January 17, 2023
“It’s not whether you get knocked down, it’s whether you get up.”— Vince Lombardi
Last year proved challenging for the market as the Federal Reserve raised interest rates aggressively to counteract high inflation. Higher interest rates and the prospect of slower growth put pressure on individual company valuations and the market as a whole. Stocks got “knocked down” into June but staged a rally, only to be knocked back down again into October. In our last letter we said, “As market participants see progress on the inflation front, stocks should act better going forward into 2023.” We did indeed see progress and the Dow Jones and S&P 500 indexes ended the year well off those October lows.
Investors appear to be looking for two very different outcomes for 2023. The first scenario is that we are heading for an economic recession caused by aggressive Fed tightening to slow the economy. Corporate earnings could decline significantly and so might the valuation the market places on those earnings. A 20% decline in the indexes from here could be the outcome under this scenario.
The other group of investors believe these headwinds have largely been discounted by last year’s market declines. The S&P 500 was off over 25% at its worst and the Nasdaq roughly 35%. Many individual stocks declined more. The “soft landing” investor group seems to be comfortable with today’s valuations as they perceive an economy that holds up. They point to continued healthy employment, a resilient consumer and a reopening of China’s economy as supportive of this view.
The Federal funds futures are pricing in that the Fed will pause their rate hikes over the next several months and that these last couple rate increases will be relatively small. The investment environment has improved since October as the economy has held up better than anticipated and inflation has trended lower. There is less need for the Fed to keep hiking rates.
Importantly, stock leadership has changed. Where high growth names selling at high valuations led the market performance for many years, companies with more of a value orientation, great balance sheets and the ability to pass on inflation, are showing strength.
Market indicators are pointing to the end of Fed rate hikes soon. The Fed, however, is continuing to express the need to see interest rates higher and to stay higher for longer. This difference between the more hawkish rhetoric of the Fed and the more dovish expectations of the market could lead to volatility going forward. Our expectation is that pullbacks and consolidations in stocks will occur within an overall positive environment for equities.
Chief Investment Officer
Senior Managing Director
Portfolio Manager & Senior Research Analyst
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