Written as of February 13, 2023.
View the Nicola Wealth Investment Returns: January 2023
Highlights this Month
- Could January's stock market performance be a predictor of the entire year?
- December CPI and PCE data indicate deflationary tendencies.
- Examining the uncertainties in the favorable outlook for the U.S. economy's gentle landing.
- Does a decline in earnings guarantee a decrease in stocks?
- Federal policy versus the markets.
- Bonds may be poised to resume diversifying role.
- Active managers may find opportunities for alpha in dispersed markets.
- While remaining optimistic, caution is warranted given the presence of several concerns.
January in Review
Following a lackluster performance towards the end of 2022, the financial markets demonstrated a robust performance in January, as evidenced by the S&P/TSX index gaining 7.4% (total return in Canadian dollar terms) and the S&P 500 index registering a 6.2% increase (total return in U.S. dollar terms). This upswing in equity market returns was so impressive that it surpassed all projected estimates for the entire year of 2023, within a single month. Notably, the average Wall Street strategist forecast, as reported by Bloomberg, had projected the S&P 500 to close at 4,050 by the end of 2023; however, the large-cap U.S. stock benchmark already reached 4,076 by the conclusion of trading on January 31. Furthermore, the majority of financial assets displayed a robust performance last month, with the exception of oil and silver, which ended January in the red as highlighted by Deutsche Bank.
This abrupt change in market leadership carried through to sector returns, with BCA Research showing that U.S. equity sectoral returns in January were also a mirror image of those in 2022. Defensive sectors, like consumer staples, healthcare, and utilities, gave back some of their strong returns from last year. At the same time, communication services (communication discretionary and information technology) regained some ground lost in the previous year. Strategas noted that this was one of the most significant market leadership reversions they had seen, with the worst-performing Russell 1000 stocks in 2022 vastly outpacing the best-performing stocks in January 2023.
Although quality stocks outperformed in 2022, investors seemed more interested in taking on a bit more risk in January. Goldman Sachs's non-profitable tech basket and most shorted rolling index outperformed the S&P 500 by a significant margin. Despite expectations of a bear market in 2023, investors have been disappointed thus far. As Bank of America strategist Michael Hartnett aptly pointed out, "the most painful trade is always the apocalypse postponed," and it appears that markets have moved beyond the concerns that plagued them in the previous year.
Could January's stock market performance be a predictor of the entire year?
Based on an age-old Wall Street adage, the stock market's performance in January tends to reflect the overall performance of the year. With the S&P 500 seeing its strongest January since 2019 and the NASDAQ off to its strongest start since January 2001, investors are feeling optimistic. According to Carson Investment Management, a substantial increase of more than a 5% return in January, particularly after a down year, has historically yielded a nearly 30% average full-year return. However, it is worth noting that since 1950, January has also been the strongest month of pre-election years, such as 2023. While some investors may attribute significance to the strong performance in January, according to MarketWatch, this month's predictive ability for the direction of the market over the next 11 months is not particularly unique. In fact, six other months share January's 60% plus track record in predicting the market's direction in the subsequent 11 months of trading.
Looking at the technical indicators, the recent rally has been noteworthy. As per Bloomberg, the S&P 500 broke its downward trend in early February and is approaching bull market territory with a 16% climb from its October low. On January 20, the S&P 500 broke above its 200-day moving average, and achieved a "golden cross" in early February, which is a coveted technical milestone indicating that the 50-day moving average has surpassed the 200-day moving average. This development, coupled with the market's perceived bottom, has instilled FOMO (fear of missing out) in investors who anticipate the onset of a new bull market. However, historical precedent suggests that markets tend to rebound, but the timing is critical.
Fundstrat's Tom Lee recently reminded investors how quickly bear markets can recover, drawing comparisons to the market's 27% drawdown in 1982, which was subsequently entirely erased in four months after Former Chair of the Federal Reserve of the United States, Paul Volcker, suggested the Fed "may shift tactics" and "consider ending the inflation war." We think it’s a relevant comparison to what markets are facing today. Bloomberg's MLIV Pulse Survey indicates that most investors anticipate reaching the market's bottom in the second half of 2023. Buy-side traders believe stocks will bottom sometime in the second half of this year. According to Bloomberg, stocks usually experience one last bear market rally before the initial downturn preceding a recession occurs, and economists may even fall prey to misplaced late-cycle optimism. During the rally, the Fed was often in the process of winding down its tightening cycle, but it was too early to see the impact on the economy. Bloomberg points out that economists were susceptible to a few final flashes of misplaced late-cycle optimism.
Each market cycle is unique, and it can be risky to draw comparisons to any particular past market, as was done by Fundstrat's Mr. Lee. Lee cites similarities to the late 1980s as a reason for investors to get involved, but Strategas' comparison to 2001 is equally relevant. For example, as we saw in January 2001, the worst-performing stocks of 2000 became the top performers in the first month of 2001. Although the market was strong in January 2001, it subsequently experienced a sell-off and only found a bottom in September of that year. According to Rosenberg Research, there have been 20 bear market rallies greater than 15% since 1927, so the current rally from the October 2022 lows may not be exceptional. It could signify the start of a new bull market, but a bear market rally is also a possibility. Ultimately, the market's direction will be determined by factors such as inflation, monetary policy, and their effects on economic growth and corporate earnings, which are discussed in greater detail below.
December CPI and PCE data indicate deflationary tendencies.
Investors in 2023 remain keenly interested in the future trajectory of inflation. The latest December CPI data has confirmed recent deflationary trends, revealing a month-over-month overall CPI decline of 0.08%, the first drop in two and a half years. Although month-over-month core inflation remained high at +0.30%, both overall CPI and Core CPI have continued to trend lower versus year-ago levels. This disinflationary trend was further evidenced in December's PCE (personal consumption expenditure) release, which indicated that both total and core PCE grew at their slowest pace since 2021. Economists, as reported by the Wall Street Journal, expect headline CPI to fall to 3.1% by the end of the year and 2.4% by the end of 2024. This decline in prices is being driven by core goods, which according to Bloomberg, make up about 27% of CPI and experienced an annualized 5% fall in the last quarter of 2022. Core goods could even see a year-over-year negative turn in the first half of 2023.
Despite widespread price drops, certain sectors are bucking the trend. The Bureau of Labor Statistics reports that while basic commodities are experiencing a continued year-over-year deflation, non-energy services are on the rise, with prices increasing by 7% in December. Additionally, the Atlanta Fed notes that "sticky" prices are remaining persistently above the Fed's target rate of 2%. The potential future trajectory of prices may also be impacted by China's economic recovery from the pandemic, as Bloomberg Economics predicts that a jump in Chinese GDP from 3% to 5.8% could raise global CPI by one percentage point, with a surge to 6.7% potentially leading to a 2% increase in global prices.
China remains a factor, but investors are expected to place greater focus on U.S. wage growth in the coming months due to the tight job market. While January 2023 saw the addition of 517,000 jobs in the U.S. and a 53-year record-low unemployment rate of 3.4%, wage growth slowed, with average hourly earnings rising 4.4% YoY, compared to 4.8% in December. In Q4 2022, the Bureau of Labor's Employment Cost Index showed that employment compensation increased by 1.0%, down from 1.2% in Q3 and a peak of 1.4% in Q1. However, there are a lot of moving parts to analyze here, including seasonality and a potential mix shift with more lower-paying jobs being added at the expense of higher-paying ones. The Bureau of Labor's Employment Cost Index considers potential mix shifts, but it also is a broader measure of total employee compensation. Notably, average weekly earnings increased by 1.18% in January, the highest since 2006, suggesting that hourly wage growth may exceed 10% by 2023 if these rates continue. However, demand for temporary workers has been weak, falling for five consecutive months from a record high in July, and may dampen wage increases.
Examining the uncertainties in the favorable outlook for the U.S. economy's gentle landing.
On the surface, recent data suggest a favorable outlook for a gentle landing of the U.S. economy, as wage growth shows signs of moderation while employment growth remains robust. However, a closer examination reveals some notable uncertainties. For example, the identification by Jefferies Group of a 5.3 million gap between job openings and unemployed workers raises questions about the accuracy of the positive outlook. Additionally, Harvard's Raj Chetty estimates that the U.S. is experiencing a shortage of 2.6 million workers compared to pre-Covid-19 worker participation rates, particularly in the low-wage sector. Despite this, Strategas has recently noted that the civilian participation rate is approaching the Bureau of Labor Statistics' 2019 projection, indicating a demographic ceiling in labor supply that could be reached in the near future.
The current state of uncertainty presents a challenge for the Federal Reserve. While inflation is decreasing without adverse effects on employment, the labor market remains tight and the potential for wage growth to slow down is unclear. It is crucial for the Fed to ensure that inflation is fully under control as persistent inflation could require more drastic measures to remedy, as demonstrated in the 1970s. However, the financial markets are not cooperating with the Fed's efforts. Despite raising short-term interest rates to tighten financial conditions, stocks have rallied and credit spreads have tightened, counteracting the Fed's actions. The Fed has indicated plans to continue raising rates to over 5% by 2023, with no intention of lowering them before 2024. On the other hand, the market anticipates an earlier pivot from the Fed, with a terminal rate below 5% by the first half of 2023 and a subsequent shift to an easing cycle and rate cuts.
There is a potential for either a shortfall or excess in the anticipated inflation rate, which could prompt the Federal Reserve to either cut rates or maintain elevated levels. This discordance in the perspectives of the market and the Federal Reserve poses a market risk that necessitates resolution, as highlighted by Alpine Macro. Despite the recent positive employment report in January, a significant discrepancy still exists between the anticipated timing and extent of rate cuts by the market and the Federal Reserve.
Notwithstanding the easing of financial conditions, an indication that the Federal Reserve is nearing the conclusion of its tightening cycle is the attainment of a Fed Funds rate above inflation, as delineated by the core PCE index. It is important for the markets to recognize, however, that the conclusion of the tightening cycle does not necessarily entail an abrupt shift toward expansionary policy. Historically, the Federal Reserve has implemented a pause before implementing rate cuts, with previous delays extending up to 14 months.
Federal policy versus the markets.
relaxed financial conditions brought on by robust markets, Chairman Powell responded unperturbedly and offered minimal opposition. He asserted that the market's anticipation of a decrease in inflation was more forceful than that of the Federal Reserve. In January, for the market's upswing in stock prices to be meaningful, it is necessary for inflation to continue to diminish, and for economic growth to remain in a positive state. Despite the median Wall Street predictor forecasting a 65% probability of economic contraction within the next 12 months, the upsurge in risk assets — assets which have a significant degree of price volatility — indicates a lower risk of recession. The median prediction has remained constant for several months, despite the market's rally, even though Goldman Sachs recently reduced the likelihood of recession to 25%.
Maintaining the health of the consumer is critical for sustaining economic growth, and the current scenario presents a mixed outlook. The rise in inflation has led to a decline in consumer spending, while wage growth has struggled to keep up, resulting in a decreased personal saving rate. A growing number of adults in the United States are facing challenges in meeting their monthly expenses. However, as inflation begins to subside, real average earnings are showing a positive upward trend. While this is beneficial for economic growth, it may not bode well for corporate profit margins.
In the current market landscape, monetary policy and short-term interest rates are significant drivers, with earnings also playing a crucial role. Recent data from Strategas indicates that although estimates for 2023 S&P 500 EPS earnings have decreased, they are still approximately 5% higher than the originally-projected $200 per share. However, the dispersion of S&P 500 earnings estimates has risen to its highest level since the pandemic, highlighting uncertainty on Wall Street regarding future earnings trends. Morgan Stanley notes that forward EPS growth has turned negative for only the fifth time since 2000, which suggests that earnings may decrease further, based on the other four times that earnings growth turned negative since 2000. Notably, while 2023 earnings estimates have declined, 2024 earnings projections have increased. Forecasts for the economy indicate a potential recession, but most analysts expect it to be brief and shallow.
Does a decline in earnings guarantee a decrease in stocks?
Despite potential declines in earnings, proponents of bullish stock market performance argue that this does not necessarily guarantee a decrease in stocks. LPL Research highlights various instances since 1950 where annual earnings growth fell, even when the S&P 500 recorded positive returns. Additionally, RBC's Pulse of the Market reports that equities typically bottom out six to nine months before earnings, indicating that the market may have already accounted for a decline in earnings. FactSet reveals that the market has already moved past any short-term earnings weakness, with companies that miss estimates trading only 0.3% lower compared to a 5-year average decline of 2.2%. BMO also suggests that the worst may be over, as 2023 S&P 500 earnings estimates have decreased by over 10% from May compared to the 4.5% average drop during similar periods in history. While we align more with the forecasts of Strategas and Morgan Stanley, which indicate that earnings could still decrease further than the current market estimation, we recognize the reasoning behind the more optimistic outlook as to why the market has shown a strong start in 2023.
With stocks already at most strategists' 2023 year-end target levels, it is challenging to know how investors should position their portfolios. Portfolios comprised of 60% stocks and 40% bonds generally fared poorly last year, even with the addition of commodity exposure.
Bonds may be poised to resume diversifying role.
Despite the rally in bond yields in early 2023, their risk return profile appears more attractive than in the previous year, positioning bonds to resume their role as a diversifying counterweight to equities in 2023. Only if inflation continues to rise, and inflationary expectations drive bond and stock prices lower, would the inclusion of bonds in a diversified portfolio become less appealing. However, in the event of an economic recession, yields are likely to decline, allowing investors to benefit from higher bond prices while receiving what we’d consider a decent coupon. Although gains may not be significant, we think this approach could help mitigate any additional volatility from the stock market during times of declining earnings. BlackRock suggests that a 35/65 (35% stocks and 65% bonds) allocation is the new 60/40, potentially offering investors a reasonable 6.5% return. Similarly, Rosenberg Research advocates for higher bond allocations in order to achieve a better risk-adjusted return.
For investors who seek income generated by bonds but are concerned about potential increases in interest rates, cash may be a viable alternative. In the event of an inverted yield curve, where short-term rates exceed longer-term yields, investors may not receive appropriate compensation for holding their funds in bonds over extended periods of time. In a higher-for-longer scenario, cash may offer investors solid returns with reasonable risk levels. The recent increase in money market fund assets suggests that many investors share this perspective. However, if short-term rates are expected to decrease in the near future due to a Federal Reserve shift to an easing cycle during a recession, then holding longer-term bonds may be advantageous.
Active managers may find opportunities for alpha in dispersed markets.
Regarding stocks, lower index returns do not necessarily equate to lower absolute returns. Although equity portfolio managers have found it challenging to exceed benchmark index returns in the past 12 years, Strategas reported that nearly 62% of managers were successful in 2022, marking the first time more than half outperformed the index since 2009. According to Bank of America's Savita Subramanian, active managers thrive in a market where individual stock returns exhibit high dispersion and low correlation. Conversely, in markets where all stocks move in the same direction, it is arduous to add value, especially if macro factors drive most stocks. A better environment for managers to excel in is where individual stock performance is more relevant, allowing their stock-picking skills to come into play and generate "alpha" for the portfolio. A concentrated market where a few leading companies drive performance poses a challenge for most managers, who tend to underweight such firms. This scenario presented itself in early 2022, with five large tech stocks accounting for 24% of the S&P 500. As this concentration unwound, active managers benefited, while investors who capitalized on the underrepresented energy sector achieved notable alpha. Undeniably, technology and energy sectors still offer alpha opportunities for investors in 2023, alongside other stock-specific opportunities in different sectors.
Similar to energy, international stocks exhibit signs of being undervalued, making them an attractive option for active managers to generate alpha. Strategas' analysis indicates that global stocks offer attractive prices, trading at more than one standard deviation cheaper valuation than U.S. stocks. Breakout Capital further highlights that while U.S. equities account for approximately 60% of the world's equity market capitalization, they represent less than 50% of the world's corporate earnings, less than 30% of global GDP, and only 5% of the world's working age population. Bank of America's Global Fund Manager Survey reveals that investors have recognized this discrepancy and are currently underweight in U.S. equities, the most since October 2005. Emerging Markets are considered a favored investment destination, followed by Europe as a distant second. In addition, Canadian equities also present a compelling case for investment.
The improved global economic outlook is proving advantageous for emerging markets, with China's recent decision to lift Covid-19 lockdowns and restart their economy providing a particular boost. In light of this, Bloomberg Economics has predicted that China's GDP will recover from 3% growth in 2022 to a potential 5.8% in 2023, though this could be considered conservative. Despite this optimistic outlook, a recent article from the Wall Street Journal cautions against relying on China to rescue the world economy, as the country's rebound is likely to have a more significant impact on its domestic service sector, given that Chinese consumers have fewer savings compared to those in other countries following the pandemic.
While remaining optimistic, caution is warranted given the presence of several concerns.
We acknowledge the positive returns observed in January, however, we exercise caution in extrapolating these returns for the remainder of the year. Our concerns are rooted in the possibility of a recession and lower corporate earnings, which could prompt the Federal Reserve to initiate an early pivot towards reducing rates. While we understand this line of thought, we are somewhat skeptical about the degree to which the market is currently factoring in these potential events. The current consensus seems to suggest that economic growth will slow, prompting the Fed to pivot, but not to an extent that would inflict significant damage on corporate profits. However, the market seems to be overlooking the possibility of inflation not falling as much as the Fed anticipates. This could result in the Fed being compelled to raise rates to achieve long-term price stability, which could lead to a harder economic landing. It is possible that this scenario has already begun, and given the lag effect of monetary policy, we may not yet have seen the full extent of the economic fallout. While the Fed may pivot as expected, we are concerned that the associated economic damage could exceed current market forecasts. We remain optimistic but cautious, given the presence of some positive indicators but also the presence of several significant concerns.
Disclaimer
This material contains the current opinions of the author and such opinions are subject to change without notice. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information presented here has been obtained from sources believed to be reliable, but not guaranteed. Nicola Wealth is registered as a Portfolio Manager, Exempt Market Dealer, and Investment Fund Manager with the required provincial securities commissions. All values sourced through Bloomberg.
