2023 got off to a hot start in January. The S&P 500 gained 6.3% but it was the laggards of 2022 that led the pack during the month. Emerging markets lost 19.7% in 2022 but gained 7.9% in January; the Nasdaq lost a whopping 32.5% in 2022 but picked up 10.7% in January. The same phenomenon held true at the sector level: Consumer Discretionary, Communication Services, Real Estate and Technology sectors led the S&P 500 in January on the heels of being the worst performers in 2022. Bond returns were also strong, with the Bloomberg US Aggregate gaining 3.08% for the month after posting its worst calendar year on record in 2022. The bond market returns were driven by a decline in interest rates; the 2 year Treasury yield fell from 4.41% to 4.21% while the 10 year Treasury yield fell from 3.88% to 3.52%. 

Several variables were in place to promote such a strong rally to start the year. With nearly everyone on one side of the boat at the end of 2022— investor sentiment still at extreme lows and asset allocators had their highest cash positions since 2005—such extreme pessimism isn’t sustainable if the threat of an economic downturn consistently fails to materialize. This increasing hope for a soft landing combined with some other bullish factors have all contributed. Although CPI is nowhere near the Fed’s 2% target, it has been steadily dropping for several months now. As a result of this, there’s a growing sense that the Fed is nearing its terminal rate in the current hiking cycle. Volatility indexes have come significantly down compared with their 2022 levels, and while throughout all of 2022 these drops in volatility presaged subsequent market declines, the sustained decrease in volatility lately might be indicative of a change in the narrative. Combine that with the fact we’re entering the third year of a presidential term which is historically the best year in that cycle for stocks, and one can understand the swift change in sentiment. Let’s also not ignore that China is in the early stages of reopening after years of strident lockdown policy. When the world’s second-largest economy comes back online in this unprecedented way, it’s tough to see it as anything but a tailwind. 

Confirming that optimism is back in vogue, the S&P 500 crossed above its 200-day moving average and blew past it through the end of January. It had crossed above that moving average in early December but only for a couple of days; sustained movement above the 200-day moving average is historically a strong bull signal. 

But the question is— is this a bear market rally or the real deal? The month ended the day before a key Fed press conference and three days before January’s job report. It’s tempting to focus on the bullish response to Chair Powell’s press conference and the blowout jobs number on February 3rd that continues to muddy the Fed’s future course of action; as significant as both of these events are, they don’t necessarily add clarity to the market’s direction and so we’re going to refrain from diving deeper on them in this newsletter. 

Perhaps the most tangible piece of evidence for those in the bearish camp is the two-pronged problem with earnings. The first part of the problem facing investors is that there appears to be a clear slowdown in earnings taking place; whereas Q4 2022 earnings were only expected to decline by 3.4% as of the end of December, the latest numbers suggest earnings for the fourth quarter will decline by 5%. In stronger market environments you typically see corporations undersell expectations so that they can look better by beating the consensus. Q4 is seeing the opposite. The second part of the earnings problem is that even though Q4 earnings are softening, the forward-looking guidance for earnings in 2023 is still too high if you expect a recession. As we have said several times in recent newsletters, the average earnings decline in past recessions is a 29.5% drop.  FactSet’s report from January 27 suggests that analysts are projecting a 3.4% growth in earnings for 2023. Those who point to this along with the inverted yield curve, rapid monetary tightening and headlines about layoffs beginning to expand from beyond just the tech sector would claim that market sentiment in January was diverging from fundamentals. 

Another important wrinkle in this story is the divergence between what the Fed says it will do and what the market is expecting to happen.  Despite insisting that they have no plans for a rate cut by the end of 2023, the CME FedWatch Tool places a 60% probability that the rate will be lower than where the Fed moved it on February 1 (4.5%) by the end of this year. One could imagine that January’s rally was less predicated on a soft landing and more driven by the prospect of rate cuts due to a recession—this would explain January’s stock leadership, wherein the stocks and sectors that got kneecapped by rising rates the most are the ones that led the pack. If it becomes clear later this year that the Fed is not cutting rates, those who were investing on that premise will be disappointed. 

In summary, there is plenty of data to support your thesis whether you’re bearish or bullish; this is always the case, but it feels more pronounced now because of 2022’s difficult market conditions and the fatigue experienced by investors who have had to endure it. The inherent ambiguity of capital markets is why investors shouldn’t invest according to their bullish or bearish disposition or fixate too much on what might happen short term, but rather construct their portfolios to meet their goals regardless of the near-term outlook. 

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