Stocks finally rallied yesterday after a 4-day decline that reached 5% bringing equities back toward fair value. Bond prices fell sharply for the second straight day in reaction to a surprisingly aggressive move by Japan’s central bank. The U.S. 10-year Treasury yield has now risen a full quarter of a percentage point since its low immediately after the FOMC meeting last week. Bitcoin and other cryptocurrencies continue to struggle. Last night’s good earnings report from Nike should add some energy to the rally again this morning.
With only a handful of companies scheduled to report earnings between now and the end of the first week in January, investor focus will move toward what might be expected in 2023. Over the near term, the last week in December is normally a good one for stocks. Hedge funds are generally pretty silent having locked in results for 2022. Tax selling is largely complete. Bargain hunters will dig through the carnage left from stocks performing worst in 2022 seeking to find a diamond in the rough left by tax sellers.
Looking beyond next week, January’s moves in the stock market often serve as a precursor for the year, something once labeled the January barometer. Statistically, it has a slight upward bias, but not one with serious statistical significance. With that said, stocks that underperformed in 2022 and continue to act poorly in January should be avoided until a supportive bottom is found.
Last year, at the start of the year, inflation was starting to surge. The Fed was ready to discard the word transient when describing inflation. It has preannounced, all the way back to the late summer of 2021, that it was winding down its QE program and would start to raise interest rates in March. Stocks began to fall around the start of the year fearing the impact of tighter monetary conditions. That fear proved well founded, at least as it pertained to interest rates. They rose far faster than perceived. By June, leading averages were down 20% or more. The NASDAQ’s decline was closer to 30%. Despite the rise in rates and the stock market’s weakness, the economy continued to grow throughout the year. Excluding short-term impacts created by changes in quarterly inventory levels or trade balances, growth throughout the year was in the 1-2% range in real terms. If there was to be a recession, it didn’t happen in 2022.
The outlook, as we enter 2023, is a bit different. Recession fears remain. The Fed is well along in its program to raise the Fed Funds rate. It is now at 4.5%. With inflation now coming down, it won’t be long before the Fed Funds rate exceeds the rate of inflation. Few can borrow at that rate. For most, short-term borrowing costs are now 5-10%. Borrowing is no longer free. With a real cost attached to borrowing, investment spending is almost certain to decline, partially offset by any actual funding emanating from the infrastructure bill passed by Congress in 2021. Economic growth will erode. However, both consumer and corporate balance sheets remain in fine shape. Unemployment is still well under 4%. Until fears of job security rise or consumers spend down their Covid savings completely, the economy is likely to remain resilient. With that said, there has been a change in behavior in recent months. Consumers are spending but they aren’t splurging. Corporations are yet to lay off workers in any significant numbers, but they are much more reluctant to hire. Given the difficulty over the past several years to find good skilled workers, companies are hoarding talent, but that won’t continue if revenues start to fall. If that happens, layoffs will be the only choice.
Thus, last year investors viewed both the bond and stock market negatively at the start of the year. Most of the ultimate pain was felt in the first half of the year. The major exception was in the technology arena. The large tech companies that dominate the top of the S&P 500 entered the year believing that no matter what the overall economy was doing they could continue to grow at a much faster pace than the overall economy. But, one by one, they hit a brick wall labeled maturity. Look at social media. Its primary revenue source is digital advertising. For decades, it grew taking market share from newspapers, TV, radio and billboards. In 2022, platforms like Facebook found out there wasn’t much market share remaining to take. Then along came Tik Tok, another platform crowding into its space. It hit that brick wall. To a lesser extent, so did Google. Meta Platforms#, the parent of Facebook, and Alphabet#, the parent of Google responded by expanding spending for new ventures that hopefully will ignite future growth. But things like the metaverse and autonomous driving are still years away. Whether their ventures into these arenas will ever be profitable is still a question mark. With capital costs rising, and stock prices falling, investors frowned on unlimited spending. Both stocks got crushed. By year end, the focus shifted to Tesla. Before the end of 2023, virtually every major car manufacturer will be making and selling electric cars. Tesla still makes the most technically advanced vehicles but it is destined to lose market share. To date, it has sold every car it could make, but wait times are falling. Soon, the company will have to spend on marketing. It may have to drop prices. Even with its stock down 2/3 from its all time high, it still sells at over 30 times next year’s earnings. Markets in a higher interest rate environment aren’t willing to speculate on exotic new battery technologies or the future value of autonomous driving. Meanwhile Elon Musk is wrapped up with Twitter’s issues, selling some of his own Tesla shares to fund his other ventures.
The top of the S&P matters. Tech companies (including some now labeled as communication services or consumer discretionary) still comprise about 30% of the S&P 500. That’s down from 38%, but still dominant. The S&P 500 isn’t going to surge anytime soon without support from Apple#, Microsoft#, Amazon# and the other companies I just named. While none are completely mature, all are experiencing a secular decline in their growth rates. Slower growth and higher interest rates are a toxic combination for stocks. Hopefully, for these companies, most of the pain is in the rear-view mirror. However, there are few signs the correction process is complete.
In time, new darlings will appear. If you look at the top of the S&P each decade, it changes dramatically. Sometimes even older names make a resurgence. Exxon is now a top 10 company once again. Some of the top 10 companies 20 years from now aren’t even born yet, but there is still space for venerable names. Berkshire Hathaway#, Procter & Gamble#, Johnson & Johnson# and JPMorgan Chase# are all in the top 15. In a race between the tortoise and the hare, these might be the tortoises, but over time they will have to share the podium with lots of hares. Some will be companies already there. Some of today’s giants will fade. Look at Intel’s recent past, for instance. Names like Kodak and Xerox are distant memories.
Back to 2023 overall, most of the damage to stock prices from rising interest rates has been done. With inflation and growth both destined to fall in 2023, it may prove unlikely that the 10-year Treasury yield will exceed 4.2% as it did in October. Thus, the focus is shifting to earnings. If growth moderates, earnings can probably hold near current levels. If a recession occurs, earnings have downside risk relative to current expectations. Either way, investors should see clarity to the future economic path by mid-year. And so should the Fed. If the economy continues to hang in around where it is now and inflation is fading slowly, the Fed is likely to follow the path just described by it last week, keeping rates around 5% as unemployment slowly increases. However, should growth fade into recession and/or inflation declines at a more rapid pace, the Fed could stop raising rates as soon as March. By fall, should a recession occur and slack returns to the labor market, a small cut in rates might even happen.
Stock prices foresee the future. They should bottom when interest rates peak. That means sometime in the first half of 2023. Because this recession has been the most advertised in history (Powell starting warning in August 2021!), stock prices have already discounted much. Whether the pain is fully discounted or not is unknown. But even if new lows are forthcoming, they shouldn’t be far below levels seen in June or October. Many stocks have already set their bear market lows. As noted, the broad exception may be technology.
By the second half of 2023, the picture should be much brighter. Investors will be focused on the timing of future rate cuts, not increases. Economists will be focusing on the end of the downturn, not the beginning. Stocks will start rising long before the economic data starts to improve. There are two flies in the ointment. First, P/E ratios aren’t at bargain basement levels. The downturn over the past week has wrung out some excesses, but stocks still aren’t cheap. Second, growth post any downturn isn’t likely to be sustained above 2%. Demographics and productivity are insurmountable headwinds.
A bear market declining 20-30% is modest by historic standards. It won’t be followed by a robust recovery as we saw in 2003 and 2009. But, if the Fed can support balance in the future, there is no reason a recovery can’t last many years.
Today, French President Emmanuel Macron is 45. Chris Evert is 68. Samuel L. Jackson turns 74. Jane Fonda is a robust 85. And, finally, Phil Donahue turns 87.
We wish everyone who celebrates a very Merry Christmas and a Happy Hannukah.
James M. Meyer, CFA 610-260-2220