A barbell year

Bottom Line

After a very difficult 2022, the S&P 500 broke from the gate in January in decidedly bullish fashion, swapping last year’s defensive darlings for out-of-favor growth stocks. It posted a 6.18% price-only return for the month and a 6.28% total return, the index’s best January since it rose 7.9% in 2019. 

The rally continued beyond last week’s Federal Reserve policy meeting, running into technical Fibonacci resistance on February 2 after a 9.3% intraday rally from the beginning of the year. So, from its oversold trough in mid-October at 3,492 to last Thursday’s overbought peak at 4,195, the S&P enjoyed a powerful midterm election rally of more than 20%. 

The question with which investors seem to be grappling is whether this strong January is sustainable. Our best guess is that weakening fundamentals will lead to a barbell-shaped year, in which stocks could correct in coming months back to their mid-October lows before rallying to new highs into year-end. What might spark such a correction? At the top of our list are deteriorating earnings, potentially sticky inflation, continued Fed hawkishness and a worrisome game of chicken in Washington regarding the debt ceiling. Stocks have corrected by about 2% in recent days. 

‘January Barometer’ positive in 2023 According to the “January Barometer,” one of the stock market’s most popular and widely followed rules of thumb, as the month of January goes, so goes the full year. Since 1950, Jeffrey and Yale Hirsch of the Stock Trader’s Almanac report that the performance of the S&P in January—positive or negative—is an accurate directional signal for the full-year performance of the stock market 73% of the time (53 out of 73 observations). When January is a positive month, as it is this year, the odds of a positive full year rise to more than 88% (38 out of 43 instances). 

Powerful start to the year This year’s strong 6.2% price-only gain in January for the S&P would rank as the index’s ninth best start to a new year since 1950. Looking at the 31 instances over this period in which the index rallied 2.3% or more (ranging up to a gain of 13.2%) during January, it finished the full year in positive territory 87% of the time (27 out of 31 instances). Its full-year return averaged 18.2% over this period (within a wide range of -13% to 45%), with a median return of 19.1%.

Fundamental headwinds We’re roughly two-thirds of the way through the fourth quarter reporting season, and it’s not going well. The economy has started to slow, and revenue growth for S&P 500 companies has risen about 5% year-over-year (y/y) in the fourth quarter, down sharply from the 16% y/y revenue gain in last year’s fourth quarter. Earnings have declined about 6% y/y in the fourth quarter, compared with a strong 31% increase in last year’s fourth quarter. 

Profit margins contracted about 10% in the fourth quarter, as companies are dealing with higher labor, commodity, transportation and warehousing costs. It’s the fourth consecutive quarter in which profit margins have contracted, and at an accelerating pace. Companies are reluctant to pass higher costs onto their customers for fear of losing market share, so they’ve absorbed them, resulting in slimmer profit margins. 

Companies also are issuing weaker full-year guidance for 2023. Last October, in anticipation of these negative trends, we cut our 2023 S&P estimate from $230 to $200, which implies a 10% y/y decline from our 2022 estimate of $220. The consensus estimate for 2023 has declined to $230 from $250 last summer, but we believe that is still too high. A further reduction toward our $200 estimate could spark a commensurate decline in share prices. 

Inflation & central bank uncertainty We do not subscribe to the optimistic “Immaculate Disinflation” and “Immaculate Pivot” theses favored by the consensus regarding inflation and monetary policy. While we agree that headline inflation peaked last year, wages and food, energy and housing costs could prove persistent. Inflation should grind back to the Fed’s 2% core target over the next two years, not any time soon. 

After hiking interest rates from zero to a range of 4.50-4.75% over the past 11 months, we expect the Fed to execute two more quarter-point increases in March and May. It likely then will pause at a terminal rate of 5.25% until 2024 before cutting rates. But if inflation remains elevated, it may continue hiking rates this year or lengthen its pause next year until the economy slips into recession. That possibility is not priced into the stock market. 

Debt ceiling debacle While the federal government reached its debt ceiling of $31.4 trillion last month, Treasury Secretary Janet Yellen can probably use measures to forestall default until the third quarter. So we’re likely to see nothing but political posturing between now and Labor Day, with Democrats and Republicans hoping the other side of the aisle blinks first. To be sure, both sides have valid points. President Biden and the Democrats are right in wanting a clean lifting of the debt ceiling to avoid a catastrophic default. But House Speaker Kevin McCarthy and the Republicans also are correct that we need structural spending reform after the binge of the past two years and should work toward a balanced budget. While we fully expect the debt ceiling to be raised, the noisy debate could easily drift into the third quarter, historically the most volatile for markets.

Keep the defense on the field We continue to advocate a tactical defensive investment posture, with a focus on less-expensive value, small-cap and international stocks and sectors with lower betas and higher dividend-yield support. If the economy does slip into a recession later this year, financial markets will begin to anticipate that the Fed will reduce interest rates at some point next year. That could spark a year-end rally. 

What are the best sectors to own in 2023? The “January Barometer Portfolio” indicator also contends that the best- and worst-performing S&P 500 sectors in January tend to follow that performance trend the rest of the year. Here are its 11 sectors, sorted by total-return performance from December 30, 2022 through January 31, 2023. The results clearly indicate the resumption of a risk-on mentality. They favor the “from worst to first” growth stocks, which dramatically underperformed last year, at the expense of the defensive, value-oriented stocks, which held up better in 2022.

• Consumer Discretionary, 15.02%
• Telecommunication Services, 14.51% 
• REIT’s, 9.90%
• Information Technology, 9.32%
• Materials, 8.98% 
• Financials, 6.87% 
• S&P 500, 6.28% 
• Industrials, 3.72%
• Energy, 2.81%
• Consumer Staples, -0.89% 
• Health Care, -1.87% 
• Utilities, -2%