Could the Stock Market Spring Forward?
Where we go from here is all about earnings and the Fed.
Key takeaways
While my base-case scenario is that this may be a sideways year for the market, it's also not impossible to imagine that we're already at the start of a new bull market.
For that to be the case, we would likely need to see a turnaround in earnings in the next few quarters, and/or the Fed ending its tightening cycle soon.
The Fed cycle will most likely continue to be driven by inflation, which has been trending in the right direction but is still high compared with the Fed's target.
With the S&P 500® up about 7% for the year so far, optimism has been growing again that the worst might be over. So it seems like a good moment to take a step back and check in on where we might be in this market cycle.
My operating assumption has been that the low the S&P struck in October will likely be the low for the recent bear market, but that the stage has not yet been set for a new bull market. My outlook for 2023 has been for a prolonged trading range, not unlike 1994 or 2015. If we think of the market in terms of valuation (which is generally a good idea), we have been stuck in a range—with the price-earnings ratio (P/E) on the S&P vacillating between about 15.5 and 18.5. I think we could stay in that range for a while longer.
Market valuation has been struck in a range
What would it take for the bulls to be right?
While it's not my base case that we're already in a new bull market—anything is possible. What would it take for this to turn out to be the start of a new bull market? I think we would either need to see earnings start to recover in a few quarters, and/or we would need to see the Fed pivot soon (or at least end its tightening cycle).
We'll get more clarity on earnings soon, as first-quarter earnings season is starting in about 2 weeks. Currently, the consensus estimate is for an 8% contraction in the growth rate, followed by a 6% contraction in the second quarter.
For calendar-year 2023, the consensus earnings estimate is for a 2% contraction. But that estimate is still coming down, and based on historical patterns, could continue to do so. I could imagine it turning out to be a 10%-contraction year.
What about the Fed?
Coming back to those ingredients for a potential new bull market, how near might we be to an eventual Fed pivot? Looking at market expectations for Fed policy (based on forward interest-rate curves), investors seem still to be expecting a quite aggressive pivot. As the chart below shows, forward interest-rate curves currently show an expectation that the Fed will actually start cutting rates soon.'
The market expects the Fed to pivot soon
While that might sound like a positive development for the market, chances are that the Fed would not pivot that hard unless the market was facing an earnings problem considerably worse than currently projected.
Inflation is still crucial
Ultimately, the course of Fed policy will most likely continue to be driven by inflation. Inflation figures are generally still high when compared with the Fed's targets, but have been heading in the right direction.
For example, last week saw a lower-than-expected inflation figure as measured by the core PCE report (which is the Personal Consumption Expenditures price index, adjusted to remove the impact of food and energy prices, which tend to be more volatile than prices of other goods). The core PCE rate of change peaked at 5.42% last June, and as of last week's report was down to 4.60% (compared with the Fed's 2% target).
As for the future trajectory of inflation, markets seem to be showing an expectation for a quick reversion to lower inflation. Inflation expectations implied by yields for Treasury Inflation-Protected Securities (TIPS) show an expectation for a rapid return to a lower, more normal rate of inflation.
Reported inflation vs. inflation expectations
On that point, however, it's interesting to note that the TIPS market has only been around for a few decades, and during that time has essentially always converged around a 2% expected inflation rate. Is the TIPS market's expectation as accurate this time as it has been in past? Or is the market thinking wishfully in assuming we'll revert to 2% again so quickly? These are profoundly important questions for investors right now.
Where do we go from here?
We are at the intersection of earnings growth and the Fed cycle. If earnings fall only as much as the consensus estimates suggest, and the Fed is either done tightening or close to it, then perhaps spring really has sprung, and we can see the light at the end of the tunnel. While it's not my baseline, it's also far from impossible.