Market Update

The S&P 500 lost 2.1% last week and closed at 3852.36. The Nasdaq lost 2.7% and the Dow declined 1.7%. It was the second week in a row that all three indexes declined. The S&P did take another run at the upper end of the trading channel on Tuesday. (See chart above) We wrote last week that, “Based on technical indicators we should get another run at the upper end of the trading channel this week or next.” The S&P poked above the trading channel Tuesday but once again couldn’t close above it. The same failure also occurred on 1 December. The 100-day failed to provide support this time. The S&P sliced through the moving average on Thursday with a follow-through on Friday. The 100-day had held support five trading days in a row from the 6th to the 12th before bouncing. A short-term top is in place and the odds favor more downside over the next few weeks.

The sell-off Thursday and Friday started Wednesday afternoon. The S&P lost about 1.4% from the time of the Fed’s rate hike announcement/press conference to the close. The Fed and Chairman Powell were more hawkish than anticipated. We wrote last week that, “A more hawkish than expected Fed announcement will also cause a sell-off.” It did exactly that starting shortly after the beginning of the Fed’s press conference.

The S&P 500 is down 18% year-to-date, despite rallying 14.1% from its October 12th low. The Nasdaq is down 30%. The U.S. Aggregate Bond index (AGG) is down 11.1%. It’s been a tough year for both stocks and bonds. The coming year may see higher-than-normal volatility. A growing consensus sees a falling stock market in the first half and recovery in the second. Bonds are being touted by investment strategists as well. A growing chorus is singing their praises for 2023. Some are suggesting they will outperform stocks next year.

The economy is expected to enter a recession in 2023. The conference board is forecasting 0.0% GDP growth in 2023. The Federal Reserve is forecasting 0.5% GDP growth. Earnings forecasts by eight investment strategists polled by Barron’s range from $199 to $231. The same strategists have an average price target of 4233 for the S&P 500 at year-end 2023. The average price target is 9% above the current level.

The Conference Board and the Fed are all but predicting a recession for 2023. Earnings forecasts are too high if the economy does fall into recession. The consensus among market strategists is for earnings growth of 5% in 2023 and 9% in 2024. It seems unlikely that earnings will grow by 5% next year. It is more likely that earnings will fall 10% to 20% as the economy enters a recession. Investors may look past a decline in earnings in 2023 in anticipation of better earnings in 2024. They may not though. The risk entering 2023 is to the downside for stocks. Bonds should perform well as the Fed’s tightening cycle winds down.

Norwood Economics is forecasting a mild recession in the second half of 2023. The stock market should retest the October lows by the summer. It may fall further depending on earnings, inflation, and interest rates. Regardless, we expect to be buying good companies on sale throughout the year.

Economic Indicators

The economic indicators last week continued to show a slowing economy. The S&P U.S. manufacturing PMI fell to 46.2 in December from 47.7 the prior month. The S&P U.S. services PMI fell to 44.4 from 46.2. Numbers below 50 represent contraction. The industrial production index dropped 0.2% in November after declining 0.1% in October. Retail sales fell 0.6% in November after rising 1.3% in October.

The inflation data was favorable and that led to a rally on Tuesday. The Fed’s hawkishness Wednesday wiped out the Tuesday rally and then some. Investors are concerned the economy will fall into recession next year as the Fed raises rates to stamp out inflation. The economic numbers are supporting that scenario.

Investing and Market Timing

I had a client and friend email me after last week’s newsletter came out. He wanted to know if we were the investors that weren’t listening (to the message of an inverted yield curve). It’s a fair question. Our philosophy is to buy undervalued companies whenever we find them regardless of our market outlook. There is a reason I don’t try to market time. I’m no good at it. Most investors, professional and otherwise, aren’t good at it either. Or so the data shows.

I can tell you in broad strokes what the stock market is likely to do over the next 12 to 18 months. It is likely that we have another sell-off in the first part of next year. We might not though. Should the sell-off come it might stop at or near the October low. It might not though. It might continue down to 3,000-3,200 as stocks anticipate a recession and a 20% decline in earnings. It might not though. It is the uncertainty that makes trading difficult. It is the uncertainty that leads to losing trades.

A general idea of what the market might do isn't enough to add excess risk-adjusted return. When do you establish a position? When do you stop loss out? When do you take profits? It’s the execution of the trading strategy that is so often botched. What you learn after 30 years of investing is that it is difficult to earn excess return by trading. The easiest way to earn excess return is by buying good companies on sale. You need to understand how to value a business. You need patience. You need to be okay with lumpy returns and short-term losses. You will earn excess risk-adjusted return if you can do those things.

Bear markets end and bull markets start. A five-year investing horizon is a luxury. You shouldn’t squander it with short-term trading. Yes, our base case is a decline of 15% to 20% in the first half of next year. Knowing that doesn’t change what we want to do, which is buy good companies on sale. It’s the best way to earn an above-average risk-adjusted return over five- and ten-year periods. And that is our goal for clients.

Regards,



Christopher R Norwood, CFA

Chief Market Strategist