Santa Delivered; But Strategists Say, ‘Hold Your Reindeer!’

Jan 10, 2023

By Ben Norris, CFA, Securities Research Analyst, Associate Vice President
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Welcome to 2023! The first trading week of the year was shortened by the observance of the New Year’s Holiday, but that didn’t stop stocks from beginning the year on a positive note. A strong start to the year was a welcome change from 2022, which saw the worst yearly performance for major indices since the 2008 financial crisis. Last year was particularly painful for investors because it was a rare year in which both stocks and bonds dropped simultaneously. Over the last 100 years, this has only occurred a handful of times and notably, U.S. bonds saw a double-digit loss for the first time in more than 50 years.

Markets were adversely affected by a variety of factors through the year, but two primary culprits come to mind: stubbornly high inflation and central banks around the world rapidly hiking interest rates in response. At the start of 2022. the U.S. Federal Reserve’s target interest rate was 0.25%; after seven rate hikes they increased their target for rates to 4.5%. This rate hiking cycle has been historic in its frequency and magnitude compared to prior cycles. The Fed has never raised rates so high so quickly. The unique nature of the Fed’s actions has caused concern among economists, investors, and average consumers. Economists and investors are primarily worried that the Fed will tip the U.S. economy into a recession, (they have done so each time they raised rates in the past.) leaving consumers to deal with a combination of still-high inflation and rising interest rates.

The last month of 2022 reflected these difficult conditions as stocks and bonds generally gave back some of the gains they saw in the prior two months. Through the month investors and market pundits were hopeful that a “Santa Claus rally” would materialize to salvage what had been a bad month to cap an even worse year. Just a reminder that a Santa Claus rally occurs if the cumulative returns in the last five sessions of December and first two sessions of January are positive. You will be relieved to hear that we did in fact get a rally from the big guy in red. Years that begin with a Santa Claus rally tend to see full-year positive returns at a slightly higher rate than the long-term average. Of course, past performance is no guarantee of future results and over the last roughly 100 years U.S. markets have been positive in nearly four out of every five years anyway.

We have been discussing the year to come here in St. Louis and we, as well as many market strategists, are not so sure that Santa has truly delivered the goods. There is an abundance of factors that argue against a strong rally for stocks, especially in the first half of 2023. To begin, the Fed has strongly indicated that they will continue to raise rates this year, and don’t see a cut in rates until 2024 at the earliest. Most investors feel that rates will have to come down for stocks, especially growth stocks, to see sustained gains. While the Fed is dead-set on keeping interest rates higher for longer, we are worried that they may be late in reacting to rapidly cooling inflation. While the latest reading of the Consumer Price Index (CPI) saw a year-over-year gain of 7.1%, the monthly gain was just 0.1%. It would take just six months of similar readings to push headline CPI near the Fed’s long-term 2% target for inflation. We think this is an overlooked risk when handicapping the odds of a recession in 2023. In fact, it seems as though the Fed is becoming more hawkish despite some data indicating they should begin to pivot toward a neutral-to-dovish stance.

Market strategists tend to offer projections and targets that are similar to one another each year. This year is no different, with a Bloomberg survey showing that 22 equity strategists have settled on an average 2023 S&P 500 (SPX) target of 4,078, or a full-year return of just over 6%. This is very close to the long-term average return for SPX over the last century. However, we should note that the average return for SPX is not the typical return. Yearly returns between 0-10% have only occurred 15 times since 1926, while returns of greater than 20% or less than -20% have occurred 32 times. All this to say, that a return of 6% isn’t typical based on historical standards.

Another factor that leads us to believe that your typical strategist will probably be proven incorrect in 2023 is that expectations for corporate profits continue to move lower. Bloomberg’s consensus estimate for 2023 earnings growth has fallen from nearly 10% at the beginning of 2022 to just 2.2% at the end of the year. Similarly, an analysis by Goldman Sachs shows that revisions to SPX earnings expectations are the worst they’ve been since 2020 and are approaching levels seen in 2008. There far more negative revisions than there are positive. One counterpoint I will make is that anecdotally, I get uncomfortable when there is a strong consensus of opinions like we are experiencing right now. It is growing exceedingly difficult to find an analyst who is very bullish on 2023, while those of us who expect a mildly lower end to the year are a dime a dozen. If my unease is founded, then the other two options are another bad year for markets or a surprisingly good one.

Stocks and bonds were positive last week (thanks Santa) as small-cap and value stocks outperformed their large-cap and growth counterparts. SPX saw a gain of 1.5%, while the Nasdaq Composite (COMP) and Dow Jones Industrial Average (DJIA) gained 1% and 1.5%, respectively. The Russell 2000, an index focused on small-cap stocks, outpaced the major indices with a 1.8% gain. Returns outside the U.S. were even better with the MSCI ex-US Developed and Emerging Markets equity indices returning 2.7% and 3.4%.

Economic data last week likely emboldened Federal Reserve policy makers as employment figures remained surprisingly resilient despite several major layoff announcements. At the same time, non-employment data is showing an economy that has already begun to slow. The Fed remains very focused on employment data despite this, and the market is placing a higher likelihood of a 0.50% interest rate increase at the Fed’s February meeting. Strong employment is bound to turn into a double-edged sword as a result. If employment figures continue to hold up, the Fed may be convinced they are on the right path while unwittingly making a policy mistake. At the same time, a strong job market may help the U.S. economy avoid a deep recession, or if the Fed is successful, avoid a recession altogether.

The coming week has an impactful slate of data releases covering employment, inflation, and consumer expectations. Thursday will be the highlight of the week with weekly jobless claims and the latest reading on the Consumer Price Index. Finally, a friendly reminder that U.S. markets will be closed on Monday, Jan. 16 in observance of Dr. Martin Luther King Jr. Day.

Date Report Previous Consensus
Monday 1/9/2023 NY Fed 5-year Inflation Expectations 2.3%
NY Fed 1-year Inflation Expectations 5.2%
Tuesday 1/10/2023 NFIB Small-Business Index (December) 91.3 91.5
Fed Chair Jerome Powell Speaks
Thursday 1/12/2023 Initial Jobless Claims 204,000 210,000
Continuing Jobless Claims 1.69M
Consumer Price Index y/y (December) 7.1% 6.6%
Core CPI y/y (December) 6.0% 5.7%
Federal Budget Deficit (December) -$21B -$69B
Friday 1/13/2023 Import Price Index
U of Michigan Consumer Sentiment (Jan.) 59.7 60.5
U of Mich. 5-year Inflation Expectation 2.9%


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