Stock market seasonals flashing green

Bottom line 

Last year was brutal for equity investors. The S&P 500 lost 19.4% on a price-only basis and 18.1% on a total-return basis. Inflation reached a 41-year high of 9.1% in June 2022 and the Federal Reserve aggressively raised interest rates to slow the economy and restore inflation to its 2% target. Stocks suffered their worst year since 2008, when the S&P plunged 38.5%.  

But as we turn the calendar page, two popular early-year market indicators we monitor suggest equities could enjoy a better year in 2023. The Santa Claus rally gained 0.8% this year and the early “January Barometer” rose 1.4%. History suggests stocks could generate positive returns this year, regaining some of the ground lost during 2022. We’ll evaluate the full January Barometer at the end of the month.

Elevated international to overweight Federated Hermes’ macroeconomic policy and asset allocation committees met yesterday and elevated the international developed and emerging markets equity categories from neutral to overweight. We funded that decision by reducing our cash allocation from a 7% overweight to a 5% overweight. That took our overall equity allocation from a 1% underweight to a 1% overweight.

The fundamental reasons for this decision: 

• China, the world’s second-largest economy, is reopening from its self-imposed Covid lockdown.
  The dollar peaked late last year against the euro, pound and yen when the Fed began to downshift its pace of rate hikes, and we expect it to slide further.
• International stocks are trading 38% below domestic stocks, well below their historical relative valuations, with dividend yields double that of U.S. equities.
• International economies that have entered recession already likely will emerge from it sooner than the U.S., which we project will hit a mild recession in late 2023 or 2024. 

'If Santa Claus should fail to call, bears may come to Broad & Wall' The Stock Trader’s Almanac defines the Santa Claus rally as the last five trading days in December and the first two trading days in January. Over the past 54 years (since 1968), the S&P 500 Index has been positive 42 times (78%) over this 7-day period, by an average of 1.3%. This year’s results were slightly worse, but still positive, with a nominal gain of 0.8%. The Almanac also says that in 35 out of those 54 years (65%), the direction of the full year—positive or negative—is the same as that of these seven trading days. But when they are positive—as they are this year—the stock market finishes the year in positive territory 31 out of 42 times (74%). 

Positive results for Early January Barometer Historically, as the first five trading days of January go, so goes the full year. Since 1950, Jeffrey and Yale Hirsch report in the Almanac that in 51 out of 73 observations (70%), the direction of the full year—again, up or down—is the same as that of the first five trading days of January. But when the first five trading days of the new year are positive—the case this year—the stock market finishes the year in positive territory in 39 out of 47 instances (83%). 

Positive start to 2023 Over the first five trading days of calendar 2023, the S&P rose 1.37%. According to the Almanac, it has posted a median gain of 0.70% and an average gain of 0.3% in the first week of the past 73 years (within a wide range of positive 6.2% to negative 6%). Over the 47 years in which this happened, the S&P ended the year an average of 14% higher. If that history were to hold, that would take the S&P 500 up to 4,377 by the end of this year. 

More pain now, then gain later? Last summer, the FactSet consensus expected fourth quarter S&P earnings to grow 10% on a year-over-year (y/y) basis. But today, those estimates have shrunk to -4.1%, due to elevated inflation, rising interest rates, and slimmer profit margins. In sharp contrast, a year ago the fourth quarter earnings rose nearly 31% y/y. This would be the first decline in profits since the third quarter of 2020, during the height of the pandemic.

When companies begin to report their earnings later this week, we expect cautious management guidance due to the risk of recession and rising labor, commodity, transportation and warehousing costs. Last fall, we reduced our outlook for 2023 S&P earnings from $230 to $200, versus $209 in 2021 and $220 (forecasted) in 2022. In July, consensus earnings for 2023 were at $250, but they have since declined to $230. 

If we are right that the fourth-quarter earnings season will prove soft, with downbeat management guidance, then consensus estimates could fall further toward our more muted assessment. The S&P 500 may also fall, potentially re-testing last year’s mid-October trough of 3,500—or perhaps lower—to reflect these less-favorable fundamentals. We’re keeping the defense on the field for a bit longer, emphasizing “stable demand” equity market categories, such as energy, health care and consumer staples. These tend to have lower P/E ratios, less-risky beta profiles and higher dividend-yield support. We envision getting more constructive on stocks later this year, as investors begin to potentially discount an economic and corporate earnings trough and a possible rebound in 2024.

More to come We’ll return to the January Barometer in February, after the S&P has generated returns for the entire month, to ascertain what potential full-year market implications we can draw and to identify what the top-performing industry sectors may be for the full year.

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