Is It Time to Go Offensive? (No, Not Yet)

By John Lau, CPA, CFP®

January 31, 2023 – The start of 2023 has been strong for the laggards of 2022. This may be due partially to the “January Effect”, which is the historic tendency for laggard stocks to rise to start a new year. The somewhat tangible evidence behind a positive start to the new year is the coordinated selling of losers in the month of December for tax loss purposes, followed by the opening of new positions once everyone returns from the holiday season.

Another reason for the rally is short coverings. Institutions that sold stocks short in December are buying them back to cover the shorts, thus creating demand that pushes up stock prices.

Stocks also extended the early 2023 rally as solid economic data was interpreted as implying a soft economic landing is more likely and that reaction, where investors embrace the resilient economy without worrying that it may make the Fed more hawkish, hints that investors already assume the Fed has reached “peak hawkishness.” But remember investors and the market had assumed peak hawkishness or a Fed pivot three separate times in 2022 and ignored contrary commentary from the Fed, and in each instance the market was wrong and the still-hawkish Fed caused a sharp, painful pullback. This setup makes this week in the markets very, very important because on Wednesday the Fed will either signal we are at peak hawkishness or again disavow it, and that will likely cause volatility.

The market is now divided into two camps: the soft landing camp and the hard landing camp. In the first two weeks of January, markets were firmly in the “soft landing” camp and stocks and bonds rallied as a result, boosted by the continued decline in CPI and some less-hawkish commentary from Fed officials. However, the “hard landing” argument was boosted in the third week via sharp drops in economic data, including Retail Sales, Empire State Manufacturing and Philly Fed surveys. The declines were lessened somewhat towards the end of the week thanks to better-than feared earnings and less-hawkish Fed commentary but on balance last week’s data favored the “hard landing” outcome. Remember I previously mentioned 2023 will be a race between the rate of disinflation and economic decline. If disinflation rate exceeds the decline rate for the economy, that would increase the probability of a soft landing. Otherwise, hard landing will prevail. The race is still on and it is not apparent yet who will be the winner of the race.

So, what does this mean for us?

First, don’t get too caught up in the hard vs. soft landing debate, or related market volatility. This issue won’t be settled in the immediate future and in that time, the pendulum will swing back and forth.

Until a hard or soft landing becomes clearer, do not expect material moves from the S&P 500. I expect the S&P 500 to trade in a range in the upper 3,000’s/just over 4,000 depending on the “tone” of the news, as encouraging soft landing news will likely send the S&P 500 towards 4,100, while hard landing news likely sends the index towards 3,800. But barring a major macroeconomic surprise or an utter disaster of earnings, we view the S&P 500 as largely range-bound for the time being. Given that uncertainty, I continue to resist giving in to FOMO (Fear of Missing Out) and to advocate for conservative equity positioning that is designed to outperform in a slowdown: Defensive sectors, value over growth, and minimum volatility funds (all of which should outperform as economic growth continues to slow).

Bottom line, the risk-reward right now is simply unattractive in my view (perhaps we get some upside if the Fed confirms peak hawkishness, but we can easily get a lot more downside if they disavow it). As such, I continue to favor lower-beta and defensive tactical over weights (minimum volatility ETFs, defensive sectors, longer dated bonds) until there’s true clarity we are at peak hawkishness. We also should expect near-term volatility to continue, but remember the soft or hard landing debate won’t be settled immediately, may be even for another several weeks or months, and until it is (and until we know which outcome is happening) we continue to think reducing volatility via defensive positions remains the more prudent strategy at this time.

Meanwhile, we are staying invested in a defensive tilt. Our client portfolios are up this year, although defensively since the start of the year. And we will continue to adapt based on constantly updating research information.

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