The Week Behind

Without any news or headlines, the majors ended last week flat to slightly negative. The DOW lost 0.17%; the S&P 500 skimmed ~0.14%; the NASDAQ stumbled ~0.30%. 

Highlights

• The S&P 500 narrowly avoided a down 20% year, closing down 19.44%. 
• The DOW was this year’s relative outperformer, ending the year only 8.78% lighter. 
• The NASDAQ was the laggard amongst the majors, losing 33.10%. 

Perspective: The New Hurdle Rate

The US 1-Year Treasury (US1Y) closed the year with a yield of ~4.7%. In other words, the short-term, risk-free rate is 4.7%. Stocks are risk-assets. To compensate for that risk, a stock’s expected return needs to be above 4.7% before becoming attractive. Otherwise, your money is likely better suited in the US1Y. In my view, it should be considered the hurdle rate. If an investment is unlikely to beat the hurdle rate, then it probably makes sense to move on to a different opportunity or buy treasuries. According to CNBC’s Market Strategist Survey, the range of 2023 S&P 500 year end targets is 22%: the widest in years. While I do not put much stock in these targets given their tendency to change as price changes, the fact such a disparity exists at the start of 2023 suggests the only certainty is uncertainty, which adds to the attractiveness of 4.7% guaranteed.

The Week Ahead 

The first week of 2023 is macro-focused. This week’s reports have the influence to set the tone for the whole month of January. On Wednesday, the FOMC minutes from December’s meeting will be released alongside job openings and quits for November. On Thursday, the ADP employment report as well as initial and continuing jobless claims hit the wire. While all of this data is likely to move markets, Friday’s nonfarm payrolls report will be the main event. If we get bearish news Monday-Thursday, Friday’s data has the potential to turn the tide. Of course, the opposite is also true. Payrolls will provide an updated look at the unemployment rate, which the Fed is using to guide monetary policy. Last month, unemployment was 3.7%. For the Fed to pause, unemployment needs to tick up. This is a “bad news is bullish” report. There is a running hypothesis that layoffs announced in the 4Q22 will finally start appearing in the data because companies opted to wait until after the holidays to go through with them.

Otherwise, we need to be privy to the possibility Apple (APPL) pre-announces a bad quarter due to the complications in China. Selling pressure in AAPL could spread to the rest of the market.

Picks: Top ETFs for 2023

It needs to be noted that these picks are not reflective of any individual’s unique financial position or goals, not even my own. I based my picks on having the best opportunity to outperform across a wide range of economic outcomes. There are more ways for these ETFs to win than lose.  

RSP – Invesco S&P 500 Equal Weight

The S&P 500 ended the year trading at ~18.6x trailing earnings. Until the Fed pauses, there is risk of continued multiple compression. Information technology, which tends to feature the highest multiples and thereby be the most at risk, holds the largest majority in the S&P 500 at 26.40%.    

On the other hand, RSP, trades at ~15x trailing earnings. With only a 14.75% exposure to information technology, there is less multiple compression risk relative to the traditional market-cap weighted version. RSP also has a larger exposure to industrials and materials. Two sectors I think will outperform in 2023. Finally, RSP’s dividend yield is 16 basis points above the S&P’s: 1.81% versus 1.65%. Concisely, I think RSP provides better downside protection and upside potential relative to the S&P while simultaneously paying you more to wait. 

I am long the RSP.

ITA – iShares US Aerospace & Defense ETF

Despite congressional division, defense funding is one of the few areas with bipartisan support. Even if the war between Russia and Ukraine ends in the next few months, earnings across the sector are well-insulated from any slowdown:

• European NATO members will fund defense budgets above pre-invasion levels for the foreseeable future.
• NATO munitions across a wide spectrum of military equipment are at historically low levels and need to be replenished.
• The U.S. has made it an imperative to narrow the gap on hypersonic missile technology with China.

As investors look to avoid the earnings collapses associated with economic slowdowns and recessions, the defense sector comes to mind due to the high margin of safety surrounding their earnings relative to other sectors. That being said, ITA’s earnings security is no secret. Many names in the sector trade at an elevated multiple. Consequently, the ITA does as well. This is an ETF to accumulate during broad sell-offs because chances are that ITA is being incorrectly thrown out with the sell-off’s bath water.  

I am neither long nor short the ITA.

IBB – iShares Biotechnology ETF

Healthcare is non-cyclical: profits are not directly correlated to economic activity. Consequently, investments in healthcare are less-likely to be affected by earnings cuts or misses if the economy slows.

With respect to healthcare, I feel we are on the precipice of a variety of breakthroughs in weight loss medication, vaccine technology, and Alzheimer’s treatment. Each is a multi-billion dollar breakthrough. Personally, I find biotech companies much harder to evaluate. Majority of their performance is related to meeting FDA milestones. IBB provides good protection from the blow-ups and good exposure to the glow-ups. It is an interesting opportunity to add growth to a portfolio without risk associated with economic activity. From a technical perspective, this is the first time the IBB has had two consecutive years of negative price performance. I doubt it tallies a third. While past performance is not indicative of future results, statistics err on the side of IBB having a positive 2023. 

I am long the IBB.

ILF – iShares Latin America 40 ETF

If you believe the dollar has peaked, then you should consider emerging markets. I prefer Latin America to Europe, Asia, or Australia. Broadly speaking, Latin American central banks are ahead of the rest of the world with respect to interest rates. The Bank of Brazil has been raising rates to combat inflation since January 2021, long before the rest of the world caught on. In August, the Bank of Brazil paused at 13.75%. They started at 2%. There is concentration risk. ILF is heavily weighted to materials and financials, 27% each. However, materials will benefit from the falling dollar and China’s reopening; financials will benefit from 13.75% interest rates. The ILF has a 12.6% dividend yield and trades at ~4.5-5x trailing earnings. Solid yield; justifiable valuation. Years for emerging markets outperformance relative to the US are few and far between, but I like the setup for ILF.     

I am long the ILF.