Might 3% become the new 2%?

Santa’s been missing in action. With just a day of trading left in 2022, the S&P 500 this month is on pace to give back nearly two-thirds of autumn’s 14% rally, putting an exclamation point on the worst year for stocks since the 2008 global financial crisis. Tax-loss harvesting before year-end undoubtedly has played a role. Since 1928, markets have rallied in the last seven post-Christmas trading days nearly 70% of the time, meaning there’s still time for Santa to make an appearance (through Jan. 5, 2023). Sentiment favors a rally—the CBOE put/call ratio is at multiyear highs and AAII bearishness is at the most “entrenched” and persistent level of bearish sentiment in the survey’s 35-year history. Technicals are supportive, too. Tech and Health Care stocks, which account for a third of all stocks above $25 million in market cap, are at oversold levels, and support at 3,800 on the S&P is holding. Moreover, January tends to be one of the strongest months for retail equity flows. It’s always difficult to get a good read on the market between Christmas and New Year due to minimal news flow, thin volumes, skeleton crews on trading desks and nervousness about managing balance sheets into year-end. Rapidly rising interest rates, high inflation and one of the most volatile years on record added to the confusion this year.

There’s confusion about next year, too. Confidence in forecasts is low—not surprising after so many got 2022 badly wrong. Empirical Research sees a market engulfed in a fog so dense that no argument is credible enough to rise to the level of being a base case. Consensus expects recession. There’s never been a yield curve so deeply inverted without one. But it’s not the depth of the downturn that’s the concern as much as its effect on earnings. Profit expectations for 2023 need to come down, with estimates currently ranging from high single-digit gains to a 15% contraction. Earnings multiples and inflation at the moment are much higher and interest rates, credit spreads, the VIX and the jobless rate much lower relative to past market bottoms. Strategic Research thinks the market may be betting on a rapid decline in inflation, a surfeit of job openings and consumer and corporate savings to save the day. That’s not a bet I’d take. Leuthold Group sees margins contracting by at least a point in 2023 vs. analyst expectations for a full point of margin expansion. On the other hand, 1930-31 marks the only instance over the last 100 years of a negative 20%+ calendar year being followed by another down year. Excellent odds! Also, since 1979, 1-year forward returns averaged 18% every time the Dow outperformed the S&P, Nasdaq and Russell 2000, as it did this year. Between new debt that must be funded and $6-7 trillion of Treasury debt that must be rolled over in three years, liquidity may represent the biggest market risk. This bear market also has lacked a “cathartic” volatility spike that has marked the bottom of every bear market since 1970. Perhaps that comes in 2023 as economic and earnings recession forecasts are realized, followed by a new up-leg as there’s strong precedent for equity market gains in years of EPS declines.

Beyond 2023, the future could look dramatically different. Many younger people first entered the equity market during the pandemic—Robinhood’s average user is 32, half the age of the average retail brokerage client. Their stock-picking methodology led to almost 3,000 basis points of underperformance this year, with Robinhood’s equity trading revenues down by nearly 60%. When asked about the investment choices they’d like to see in their 401(k) plans, millennials and GenZers cite guaranteed annuities and cryptocurrencies (two strange bedfellows, don’t you think?), ESG and fractional shares. Even though these younger cohorts currently hold just 7% of all discretionary fractional assets, Empirical believes demography eventually will prove to be destiny, making for a more unstable market than in the past. The pace of this change may be glacial—two-thirds of financial advisor clients are 55+ and a third are 65 and older—but it is coming. The geopolitical front is changing, too, with China aligning more closely with Russia and OPEC. In President Xi’s first-ever visit with Saudi and Gulf Cooperation Council members earlier this month, Credit Suisse saw echoes of FDR’s meeting with King Abdul Aziz Ibn Saud on Valentine’s Day 1945. With the West supporting Ukraine and increasingly suspect of China, new Cold War lines are being erected. The threat for the U.S. is that this could end three decades of cooperation that played a major role in global disinflation, making the Fed’s 2% goal all the harder. Might 3% become the new 2%?  

Positives

• The outlook for inflation is improving Global headline CPI in November rose just 0.1%––the smallest monthly gain in two years. Supply chain bottlenecks have eased as has tightness in the U.S. residential rental market, which indirectly accounts for 42% of core CPI. Regional manufacturers’ surveys suggest most firms expect to pay less for materials. Ten-year inflation expectations sit at 2.2%, just below where they were in 2002-2008, and the real 10-year yield is almost 1.5%, also a bit below the ’02-’08 average.
• The recession may get pushed back Capex and employment continue to bolster the economy, and restaurants are reporting surprising strength, with sales over the past four weeks their highest since October 2019. Q3 real GDP growth was revised up to 3.2% and, according to the Atlanta Fed, is currently running at an even stronger 3.7% pace for Q4.
• Despite the holiday mess, airlines looking up too According to Hopper.com, which caters to Gen Z and millennials, “Americans will prioritize travel & experience in the year ahead, international travel will make a big comeback, especially to Asia, and for remote workers, flexible schedules will mean more travel.” Hopper says 62% of searches are now for international trips vs. 55% last year, and while Europe makes up a third of all searches, the interest has jumped the most for trips to Asia.

Negatives

• Housing continues to crash Pending home sales plunged a much worse-than-expected 38% in November, the 18th straight monthly decline and the biggest in a year. Abetted by deferred sales of new homes by homebuilders and the rapid rise in mortgage rates, the weakness in housing demand is broad-based, weighing on sales of furniture, appliances and furnishings. On the plus side, housing’s slide is, according to TrendMacro, simply returning it to a decade-long trend after 2020-21’s big run-up.
• Higher for longer November’s consumer confidence survey, which showed that the “jobs plentiful” series remained high at 45.8% while the “jobs hard to get” series remained near recent record lows at 13%, indicates there’s still a lot of work for the Fed to do to rein in wage growth. Moreover, the trip back to the Fed’s 2% target, if we ever get there, is unlikely to be smooth, owing in part to services. They constitute almost a third of the core index and were up 7.25% year-over-year in November.
• Has oil put in its low? Even with this year’s elevated prices, oil companies’ capex has only increased 6%. Investment stood two-thirds higher the last time oil prices were this high, suggesting shortages could emerge as China reopens. If global oil demand continues to increase, particularly as sanctions hit Western supplies, oil prices could move much higher as ongoing underinvestment leads to much tighter supply.

What else

A year of surprises, courtesy of Gavekal Research Imagine an investor who, a year ago, had been told that in the course of 2022, Europe would experience a major land war and inflation in the U.S. would reach 8.5%. That investor would probably have bought gold. And our investor would now be roughly flat for the year.

Imagine an investor … who, a year ago, had been told that in the course of 2022, oil prices heading into late December would be down. Our investor would have likely avoided energy stocks. In the end, energy stocks were the only mainstream option for equity investors to get positive returns.

Imagine an investor … who, a year ago, had been told that in the course of 2022, OECD leading indicators and ISM surveys would both swing into negative territory. Our investor would have likely chosen to buy OECD government bonds, only to face a drawdown not seen for a generation.

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