After the S&P 500 posted a 19% drop in 2022, the first down year for the index since 2018, investors are rightfully worried about what the current year will bring. Inflation is still high, interest rates are still going up, and an economic downturn is a real possibility. There must be a way to prepare for what might come.
It starts with thinking about potential downside scenarios in the near term. The smartest investors are always aware of what factors are most pressing for markets and the economy at any given time. Here are three of the biggest risks the smartest investors know about in 2023.
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1. Pay attention to the Federal Reserve
First on the list of the most important things investors should be aware of is what the Federal Reserve does. The U.S. central bank is not only tasked with keeping unemployment low, but also with keeping prices across the economy under control.
With inflation at historically high levels since the middle of 2021, the Fed has had to aggressively hike interest rates starting last year to restore balance between supply and demand.
If we've learned anything over the past decade, it's just how influential the Fed is to investor sentiment. Investors have begun to appreciate loose monetary policy, because it can stimulate economic growth and boost asset prices.
Between the start of 2012 and the end of 2021, the S&P 500 increased at a compound annual rate of over 14%, far higher than its historical average of 10%. Much credit goes to the Fed's low interest rates and significantly expanding its balance sheet.
If inflation remains elevated, especially above the Fed's 2% target, then expect interest rates not to come down anytime soon. And this could pressure stock valuations, something investors need to keep in mind when allocating their portfolios and deciding what companies to own. But if the opposite happens, and inflation continues to cool down, markets could indeed march higher throughout 2023.
2. Prepare for a possible recession
Higher interest rates have sparked expectations that the U.S. will enter a full-blown recession this year, if we're not already in one. Businesses are cutting costs and laying off employees, revenue growth estimates are muted, and consumer confidence is depressed.
In a recession, it's likely that corporate earnings will be hit hard. We've already begun to see this with the recent financial reports of major banks, often seen as economic bellwethers. While JPMorgan Chase and Bank of America saw single-digit gains on the bottom line, Goldman Sachs, Morgan Stanley, and Citigroup all posted double-digit year-over-year profit declines.
When economic uncertainty is sky-high, and a recession -- whether mild or more severe -- is a real possibility soon, the best course of action is for investors to properly prepare their portfolios to better protect against downside risk. This means looking for companies that are resilient and recession-proof, as opposed to ones that are unprofitable, speculative, and saddled with debt.
Warehouse club operator Costco Wholesale immediately comes to mind here. This massive retailer is beloved by its customers thanks to its intense focus on keeping prices as low as possible. And when consumers need to stretch their dollars, it's not hard to believe that Costco's demand should remain healthy.
3. The housing market is cooling
As I mentioned earlier, interest rates have gone up, and with them, mortgage rates as well. The average 30-year fixed-rate mortgage is at 6.15%, the highest it has been since November 2008 (excluding a few months ago when it went above 7%). This obviously makes it more expensive to finance a home purchase.
With that being said, another important risk investors shouldn't ignore is the cooling housing market. According to data provided by real estate brokerage Redfin, the median home price in the U.S. has declined in every month starting in May last year. What's more, the number of homes sold in the month of December was down 37% year over year.
There isn't just the contagion that could occur if these mortgages go underwater with declining home values, leading to higher foreclosure rates across the country; the impact could extend into the overall economy.
That's because of something called a wealth effect, where households that feel richer tend to spend more. On the flip side, lower spending could be a major headwind for companies.
And as home values depreciate, households might liquidate their equity holdings in order to finance purchases. The result would be further downward pressure on stock prices.
