2023 – What could spark a rally in stocks

By David Nelson, CFA CMT

What did we learn last week? It should be clear that Jay Powell isn’t going to be able to declare victory until he sees visible deterioration in the job market. Peak inflation is likely behind us. Unfortunately, better-than-expected prints in headline indicators like the CPI won’t be enough to get anything that resembles a Fed Pivot.
The Federal Reserve desperately needs to wash away the stain of their transitory call that let already raging inflation become entrenched in the system. In the eyes of the FOMC that can’t be achieved until a lot more Americans start losing their jobs.

Any rational view of the job market has to be nuanced. All the signs of a deteriorating job market are visible with each passing week. Wave after wave of layoffs in the economic growth sectors and a household survey that showed we actually lost 138k jobs last month don’t seem to play into Fed thinking.

The soft-landing playbook seems increasingly hard to pull off with the terminal rate still near 5% and economic activity slowing everywhere.  Retail Sales and Industrial Production were a disappointment last week coming in at -0.6%, and -0.2% respectively. Adding to the pain is earning’s estimates for next year that continue to roll over along with a forward PE of 17x. All in it becomes increasingly difficult to justify current valuations in the context of an elevated risk-free rate. 

The good news is that the above view is rapidly becoming consensus as market targets have been resetting lower for months.

What could repair the above?

  • Time – It doesn’t heal all wounds but by the end of the first quarter of 23 the 4-quarter look ahead will start to include part of 2024 earnings. By July the outlook for 2024 will be equally as important as the current year showing earnings growth instead of declines. 

What could surprise on the upside? 

  • Q4 earnings upside surprise – Given the gloomy commentary coming from most of the Wall Street banks an upside surprise is not priced in and anything close to that would spark short covering. Remember an earnings report is also a report card on how good or bad analysts were at pegging the numbers
  • Wage growth starts to stall – Wages are a major focus for Chair Powell and why he is so Hell bent on crushing employment. Key for him in that effort is seeing the JOLTS numbers come in. Difficult for employers to stop offering wage hikes when there are so many jobs still left unfilled.
  • Peace in Europe – This is the classic 100-1 bet but when it comes to War all options are on the table even peace. The peace dividend would come in many forms not the least of which would be an easing of energy and food supply concerns.

The above is nice to consider and always important to explore the contra view but reality is a bitch. The most likely scenario is at least another quarter of slogging it out as the cycle runs its course.

Stocks aren’t the only story – TLT iShares 20 Year Treasury ETF

Bonds have had a bid and the yield curve inversion could be screaming the Fed is wrong. If we don’t get a recession next year it would be the first time in a half century that a yield curve this inverted got the prediction wrong. The bid in bonds across the yield curve breathes life into the 60-40 portfolio as fixed income starts to act once again as an offset to equity risk.

Gold – GLD ETF

With crypto in the toilet Gold is regaining its status as an alternative to fiat currencies like the dollar.

U.S. Dollar

The U.S. dollar may have peaked and plays two important rolls. The first is that it helps investors holding international funds and the second is a tailwind for U.S. multinationals. Earlier in the year I said each 1% move higher in the U.S. dollar could shave off about 1/2% in earnings. Well, the reverse should also be true.

With 40% of S&P 500 offshore the dollar will play a key roll in any market rebound. 
We’re coming into the close of the year and I just want to extend my Holiday greeting to everyone.
Please feel free to reach out with any questions. Have a great week.

*At the time of this article some funds managed by David were long TLT and GLD