03/07/2023
Market Comment - March 2023
As the end of the first quarter approaches, mixed economic and market data continue to frustrate investors, with the bulls and bears struggling to adjust to the ever-changing market narrative. Since the current bear market began early last year, US stocks have mustered four bear market rallies, including a 17% advance from mid-June through early August of last year. The most recent 9% rally topped out on February 2 when investors began to re-assess the Fed policy outlook following stronger than expected economic and inflation data.
Of course, differences of opinion are what makes a market, and the foregoing comment assumes we are still in a bear market. Certainly, there is a bullish camp that believes the market bottomed mid-way through October, when stocks enjoyed a ~14% rally through the end of November. It is true that stocks in general have gone up since mid-October, but the most speculative of the widely followed indices, the Nasdaq Composite, made new lows on December 28.
The bulls also seem to be overlooking softening corporate earnings outlook as both 3rd and 4th quarter S&P 500 earnings came in weak compared to forecasts from earlier last year. While 3rd quarter S&P 500 earnings were slightly positive on a year-over-year basis, this was mostly attributed to historically strong earnings in the energy sector. If you strip out the energy sector, earnings in the remaining sectors declined almost 4% year-over year. With 4th quarter earnings season behind us now, earnings per share (EPS) declined 4.8% year-over-year, and the consensus forecast for 1st quarter EPS has now fallen to -5.7% year-over-year.
Despite the weakening profit outlook, stocks staged a strong rally in January, as all major indices enjoyed gains, with the S&P 500 up 6.2% and the Nasdaq rising 10.7%, its best January since 2001. The last data point is notable because the January 2001 rally occurred 10 months into the 2000-2002 bear market, which eventually saw the Nasdaq collapse 83% from its March 2000 high. During the recent bear market, the Nasdaq had declined more than 36% off its November 2021 high as of December 28. Even so, many technology stocks remain expensive, and it was the lowest quality stocks, i.e., the most unprofitable stocks, that were the strongest during January. Rampant speculation lends little credence to the notion that the bear market is over. Bonds were also strong, rising more than 3% on the month after suffering their worst year in history.
Nonetheless, February ushered in a reality check for the optimists as stocks began to decline again. Various economic data releases challenged the bullish narrative that a pause in Fed rate hikes is just over the horizon. A pause would be broadly interpreted by the bulls as “the pain is over, let’s get back to the party and drive stocks higher,” but they ignore the fact that historically, stocks have not bottomed for many months until after the Fed pause. Certainly, this time could be different (Covid-19 anybody?), but ignoring history can be painful for investors.
Specifically, the bulls have been pointing to strong GDP and employment data to bolster their arguments. For one thing, US GDP rose at an annualized 3.2% and 2.7%, respectively during the 3rd and 4th quarters of last year, after declining during the first two quarters of 2022. Not only that, but employment data also continues to show strength, with the 3.4% employment rate in January sitting at its lowest level in 54 years. Finally, the Nonfarm Payrolls monthly job report showed that 517,000 jobs were created in January, a huge upside surprise and almost triple what economists had forecast.
Another argument for a Fed pause was the fact that inflation had steadily declined each month from a peak of 9.1% back in June down to 6.5% in December. Moving into the new year, economists forecast that it would fall further to 6.2%, but the official number came in hotter-than-expected at 6.4% in January. Other measures of inflation, such as the producer price index and the personal consumption expenditures price index, also came in higher-than-expected.
While strong GDP and employment data would normally be welcomed, that’s not necessarily the case in the current environment where inflation remains far above the Fed’s stated goal of 2%. Relatively strong economic conditions and sticky inflation means the Fed will need to hike rates higher and leave them there for longer than investors had previously expected. Indeed, at the beginning of February, the market was expecting two more 0.25% rate hikes and then a rate cut near the end of the year. After the strong economic and inflation data came out, those expectations have now risen to three more rate hikes this year and no rate cut. Furthermore, at the beginning of February, the market was pricing in a 0% chance of a 0.50% rate hike at the March FOMC meeting while those odds have now risen to ~ 30%.
While the strong start to the year was a welcome respite from a poor 2022, we believe the balance of the evidence means that continued caution is warranted by investors. Remember, the old Wall Street adage, “don’t fight the Fed,” works on the downside as well as the upside. Aside from the rate hikes that have yet to come, the bulk of the hikes from last year have still not percolated throughout the economy, a series of rate hikes that were perhaps the most aggressive in Fed history. All these rate hikes will continue to slow the economy.
For many months, investors have debated whether the economy is headed for a “soft” or “hard” landing, depending on how well the Fed is able thread the needle on bringing inflation down without tipping the economy into recession. Our belief is that the Fed knows they are going to have to cause a recession (hard landing), they just can’t say so publicly for political reasons. And for all the talk of soft landings, the Fed has only successfully engineered a soft landing once, arguably twice, during its entire history.
There are many other factors pointing to a hard landing. The inversion of the yield curve between 2-year and 10-year Treasuries, the most reliable of all recession indicators, reached its widest point this past week. Furthermore, the index of leading economic indicators fell in January for the 10th straight month, something that has not happened outside of recessionary conditions. Also, several indicators point to a noticeable tightening of bank credit over the past quarter. Finally, the most widely followed gauge of the money supply, M2, contracted 1.7% year-over year in February, after also contracting slightly in January. Before January, this broad measure of financial liquidity had never contracted in the history of measuring it going all the way back to 1960.
All this adds up to a cautious outlook on our part. We believe a recession is a foregone conclusion at this point and it’s just a matter of timing as to when it happens. Most economists believe it will be a 2023 story while some look out to early 2024. Historically, stocks generally don’t bottom until we are part way through a recession, as the stock market is often late to recognizing the economic weakness. While we recognize the market has already endured pain, the weight of the evidence suggests there is more pain to come, and we plan to remain defensive until our indicators and conditions become more constructive.
