to-earnings ratios and price-to-book ratios.

Past performance is no guarantee of future results. P/E is price/earnings and P/B is price to book. Data for each is measured monthly and compares the Russell Midcap Index versus the top 200 stocks in the Russell 1000 since 1990. Sources: Haver Analytics and Fidelity Investments, as of 11/30/2022.

4. By region: Watching emerging markets

Emerging-markets (EMs) equities show the potential to be a strong-performing region, depending on the relative performance of the US dollar, which began to weaken in November. It’s not my highest-conviction idea, but it’s on my radar.

A continued downtrend for the US dollar index, which measures the dollar exchange versus other major currencies, could help set the stage for EMs to outperform versus US large caps. This makes fundamental sense, as higher US rates and a stronger dollar tax the economic activities in emerging markets. A weakening dollar lowers this tax.

Chart shows historical MSCI Emerging Markets Index return relative to the S&P 500 since 1998.

Past performance is no guarantee of future results. Relative index comparison is indexed to 100 using weekly returns data beginning June 5, 1998, through December 2, 2022. Sources: FactSet and Fidelity Investments, as of 12/2/2022.

The chart above reflects that the last major downtrend for dollar strength, starting in roughly 2002, set the stage for a multiyear trend of outperformance for EM stocks versus the S&P 500 that carried through the Great Recession. EM stocks then underperformed for more than a decade, corresponding with a strengthening dollar.

Another reason to watch for this possible change in the relative trend is that Fidelity’s Asset Allocation Research Team believes emerging markets could see the highest real (inflation-adjusted) return potential for any public market asset class through 2041, driven by superior economic growth and better starting valuations.

5. By sector: Materials could shine

Energy stocks over the past 2 years enjoyed a run superior to every other sector in any other 2-year time frame going back to 1962. The trend may continue to be energy’s friend.

From my perspective, the materials sector looks even better at the start of 2023. Much like energy, materials stocks appear cheap based on price-to-earnings and free cash flow at the start of the new year. Yet unlike energy, supportive valuations could offer strong potential for alpha in certain segments, even if margins decline.

Chart shows metals and mining relative performance in various valuation quartiles and deciles since 1976.

Past performance is no guarantee of future results. Relative performance is measured using a list compiled by Fidelity Investments that seeks to include the top 3,000 stocks in the US by market cap since 1976. Metals and mining stocks within this list of 3,000 are then compared with the entire list. Valuation measured by relative forward price/earnings. All data gathered monthly. Sources: FactSet and Fidelity Investments, as of 11/30/2022.

For example, at the end of 2022, valuations in the metals and mining segment within materials traded at bottom-decile price-earnings valuations. Going back to 1976, metals and mining stocks in the bottom decile produced a 12-month rolling relative return of 14.5%, on average, far better than any other quintile.

Conclusion

Many professional investors see the S&P 500 closing lower at the end of 2023. It’s possible that the S&P 500 could still breach lows set in the fourth quarter of 2022 and experience meaningful volatility over roughly the next 12 months. It’s also hard to rule out a hard landing for the economy.

That said, the level of pessimism I’m seeing and the historical market response when I’ve seen a similar amount of pessimism has encouraged me to look opportunistically for bullish opportunities. I believe looking at specific segments with historically low starting valuations could increase the chances of positive returns in 2023, and I plan on keeping an eye out for these types of opportunities for much of the year.

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She uses history to share probability analysis on the US equity sectors.

SOURCE https://www.fidelity.com/learning-center/trading-investing/five-ideas-for-newyear

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