December Private Client Letter

Our economic outlook has not changed much in recent weeks.  We expect the Fed’s tightening of monetary policy will keep equity market volatility high and range bound into 2023.  Any indication that the Fed is contemplating a pause in early 2023 will drive sharp rallies.  Any data reports that suggest inflation remains stubbornly high will trigger selloffs in equity markets.  This reality was on full display as November ended and December began.

On November 30th, Fed Chairman Jerome Powell delivered a speech in which he indicated the path of further tightening would proceed with “moderation”.  He indicated that the Fed "doesn't want to overtighten monetary policy” and that he believes the prospect of a soft landing is still "very plausible" and "still achievable."   

Equity markets responded to Powell’s speech with a sharp rally with the Dow surging by about 800 points.  Two days later the November employment report showed an increase of 263,000 new jobs, well above the consensus of 200,000.  These numbers reflect a labor market that is unlikely to produce a sustained slowdown in wage inflation.  Average hourly earnings rose 0.6% month over month versus expectations for 0.3%, while hourly earnings were up 5.1% year-over-year versus last month's pace of 4.7%.  Wage growth is an inflation indicator that some worry is tougher to bring down.  Accordingly, equity markets have been under pressure as December begins.

United States Unemployment Rate

Despite the assurances from Powell regarding the Fed’s moderate posture going into 2023, the U.S. yield curve is still deeply inverted and is forecasting a recession.  The popular 2-Year/10-Year inversion remains the deepest since 1981.

While the third quarter GDP numbers were recently revised higher to 2.9% (from 2.6%), the consensus forecast for the fourth quarter is currently for a gain of only 0.5%.  The November ISM Manufacturing data recently contracted for the first time since mid-2020, with only six of eighteen industries reporting growth.   Along with this notable deterioration in global demand, there is mounting evidence that the economy is decelerating rapidly in response to tighter monetary conditions and higher interest rates. 

A slowdown in economic activity will put downward pressure on corporate earnings and we expect profit forecasts for the full year 2023 to be reduced early next year.  Should the economy officially tip into recession, the downward adjustments to forward earnings estimates would likely accelerate.  Earnings expectations for the S&P 500 in 2023 have already fallen from $252 to about $230.  Significant downgrades to corporate earnings from here would trigger downward pressure on equity prices as investors reset valuations.  Markets historically bottom out at roughly a 13x multiple in recessions, on average. 

We recognize that downside risk persists for equity markets, and we may have to retest the lows of 2022 before a bottom to this bear market is established.  This would take the S&P 500 towards 3,600, or roughly 10% below current levels.  It is important to note, however, new bull markets have historically started during recessions, and about 6 to 9 months ahead of a trough in earnings.  We believe a trough in forward earnings estimates could come early in 2023.

This said, establishing realistic return expectations for the next 12 months is quite difficult given the many distortions created by the COVID pandemic and the excessive government stimulus that followed.  The unprecedented spike in money supply (M2) has led to 40-year high inflation and the fastest Fed tightening cycle ever.  There will be limitations to traditional macro-economic disciplines over the next couple of years as the global economy returns to normal following these distortions.       

Late in November the S&P 500 punched through its 200-day moving average for the first time since April and finished higher for the second consecutive month.  This has not happened since August 2021.  The strength of the stock rally over the last two months does not come as a surprise, given how much pessimism had been priced into the market.  By some measures, investor appetite for risk recently registered at all-time lows (AAII Bull-Bear Spread).

For several months I have been writing about the nature of bear market rallies, and I believe this current rally is not likely sustainable into 2023.  The bear market following the dot-com bubble (2000-2002) experienced eight bear market rallies before the market reached its true bottom.  In the case of the financial crisis (2007-2009) the resulting bear market saw twelve bear market rallies that ultimately failed, prior to the onset of a new bull market.  Last month I observed that bear market rallies are quite common and often spectacular.   

The current environment all comes down to whether inflation is cooling.  We believe inflation peaked earlier this year and will abate in the coming months as base effects dissipate.  Supply chains are finally back to normal after two years of pandemic-related problems.  We recall the shocking story earlier this year of hundreds of cargo ships stacked up off the ports of Southern California, and we are encouraged to observe the backlog is down to only a half dozen ships waiting to unload.

When the improving trend in inflation becomes more conspicuous in the data, we should have clarity as to when the interest rate cycle will shift.  Historically, stocks tend to rebound once inflation data begins to improve.  Since 1960, the consumer price index (CPI) has gone above 6% only four times (1970, 1974, 1979, and 1990) and in every instance the stock market experienced sustainable rallies within a year following inflation’s peak.

We have had to contend with a torrent of ever more troubling developments this year and the macro landscape remains quite challenging.  We believe our strategies are best served by being relatively defensive for the next 3 to 6 months as inflation and growth conditions remain unfavorable.  We face headwinds from rising real interest rates and considerable uncertainty regarding how much the economy will eventually slow. 

This said, it is our view that the coming recession will likely be short and shallow.  By mid-2023 we believe the worst of this bear market will be behind us and investors will need to look past the lingering difficulties in order to fully position for the next bull market.  There is a lot at stake when the bear market finally gives way to a new bull market, and we do not believe market timing strategies best serve the long-term objectives of our clients.

Enduring market volatility is an unpleasant element of successful investing.  Volatility is not the same thing as risk if risk is understood as the possibility of permanent loss.  Rather, volatility is a temporary fluctuation in price and should be recognized as such.  Throughout history bear markets end when news is bad, and sometimes still getting worse.  Positioning for a market rebound has meant being invested when everything looked awful and felt unbearable.  We are reassured that it has always been true that bad times follow good times, and good times follow bad times.

We wish you and your family a joyous and happy holiday season.  As always, thank you for your continued confidence. Please reach out should you have any questions or concerns.

John E. Chapman

December 2022