It may be difficult to remember, but at the beginning of last year global financial markets were in a bullish mood. Equity markets and bond markets were close to all-time highs. Real estate, private equity, these asset classes too were trading on valuations at or close to their highest levels in history.
Then came a series of negative surprises through the year: continued rises in inflation to the highest levels in four decades, war in Ukraine, an energy price spike (most notably in Europe), COVID lockdowns in China.
When optimistic expectations (reflected at the start of last year as high asset valuations) met a series of unexpected negative events, asset prices declined and volatility increased. This process reflected the mis-match between what the market thought was going to happen vs. what actually happened. That was the story of last year, a bear market for stocks and bonds, as asset prices started off too high relative to what actually then transpired in the real world.
When we look at the starting point for investors this year, it’s a very different story. Expectations have been reset much lower over the past year (reflected in asset markets by lower valuation levels today).
Inflation is known to be high and is actually now falling in many parts of the world. Energy prices have declined from their peaks last year. Energy costs in Europe are coming down. China is reversing its COVID lockdown policies and re-opening its economy.
Could 2023 end up being defined as having started with pessimistic market sentiment (reflected in lower asset valuations) which then met a reality that was better than expected. The polar opposite of 2022. Lower asset valuations meeting better than expected outcomes, all else equal, results in prices of assets rising.
The balance of expectations and valuations at the start of this year is much more in our favour as investors than was the case at the start of last year. Market expectations today are much less optimistic than they were this time last year.
The lower your starting valuations for assets, the smaller the price declines will be from each incremental negative surprise, and vice versa, the higher the price rise will be from each new incremental positive surprise.
If your starting position is one where market sentiment is overly pessimistic, this increases the probability of positive surprises.
Identifying a moment of overly pessimistic sentiment in markets correctly can therefore be very rewarding for an investor willing to commit to buying assets and thus benefitting from subsequent price rises as those positive surprises roll in.
This begs the question: Are we there yet? Is market sentiment today overly pessimistic, thus creating the opportunity to buy assets and benefit from the asymmetry in positive vs. negative surprises to expectations?
For markets as a whole, we would argue: not yet. We continue to think we could see tests of new lows for stocks in the first half of 2023.
But in some sectors, asset classes, and individual stocks, we are there now. In those specific cases, valuations and sentiment are too pessimistic and offer the opportunity to take the other side as an investor.
This means now is the time to be buying those assets, and to continue buying through 2023. We think some areas of the commodity sector, especially those linked to climate change mitigation, offer such opportunities. Emerging market value is another one.
We have been cautiously but steadily buying into specific sectors and stocks we see as offering this opportunity, the opportunity to, as Warren Buffett puts is, be greedy when others ae fearful.
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