As we start the second quarter of the year, our outlook for 2023 is unchanged from our views at the beginning of the year. From our 1Q Outlook:
“We believe it is likely that we will see more volatility to both the downside and upside this year. This will make 2023 a more difficult year to navigate the markets…there will be many narratives that will seem probable this year, both bullish and bearish, and we expect the data will point us in different directions multiple times this year.”
The Fed’s tightening campaign seems to have reached the point where their actions have “broken something” as evidenced by the recent string of bank failures. The expectation is that we may be in the final months of the Fed tightening campaign. Valuations seem stretched relative to what one can earn on short term fixed income securities with a high degree of relative safety. Investor sentiment, as well as institutional positioning, is as bearish as it has been since the 2008 market correction.
There is a strong tendency for the market to do well in a pre-election year and this year it is following that trend. The market as measured by the S&P 500 has moved higher during the quarter (up around 7%) as underinvested investors have embraced a potential Fed Pivot. However, most of the gains were due to a handful of large mega-cap technology companies. (10 companies out of 500 were responsible for 90% of the performance last quarter.) The equal weight S&P 500 index was up just 2%, while the Dow Jones Industrial Average and US Small and Mid-Cap indices also averaged around 2% for the quarter.
The Economy, Federal Reserve Monetary Policy, and Interest Rates
Apart from a robust employment backdrop, there are growing signs of economic weakness. The ISM Manufacturing Index declined from 49 to 47, the first sign of a significant level below 50, a number below 50 is an indicator of recession. The ISM Services Index declined from 55 to 51. Still above 50, but decelerating. The Leading Economic Indicator Index is at -6%, which has presaged a recession every time since 1970. There has also been an uptick of delinquencies in consumer loans and large bankruptcies. Recent bank losses will usher in regulatory pressure, which means that Banks must improve their own liquidity, resulting in tougher lending standards for new business. All signs seem to point to a weaker economy at some point in the future.
However, there are two potential positives to a weakening economy: Firstly, it improves the chances for the Fed to cease and desist in their tightening cycle, as evidenced in the fall in long term rates as they slowed to a 25bps hike in their latest move. Investors have been trained to interpret such a “pivot” in Fed policy as a coming positive – this is the behavior that created a bottom in equity prices in early 2019 after the repo crisis and in the middle of Covid in 2020. However, a Fed pivot, over the last few decades, has not always been a positive. When the Fed does pivot, it is because the economy is faltering and the economy falls into recession, that is often when earnings become impacted, and a bear market decline ensues.
Secondly, if the economy weakens mildly, but this does NOT translate to lower earnings, this sets the stage for the elusive soft landing. Soft landings are rare – the last one we had was in 1994 – but they are usually bullish outcomes. However, the Fed usually tighten too much, and the economy falls into recession. How this will play out in the near term is uncertain. Our base case is that later this year, the effects from one of the quickest and largest increases in interest rates will negatively affect earnings in a meaningful way. However, the transmission mechanism from higher interest rates to a weaker economy happens slowly, and there are still vestiges of Covid related easy fiscal policy moving through the economy, so a slowdown in earnings will not develop until later this year.
Equities: Valuations, Earnings, and Sentiment
In the long term, equity valuations have the largest effect on future returns, and current valuations suggest that the market is on an unsteady foundation. Currently the P/E of the market is around 18X, up from the lows last year of 15X. In an environment where earnings are at best uncertain, and at worst, set to decline materially in a recession, we see little upside to valuations. In particular, the 18X P/E is equivalent to an Earnings Yield of 5.5%, not terribly different from where short-term interest rates are. The secular lows in the market in 2009, 2015, and 2020 were accompanied by earnings yields higher than bonds by 2-5%. Valuations would be more attractive to us if Earnings Yields approached 7%, or a P/E ratio of 14-15.
Before we get too bearish, we want to impress some important bullish counters to these bearish valuation readings. First, there is a strong seasonal tendency for the market to do well in a pre-election year. Moreover, we see signs that investors are too bearish and underinvested. In such an environment, the smallest positive surprises can have a significant effect on the market as underinvested traditional investors, and hedge funds positioned short, feel the need to invest cash and cover shorts as the market rises. This is exactly what has been driving the rally over the last few months, and we see few signs that such pessimism has abated. This underinvestment is what drives the market higher in what is often called “climbing a wall of worry.”
In the end, we have an overvalued market that would seem to have a ceiling not far above current levels, but is being fueled by strong bullish seasonal tendencies, as bearish, underinvested investors are pressured to get back in. This is the definition of what causes a trading range in a market. We have been trading around current market levels since last May, and even with the dips and rallies in between, we have made little progress. On May 27th, 2022, the S&P 500 closed at 4158 and we are at 4123 today.
Heading into the second quarter, we have a market with declining fundamentals, rich valuations, but with supportive technical strength. Is the secular bear market that started last year still in effect or is it ending as the Fed may soon contemplate a pivot? It is likely that equity markets will remain in a pause until the fundamentals become clearer. We see many potential outcomes, with much fogginess along the way.
We would also argue that we are not really in a traditional business cycle. The last few years of the current business cycle have been fueled by a Covid induced government fiscal and monetary policy response, which makes the future much harder to “read’ and forecast. We are not alone in trying to weigh out conflicting evidence. Bloomberg measured the gap between the highest and lowest price target for the S&P 500 by strategists and found that the difference is the widest in two decades (the last 2 wide gaps were in 2002, when the bear market continued for another year and a half, and 2009 – the low for the bear market post-GFC).
2023 will be a year of staying patient until a clearer economic picture asserts itself. Our job is not to guess, but to measure each piece of information and position ourselves, in real time, the best we can!