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Market Update Winter 2023
The U.S. equity market and bond market simultaneously entered a bear market last year – an uncommon event. Behind both Bear markets are inflationary supply side constraints and government Fiscal and Monetary Policy mistakes. The Federal Reserve (Fed) is closer to the end of its rate tightening cycle, the fastest ever, aimed at slowing economic growth which in turn should lower inflation that reached a 40-years high. I think this Bear market ends when the Fed stops hiking the Federal Funds Rate (FFR) this quarter. Every Bear market is followed by a Bull market. Investors are very close to the shore…stay invested.
The S&P 500 nearly declined -20% in 2022%, the worst year since 2008. What does history tell us about the end to past Bear markets. History suggests a rebound is probable. Research by CFRA shows that after all 21 down years since 1945, the S&P 500 gained an average of 14.2% in the following year, 81% of the time. The stock and bond market signaling that inflation has peaked. S&P 500 returns are usually positive over the next 12 months after inflation peaks. Markets also have rallied based on the narrative that the Fed is nearing the end of its historic tightening cycle.
Markets were hit last year with the fastest tightening cycle on record. The Bear market low may or may not be in. That depends on further action by the Fed which would overtighten financial conditions in my opinion. Recession fears are ratcheting down but remain elevated. The economic impact of ultra-aggressive Fed tightening has yet to fully impact economic growth. It is touch and go whether or not there is a mild recession or a uncommon soft landing. If U.S. economy slips into a recession there could be a little bit more downside to the S&P. My downside level is 29% drop in price from S&P high was reached last year. It will be a V bottom this time as many long-term investors would buy at those valuation levels given a second chance. Also, the recoveries from smaller recessions have been quick.
The ISM Service Index and Manufacturing Index have fallen into contraction territory which suggests weakness in earnings growth this year. Analysts have sharply revised earnings projections and are becoming less pessimistic on future earnings. Many strategists are calling for a bottom in earnings contraction sometime in the first quarter. The S&P 500 Index tends to bottom around a bottom in ISM Indexes. When yields peak, stock indexes valuations stop declining, and analyst downward earnings revisions should stall. Analysts are still projecting earnings growth of 4.6% in 2023 according to FactSet. That only happens if the economy has a soft landing.
If U.S. economy does slip into a recession, it could be shorter-lived and less severe, based on the resiliency of the labor market. There are 1.7 job openings per every unemployed worker in the U.S. according to the U.S. Bureau of Labor Statistics. Moreover, today’s rates are not high enough to cripple credit growth. Consumers and businesses are still borrowing. Earnings may not decline as much as in a normal recession. The U.S. consumer is still spending. supported by a resilient labor market with jobless claims still relatively low. While slowing, and lower, there is continued job growth. Which is key because Consumer spending accounts for almost 70% of GDP. All bodes well for corporate earnings to shrink by a smaller percentage, about negative 5% in 2023 and not 15-20% which is more normal for a recession with ISM Indexes at 45 level. S&P 500 Index rises before a bottom in earnings. It also rises about mid-point in a recession. Given forward valuations for S&P 500 Index, I am buying investment grade bonds over S&P 500 stocks.
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