The Cautiously Optimistic Bull Case for 2023
2022 was an extremely challenging year for the overall markets. A slew of macroeconomic headwinds plagued the markets as persistent inflation, supply chain constraints, China Covid lockdowns, widespread inflation and the Russia/Ukraine conflict roiled investors. In the backdrop of these major macroeconomic issues, the Federal Reserve made a sharp and abrupt pivot in its monetary policy. The Federal Reserve transitioned from an easy, highly accommodative stance to a prohibitive and highly restrictive monetary policy shift throughout 2022. The Federal Reserve deployed four consecutive 75-point rate hikes followed by a 50-point rate hike to close out the year and combat runaway inflation. Collectively, the Fed raised rates by 400 basis points in 9 months.
As a result, the strength of the U.S. dollar soared and drastically reduced the earnings profile of multinational companies and wreaked havoc on richly valued technology companies. During the aggressive rate hike cycle of 2022, all equities were laid to waste and valuations were meaningfully reduced across all sectors. Pockets of transient sector strength sputtered, and no sector was immune from the carnage that resulted from the magnitude and rapid pace of rate hikes. These negative macroeconomic inputs culminated in extreme market volatility with steep plunges and pockets of parabolic moves higher with an overall negative downward trend throughout 2022. As 2023 is underway, let’s look at the set-up, evaluate the battle on inflation and propose the cautious bull case for 2023.
2023 Set-Up and Overly Bearish Sentiment:
Wall Street has bleak expectations for earnings growth for 2023 of just 4% for the S&P 500. This 4% projection is the lowest forecast over the last 35 years per Deutsche Bank. This bleak forecast is interesting as there’s been several years over this 35-year period where earnings actually contracted into negative territory. Despite negative growth rates in some years over this timespan stocks did not decline in 1998, 2012, 2015 or 2020 (Figure 1).
In addition to this bearish outlook, bears have exceeded bulls for 40 straight weeks in the AAII retail-investor poll for the first time ever, active managers in the NAAIM positioning survey showed an historically low 39% equity exposure in early January of 2023 while the final weeks of 2022 saw heavy flows out of equity funds.
From a valuation perspective, the start to 2023 is much more reasonable at a ~17 P/E (at the 20-year average) than it was at the start of 2022 at a 21 P/E. This step-down function in valuations doesn’t necessarily translate into stocks being cheap. However, when stock prices fall and valuations compress, risk is removed from the markets. When markets become de-risked, the potential for future gains is certainly enhanced.
Figure 1 - S&P 500 earnings per share growth predictions at the start of each year. 2023 marks the lowest consensus estimate over the past 35 years of data.
Inflation Battle Over?
Inflation has come to a screeching halt and has been falling for months in some areas such as cars, gasoline, shipping, commodities and housing. The Federal Reserve has put through substantial rate hikes to combat inflation and ostensibly has inflation concern has been resolved. This makes a compelling case that the Fed can stop raising interest rates.
Per Jeremy Seigel, the market has rallied so far this year because investors see signs that inflation is coming back down. He said the most recent CPI reading for December was a data point that could be taken, with some tweaks, to show inflation is a problem for the country that has been “solved.”
CPI, which measures the prices of a broad basket of goods and services, fell 0.1% for the month but was still up 6.5% from the same month a year prior. “Core” CPI, which measures the same basket with the exception of food and energy, rose 0.1% from November to December and was up 5.7% from a year ago. Both readings came in line with Dow Jones expectations.
Seigel pointed specifically to rent as a lagging data point within the CPI composite and highlighted other data such as rental indexes showing housing costs have decreased. With that declining figure calculated in place for rent prices, Seigel found “core” CPI actually should have fallen for the month as well. Core inflation is what influences the Fed’s decisions the most.
Because of that, he said it’s clear the Fed does not need to implement further interest rate hikes. He said December’s 0.5% hike should be the final increase, but he’s “not gonna quibble about 25 basis points,” “The market knows better than the Fed what is actually going to happen,” Siegel said.
There’s a compelling bullish case for stocks for 2023:
The market bottomed in October, the most common month for bear markets to expire, just ahead of a midterm election, which history says ushers in the best year of the presidential cycle.
The market low came on the heels of a bad CPI report but the kneejerk sell-off immediately reversed course as the market concluded that inflation had peaked.
Since October, the S&P 500 is up ~20% while the US Dollar Index plummeted by over 10%, a tailwind for international companies translating their currency back into US dollars.
The Volatility Index has been stable for two months and closed mid-January at its lowest level since just after the market peak, an indication that the market may be gaining its stability footing.
The overly negative sentiment coming into 2023 was some of the most bearish readings for earnings and economic surveys in decades. From a valuation perspective, the start to 2023 is much more reasonable at a ~17 P/E (at the 20-year average) than it was at the start of 2022 at a ~21 P/E. Markets are reaching an equilibration with abating Federal Reserve hawkishness, declining CPI numbers, increasing unemployment, weakening housing market, softening labor market and cooling inflation.
Despite a challenging 2022, markets appear to be normalizing and can appreciate higher over the long term. The 2022 bear market is on par with historical bear markets in terms of duration, breadth and depth of the sell-off. As such, the 2022 bear market is likely reaching its terminal stages as 2023 unfolds and coupled with the evitable dovish Federal Reserve policy shift, markets can appreciate higher in a meaningful way. In short, a cautiously optimistic bull case is compelling for 2023.
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