Market Navigator – February 2023 edition

Monthly letter

2023 is starting off as the mirror image of 2022

In 2022, stocks peaked in the first week of the year and went steadily down throughout the month. Bond yields shot higher as did the U.S. dollar index. Growth stocks fell hard, and a basket of popular smaller cap growth stocks declined over 20% in January. The volatility index doubled from its low during the month. The entire stock market decline at the beginning of the year, really into mid-year, was a result of valuation compression—this more than offset earnings, where trends were moving higher.

In 2023, stocks have basically gone straight up since the start of the year, while bond yields and the U.S. dollar have moved lower. Growth stocks have led by a wide margin, and the same popular basket of small cap growth stocks are up well over 20%. The volatility index has steadily moved lower. The entire equity gains to date have been driven by expanding market valuations, which have more than offset declining earnings estimates.

For context, a large portion of this year’s gains are simply markets getting back to where they traded in December, around the time we published our annual outlook. The most beaten-up areas of the market have also benefitted on repositioning as year-end tax loss selling subsided.

So upward and onward from here? We are keeping an open mind, one of the keys we see to navigating the post-pandemic environment. However, the weight of the evidence suggests the risk/reward is less favorable following the recent rebound in risk assets.

By far the strongest support for a more positive stock market outlook in our work is the sequencing of the recovery and the technical price action. Markets often bottom when negativity is at an extreme.

• In classic fashion, the S&P 500 made its low of the cycle on October 13 of last year, the very day core inflation reached its highest level since 1982.
• Since then, markets have showed resilience, market participation has broadened, and stocks have risen above important technical price and moving average levels. Defensive sectors have weakened.

Yet, we see the near-term market risk/reward as less favorable after the rebound given fundamental and macro challenges.

• The S&P 500 now trades at 18x forward earnings. In the past 30 years, stocks have only been able to sustain a higher valuation level twice–during the tech bubble and the pandemic overshoot. The peak level it achieved outside of the pandemic over the past decade was 18.5x. 

• If the economy stays stronger, as illustrated by the robust January jobs report, we expect the Fed and other central banks to maintain a tight monetary policy. This is likely to put a cap on equity valuations.
• Or, if instead, the economy starts to weaken as we progress through 2023, this will likely translate into lower corporate profits and challenge asset prices.
• Given still elevated macro and earnings risk alongside interest rates that are much higher than in the past decade, our view is stocks do not warrant an above-average premium.

Several shifts to our positioning this month

Given the weight of the evidence and following the sharp rebound in capital markets, we are moving cash to more attractive. Stocks are moving toward the upper end of our expected range, and bonds have also rallied sharply since we upgraded them in late October.

We are reducing the magnitude of our U.S. equity tilt and slightly boosting international developed markets (IDM). We have benefitted from the significant outperformance of the U.S. over recent years. However, more recently, IDMs have performed better, and relative economic and earnings trends are improving. The one-two punch of a much warmer winter in Europe, helping to avoid an energy crisis, followed by the abrupt and unexpected reopening of China provided a positive shock to international markets. Our modest increase to IDM acknowledges incremental improvement.

The reason we are not increasing our outlook more aggressively, at least not yet, is even though IDMs are still trailing the U.S. markets by a wide margin over the past decade, the three-month performance has moved to a short-term extreme. Moreover, the U.S. historically tends to outperform during periods of a global slowdown, and we still have concerns around Europe’s ability to withstand the significant rate hikes underway by the European Central Bank. Also, the Ukraine-Russia war shows no sign of easing and could be set to escalate given the advanced weaponry pledged by NATO countries, including Abrams and Leopard tanks. Thus, we will continue to monitor developments and make additional shifts as appropriate.

We are also taking further steps to move toward a sector neutral stance, given the mixed signals in our work, until clearer leadership emerges.

• We are taking profits on the energy sector as we downgrade it to neutral for the first time since going overweight in February 2021. The sector’s earnings and relative price trends are softening alongside weaker oil and natural gas prices.
• We move the technology sector to neutral from underweight to acknowledge the improvement in relative price and earnings trends, which are offset by above-average valuations.
• Industrials now represents our sole overweight and communications services our one underweight.

Within fixed income, we still view corporate spreads as being overly optimistic and expect slower growth and rising default rates to lead to further spread widening this year. Thus, we continue to advise keeping fixed income allocations simple, with an emphasis on high quality bonds.

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