What Now? The Positive & Negative Path for the Market in 2023

By John Lau

March 1, 2023 – Stocks continued to decline last week amid increasingly hawkish Fed policy expectations while economic data pointed towards stagflationary trends emerging and retail earnings disappointed. The S&P 500 fell 2.61% in February and is now up just 3.40% YTD (S&P 500 was up 6.18% in January).

Stocks dropped in February, and the reasons for the reversal of fortune from January couldn’t be clearer: Disinflation has slowed materially and as a result the market is increasing Fed rate hike expectations, which is causing Treasury yields to surge and that is pressuring stocks. To that point, stocks and bonds rallied in January on the ideas that 1) Inflation was declining (or disinflation), 2) The Fed was almost done with rate hikes, and 3) There wouldn’t be a hard economic landing. The first two ideas have since been refuted by the data of the past three weeks, and that is why stocks have given back more than half of the January gains.

Broadly speaking, for these declines to stop markets need to see data that shows inflation is again dropping and, in turn, the Fed is getting close to ending rate hikes. Until that happens, we should expect continued pressure on both stocks and bonds.

From a strategy standpoint, we have remained defensive and skeptical about rallies that took the S&P 500 out of what we considered “Fair Value” (3,825 – 4,050) although we will continue to stay invested, albeit tilting defensively. I say that because, even though economic data has turned against the market (slower disinflation and strong growth), that can easily change back and if/when it does, the rally will resume. In my view, any good money manager must make allowances for the other scenario occurring too, and the truth is there are positives occurring in the market, and a rally is not out of the question.

Given the current set up, we continue to advocate for any equity allocations to go towards defensive sectors and value. The worst-case scenario for stocks is a recession that crushes growth and earnings. In that outcome, defensive sectors will likely handily outperform, and they should keep losses manageable. If/when a soft landing becomes more likely, we will happily abandon value and defensives and embrace growth and tech, but we are not yet at peak Fed hawkishness and as such I am wary of rising yields that will pressure growth and tech as it has done for more than a year now.

Bottom line, stocks and bonds can bounce back but they need the following: 1) Signs of a resumption in the drop in inflation, 2) Stable economic growth (not too good or too bad) and 3) Fed rate hike expectations to stop rising. When that happens, stocks can rally, but until it does, we will remain defensive and cautious.

Side note: I recently recorded a webinar of the same title “Positive & Negative Path for the Market in 2023” in which I discussed the signs that will provide some clues to how the market will behave (rally or decline) in 2023. You may access my recording here. Call me at (925) 800-7470 for a complimentary financial and portfolio checkup.

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