What Can Break The S&P 500 Out of the Current Trading Range?

By John Lau

May 1, 2023 – The S&P 500 has stayed broadly rangebound for most of 2023, trading between a low of 3,800-ish and a high of 4,200-ish.[1] For the market to break out of the current trading range, though, I believe real progress has to show up in the monthly jobs reports, CPI reports, and the 2024 S&P 500 earnings.

In February, I recorded a webinar titled The Positive & Negative Path for Markets in 2023 wherein I listed the key variables to watch for stocks and bonds in 2023. In my opinion, the top three, in the order of importance, are inflation, employment, and corporate earnings. In this report, I want to provide an update of where we are on these variables, and whether they appear to be pointing to a market break-out (or not).

Inflation – The latest inflation report (CPI) shows headline inflation is down to 5.0% while the core inflation is 5.6%, up slightly from the previous rate of 5.50%. Headline inflation–commonly known as the CPI一includes more volatile food and energy price data, whereas the core inflation index excludes it. Recent updates suggest the indexes are moving in slightly different directions, with the CPI showing signs of decline while core inflation continues to rise. For the Fed, which tends to rely more on core inflation, this may mean continuing tightening ahead. Investors too, should brace for the possibility of a longer period of inflation, further economic deceleration, and increased probability of recession.

Back in February, I said if inflation drops below 4.0% by the end of June, it would be an incremental positive for markets. Both headline and core inflation are still lingering at 5.0% and above. To break the S&P 500 out of the current trading range, I believe core inflation needs to fall below 5% and ideally below 3.9%, and we still have a ways to go.

Employment – The March Employment Situation, released on April 7, 2023 by the US Bureau of Labor Statistics (BLS), indicates that total nonfarm employment rose by +236,000 in March on a seasonally adjusted basis while the national unemployment rate declined to 3.5% from 3.6% in February. To see a market break out, I think markets need to see job adds fall below 200k (and ideally below 100k), the unemployment rate rise towards 4.0% and wages drop below 4.0% year over year.

Earnings — The third potential catalyst is one that is a bit further off in the future, 2024 S&P 500 earnings. I believe the S&P 500 is pressing up against the bounds of “reasonable” valuations given $225 2023 S&P 500 earnings. At 4,100, the S&P 500 is trading at an 18X multiple, which is, to me, simply very high for an environment of 1) Slowing economic growth, 2) Fed rate hikes and high rates, 3) Geopolitical uncertainty and 4) Banking stress. In my opinion, it’s very, very hard for fundamentals to justify the S&P 500 being much higher than current levels simply because that view is too optimistic, and valuation is part of the reason the S&P 500 has struggled to rally much above 4,100. Q-1/2023 corporate earnings season is currently in full swing. If all we do is focus on the results vs. expectations, then it seems earnings season is so far off to a solid start. At the start of last week, a little less than 20% of S&P 500 companies had reported, and over 70% beat EPS and more than 60% beat revenues. Those sound like good numbers! But here’s the truth: “Beating” earnings estimates doesn’t mean what it normally does in today’s market environment. In my view, what matters more now is corporate guidance, and there has been a lack of widespread positive guidance for the second quarter, or for the full year. There were some small guidance upticks, but nothing that implies they see a materially better business environment in the future.  That lack of positive guidance, despite otherwise strong quarterly performance, worried analysts that these companies see economic or business headwinds, and that reinforces the “hard landing” narrative.

Starting in July (so during the Q2 reporting season), analysts will begin to value stocks and the major indices using 2024 expected S&P 500 earnings, and they are currently sitting at $240/share. If the lack of positive guidance causes the 2024 expected S&P 500 earnings to drop, it could represent additional headwinds for stocks.

Bottom line: In my analysis, for the S&P 500 to break out, there must be real, tangible progress from key data points (Employment Report, CPI) to further solidify that the Fed is indeed 1) Not hiking anymore and 2) Rate cut expectations are credible. If one (or more) of these conditions are met, and we don’t see any further macroeconomic deterioration (so no more bank failures, no conflict between Russia/NATO or U.S./China, no sudden collapse of economic data) then we would be inclined to increase stock exposure and get more aggressive on this break out because at that point a “soft landing” could become much more likely. However, given the level of uncertainty in the markets, we much prefer to have proof inflation is falling and the labor market is normalizing via CPI and the jobs report hitting those metrics listed above. If neither happens then I think it is likely that once again Fed assumptions will be too dovish, and the S&P 500 will not break out of the current range and may well fall back into the lower end of it.

Wild card — Debt Ceiling: We have not yet covered the looming debt ceiling battle in Washington simply because what I believe are more pressing issues such as disinflation, economic growth and Fed rate hike expectations were in my view the main drivers of markets. However, it appears to me that’s starting to change as I see the looming debt ceiling battle is now beginning to impact markets. I will be monitoring developments in the debt ceiling battle and will update on any market impact and on our portfolio management tactics.

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[1] Bloomberg

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