In this special occasion that is the new year, I want to look back on where did 2022 go so wrong and put forth my thoughts on how can 2023 go right.

What happened? How did we get here?

The seeds of 2022, the worst year since 2008, were planted in November 2021 when the Federal Reserve decided to end its easy monetary policy and started the most aggressive tightening campaign since 1970s. However, the Fed’s messaging was muddled by two things. First, the burst of the Covid omicron variant prompted the central bank to offer a less-harsh message to the markets. Second, the endless chatter about whether the Fed did too little or was too late (or both). Those kinds of arguments predominated investors' sentiment, and many were caught off guard.

Two major market events happened in 2022 as a result of the tightening campaign. One, we eliminated "froth": devaluation of speculative assets such as cryptocurrencies, non-profitable tech companies, trashy IPOs, and even companies with some earnings but simply not enough for the prices they were trading at. Two, we brought the market's multiple to historical average. Entering 2022, at the peak, the S&P 500 was trading at 22 times forward earnings. By the end of 2022, the multiple is now roughly 17 times. 

What do we do now? Sticking to our doctrine

The big takeaway from 2022 is that if a company doesn’t make things and do stuffs profitably, has a reasonable price-to-earnings ratio and returns capital to you in the form of dividends or buyback, they won’t work. 

That doctrine, which we started applying in late 2021, severely limited what could be owned. It cordoned off so many profitless entities, everything from enterprise software and electric vehicle start-ups to SPACs (special purpose acquisition companies) and anything crypto. 

Before the Fed started the tightening campaign, market was talking about measuring enterprise software companies by the Rule of 40 — a shorthand formula invented by Fred Wilson. Per this rule, if your company is growing at a combined revenue growth and profit margin of 40% or greater, it’s a good investment. It didn’t matter how you reached that level. The company could be growing at 50% with a minus 10% profit margin, or at 30% with 10% profit margin. As long as it all added up to 40%, the company was golden. The problem with that kind of analysis, which is really meant for venture capital investors is that there were too many companies that fit or almost fit the bill. The profitless companies today — like the dot-com stocks in 2000 — almost all disappointed and will continue to disappoint in 2023. That’s because they perform poorly in an inflationary environment and a tightening cycle that is ongoing.

Our doctrine holds that money losers don’t belong in your portfolio. Our doctrine holds that the alternate metrics that the bulls draft up to justify sky-high valuation: the price-to-sales ratio, EV to EBITDA, ... is of no value because we must now value companies by viability and growth. We can no longer assume that a company has time down the road to get to profitability.

A shrinking universe of stocks

What else does our doctrine eliminate? Cryptocurrencies. As we learned from the Sam Bankman-Fried scandal, not only does it carry risk from being part of a fickle and  rigged market, it also can’t be stored anywhere safe. There are hundreds of coins that have been made up, and they are all worthless and will be proven as such.

SPACs are also ruled out. They have been revealed as a comical exercise in finding businesses that could never be bought public because they are so bad. The whole concept of the blank check is repugnant. You would never give anyone a blank check, would you? No, you’d never be that trusting or stupid.

Our discipline rules out pretty much every enterprise software company. There are just so many. It’s painful to look at them all. These were the darlings since 2010, but keep in mind, interest rates from 2010 - 2020 were historically low. I am tempted to write that enterprise software is anything a regular person can’t understand. If they are profitless — and most are —  they've got to go.

The doctrine rules out most biotech companies — unless they make money. When the market lacked discipline, the brokers flooded us with biotech. These are poster child for speculations. They don’t make things or do stuff at a profit, they use a lot of money trying to find things that potentially may work.

It rules out most Chinese stocks, even on the cusp of the great reopening. The Chinese government reserves the right to turn on or off profitability. Plus, we don't really own any piece of these Chinese companies when buying them here. Yet the brokers keep recommending them. That’s because, unknown to most, they pay the biggest fees and are the best source of IPO profit.

Owning our mistakes in 2022

One of the mistakes we made in 2022 was keeping Salesforce (CRM) in the portfolio. The market was unduly harsh to software companies with big cash flow but also high price-to-earnings ratios. We thought Salesforce would be immune from the stock dumpster because it was profitable on an operating cash flow. Plus, we thought the company's business model was supposed to be recession-resilient. However, its forward P/E north of 40 was too high for a market that appears to be favoring only stocks that are closer to the 17 P/E that the overall market clocks in for 2023 estimates. And indeed, CRM was cut in half.

We also fell prey to the market’s shift in discipline with Advanced Micro Devices (AMD), a great company with a great CEO, but a stock with a high P/E north of 30. It just didn’t matter how smart CEO Lisa Su is.

Four predictions for the first half of 2023

The good news is that we have a winning formula as demonstrated by our winners. Let’s talk about five factors that are my worldview for the first six months of 2023. 

1. The Fed won’t pivot until it sees wage declines. This can’t happen until there are meaningful layoffs. At this point, inflation readings in terms of goods and services are just hindsight. The Fed will only budge until they see that unemployment goes higher, aggressive layoffs start to happen. So don't pay too much attention on CPI readings (although a CPI that goes higher than expected will certainly be bad for the market); rather, pay attention to employment and wage reports.

Credit card debt and defaults are indeed rising, and that’s something that’s worrying the worrying class. But that’s not a factor beyond the usual functions of the borrowing system. It won’t impact the banking system like the housing defaults in 2008.

2. Bonds are more attractive than stocks. Unfortunately, this is distinctively negative: The Fed will keep taking rates up to where CDs or Treasuries are more compelling than most stocks. Money will be exiting the stock market all year into the safer and somewhat greener pastures. Despite being a stocks guy, I don’t think you can go wrong with owning a 2-year Treasury, getting ~4% every year that will allow you to sleep without worrying about the rigorous criteria for picking stocks. There are a lot of loser stocks out there, probably more than 2022, including expensive companies in the S&P 500 — expensive on earnings estimates in a slowdown, which is the likely scenario. 

4. Companies with pricing power will win. In a deflationary environment that the Fed is furiously engineering, a company must have the ability to pass its costs onto consumers. Optimal situation are the drug stocks, which have no economic sensitivity and can keep raising prices. Dangerous situation are tech companies, which have became too many, and used to thrive on low interest rates which is no longer the case.

We want to stay invested in oils that will most likely continue to pay high dividends as long as oil remains above $70, even as their earnings may not be high enough to avoid estimate cuts. That’s what their P/Es of 6 to 9 tell us. 

5. Look for benefactors of Washington’s spending. Who benefits from the federal infrastructure money coming? Even though the bills have been hard-fought for and passed since 2021, that money is still up in the air. In 2023, the stock market is going to anticipate that money going to states and then contractors by the end of the year. 

These are reasons why we continue to own Caterpillar (CAT), and remain attracted to companies like Nucor (NUE), Deere (DE), United Rentals (URI), which are all winners in an infrastructure-driven economy. We often hear the saying "don't fight the Feds," but the Feds and Congress' spendings are not in the same league.

What to do

Now, the tough part. We know what went wrong in 2022. We know what to look for in 2023. Where does that leave us?

Let's talk tech stocks first. Alphabet (GOOGL) trades at 18 times earnings and the earnings are real, but based on a stabilization of advertising. That can’t happen until the slowdown ends. Call me concerned, but this must be the year that Alphabet has to rein in its costs in order to retain its earnings power.

Microsoft seems to be the most comfortable of the list simply because it is the best run and most likely to beat estimates. 

Advanced Micro Devices have experienced enough pain, as the P/E has come down from 40s in 2021 to 20 as of today. This means they think the earnings are going to be cut in half. I think a lot of risks have already been priced in to the semis, so it's a matter of waiting to hear when the inventory problem has been resolved. But you won't be able to catch that moment; the stock would have bottomed long before that.

In light of what I said, we need more infrastructure, which draws me to the 4 times earnings Nucor. That’s a pretty ridiculous P/E that reflects recession, but again, we have Congress' spending.

Where will the markets finish the year? That’s a parlor game not worth playing, as a fundamental investor. In the past month, every day you hear analysts come on air and talk about the first half of 2023 being tough, followed by a bright second half. In my experience, almost always the opposite will happen.