Economic & Market Report: Reality Check

Summary

  • Fundamental check: Stocks are still expensive as corporate earnings continue their descent.
  • Technical check: Stocks are testing key support levels.
  • Fed check: Not fighting the Fed cuts both ways.
  • We’ve traveled a long way through today’s bear market but more work lies ahead before the journey is complete.

After a blazing start to 2023, the U.S. stock market has cooled in recent weeks.  Looking ahead to the upcoming spring, the path of least resistance for stocks appears to be to the downside.  For while the underlying economy has remained solid in the face of aggressive monetary tightening from the U.S. Federal Reserve, this resilience in large part is also a primary headwind preventing stocks from fully shaking off the bear market blues.

Fundamental check.  One of the initial challenges confronting U.S. stocks at this stage of the market cycle is the fundamentals.  Even if underlying economic forces were lining up behind stocks, the fact that corporate earnings remain elevated at a time when underlying valuations are still rich is a one-two fundamental punch that stocks have yet to resolve the way they have historically to strike a bear market bottom.

Corporate earnings have started to descend.  With fourth quarter earnings season now largely in the books, S&P 500 earnings have declined by -8% on quarter-over-quarter basis and -13% from the peak in earnings over the past year.  While this is a start, this remains only a fraction of the -30% to -40% peak-to-trough decline in earnings that we typically see during normal bear market cycles.

Looking forward, it appears that the decline in earnings is set to continue, as forecasted earnings through the remainder of 2023 are projected to be flat to negative over the next two quarters and only marginally better for the last two quarters of the year.  Given that corporate earnings forecasts are notoriously optimistic the further out the forecast horizon, the fact that these projected numbers are already so weak highlights the corporate earnings challenges that still lie ahead for stocks.

Investors might have the ability to look past this deteriorating earnings forecast were it not for the fact that stocks are still expensive.  Despite being down nearly -20% from its all-time highs from more than a year ago, the S&P 500 still trades at nearly 22 times trailing GAAP earnings.  Not only is this a more than +30% premium above its historical average, but it is also well above the 12x to 14x multiples that we have seen on the S&P 500 at bear market lows in recent years.

Technical check.  Stocks made a good run at a full-fledged upside breakout at the start of 2023.  After exploding above its downward sloping trendline resistance in mid-January, the S&P 500 continued its ascent through the remainder of the first month of the year.  But no sooner did the Fed speak and the latest monthly jobs report hit the headlines right around the exact same time that the S&P 500 reached its 400-day moving average resistance, and the rally was stopped dead in its tracks.

In the month since, U.S. stocks have descended back toward its downward sloping bear market channel that has been in place since late 2021.  And while the S&P 500 has found support at its recently upward sloping 50-day moving average and still downward sloping 200-day moving average along with an upward sloping trendline dating back to its October 2022 lows, the fact that its Relative Strength Index (RSI) has descended back into bearish territory suggests any bounce from these support levels may be meager at best.

It will be worth watching how the S&P 500 responds in the coming trading days to this important technical convergence.  For if stocks continue their descent back into its bear market trading channel, a further decline toward the 3200 to 3400 range by the time the springtime flowers are blooming is increasingly back in play.

Fed check.  So what would be the primary driver pushing stocks to the downside in the coming weeks beyond the fundamental and technical factors already in place?  The most likely culprit remains the U.S. Federal Reserve.  For just as we should not fight the Fed to the upside, we should not ignore it to the downside.

Heading into the year, the broader market as measured by the CME Fed Funds futures had priced in the following outcome: the Fed would raise once or maybe twice more early in the year – a quarter point in February, maybe even a quarter point in March – then they would be done raising interest rates with inflation coming back down.  The economy would descend into a mild recession in mid-2023, but by Q4 the Fed would be back to cutting interest rates and the worst would be behind us.  Quod erat demonstrandum, am I right?  Chalk drop.

Um, no.  With two months in the book, what the market is now pricing in has meaningfully changed, and with good reason (the notion that the Fed would be cutting rates by the end of 2023 requires a historical perspective that only begins after the mid-1980s – this is NOT the way the inflation battle is won as the late 1960s to early 1980s repeatedly proved).  The inflation rate has come down, but the level of inflation remains uncomfortably high and the pace of the decline has slowed dramatically.  In the case of the Fed’s preferred Personal Consumption Expenditures (PCE) Price Index actually ticked back higher in January on a Core PCE basis (gulp).  These developments are a problem, as they signal that the Fed may not yet have done enough rate hiking to fully extinguish the inflationary flames.

Already, the notion of Fed rate hikes at the end of 2023 are off the table.  Instead, the Fed is now projected to deliver three successive quarter point rate hikes in March, May, and June before topping out the Fed funds rate at 5.50% and keeping it steady through the rest of 2023 and into 2024.

Unfortunately for stocks, I continue to think that this consensus Fed forecast is still not enough.  With the jobs market still notably strong and the unemployment rate at a historically low 3.4%, the Fed still likely has a lot of lifting left to do to cool inflationary pressures (a tight labor market is inherently inflationary, particularly in a world that is increasingly showing nationalist tendencies).  And the fact that the rate of inflation is falling at a slowing rate (if not marginally rising again in certain key spots) further suggests that the Fed may need to do even more than the market is anticipating and for longer to get the inflation fires fully under control.

If we are to not fight the Fed, the fact that the Fed is still tightening and may need to tighten more than the market is currently expecting implies a fight that may continue to be challenging for stocks at least in the near-term.

Bottom line.  We as investors have come a long way through the bear market that has transpired so far dating back to the start of last year.  And while the underlying economy remains sound and underlying financial system health continues to be strong, we remain in an inflation firefight that appears not yet over.  The Fed likely has more work to do on the interest rate hiking front as we progress through 2023.  This implies an economic slowdown that may come a bit later (perhaps in the second half of 2023 and into 2024), may last a bit longer and cut a bit deeper economically than previously anticipated, and may require more patience than originally anticipated from investors that have understandably become accustomed through their experience from 2009 to 2021 to stocks quickly bouncing back from any bouts of short-term downside.

Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Investment advice offered through Great Valley Advisor Group (GVA), a Registered Investment Advisor. Great Valley Advisor Group and Stonebridge Wealth Management are separate entities.

This is not intended to be used as tax or legal advice. Please consult a tax or legal professional for specific information and advice. Third party posts found on this profile do not reflect the views of GVA and have not been reviewed by GVA as to accuracy or completeness.