As the market enters a new year, stocks are down 20% from their highs. Treasury yields are climbing. The Fed’s raised rates again and again, and Fed Chairman Jerome Powell has stayed hawkish.
No, we’re not talking about today.
We’re talking about four years ago as Wall Street approached 2019. And what happened that January? The S&P 500® index (SPX) rose nearly 8% month over month and finished 15% above its December low.
Could January 2023 promise anything similar coming out of this long bear market? Don’t get your hopes up, but perhaps the new month and year won’t be as much of a downer as what we’ve seen in 2022.
To be sure, things are very different now than before the dawn of 2019. Powell may still be Fed chairman, but in most other ways, there’s just no comparing four years ago to today. Inflation and wage growth remain too high for the Fed to repeat a similar reversal on rates setting a happy tailwind for Wall Street.
Additionally, January 2023 is likely to bring more bad news; this time in the form of declining earnings expectations that could make even today’s beaten-down stock prices look too high.
But aside from some significant bearish arguments we’ll make in more unpleasant detail shortly, anyone feeling bullish could have a case to make at the start of the coming year.
New Year, New Optimism?
The stockings weren’t completely full of coal this Christmas, difficult as that may be to believe. Three things to consider:
- Investors got a few more hints last week that inflation is going in the right direction.
- The Fed has hiked rates so much it may have fewer and smaller increases ahead.
- Many high-quality stocks are now at levels that look relatively cheap as they’ve been dragged down with others that arguably deserved to lose their luster.
The equal-weight SPX—which has the same components as the familiar SPX but with each company given a fixed weight of 0.2% so mega-caps like Apple (AAPL) and Alphabet (GOOGL) don’t dominate—is actually up 11% so far in Q4 versus just a 7% rise for the unadjusted SPX. The unadjusted SPX did worse in part due to dreadful Q4 performances by heavyweights like APPL, GOOGL, and Tesla (TSLA).
As a reminder, the SPX is weighted toward market capitalization, meaning shares of the biggest companies have far more impact on the index than those of smaller companies.
The equal-weight performance suggests the average stock in the SPX had a pretty decent Q4 despite many headwinds. And in general, the SPX has made progress since September 30, even though it’s down more than 5% in December. Just as the outperformance of mega-caps hid troubles lower down in the index back in the 2019–2021 era, the weaker mega-caps of today are likely disguising some progress below the surface.
Speaking of progress, the Fed’s recent 50-basis-point rate hike brought the target federal funds range to 16-year highs between 4.25% and 4.5%, not too far from the Fed’s current projected terminal, or peak, rate, of between 5% and 5.25%. There’s no guarantee the Fed won’t raise its terminal projection again at some point, but for now, anyway, it appears the rate hike cycle may be at least past the “end of the beginning,” to paraphrase Winston Churchill.
The Federal Open Market Committee (FOMC) won’t make a rate decision in January but will deliver one on February 1. The futures market is baking in 63% expectations for just a 25-basis-point hike. That would be the first hike of just 25 basis points since last March.
While rate hikes are never bullish events, at least the most dramatic increases appear to be in the rear-view mirror. But a lot will depend on whether another positive trend continues in January—the gradual loosening of inflation’s icy grip on the economy.
For big signs of further progress on inflation in January, investors will want to watch:
- December Consumer Price Index (CPI) on Thursday, January 12
- December Producer Price Index (PPI) on Wednesday, January 18
But even before those releases, December Nonfarm Payrolls Report (arriving Friday, January 6) features a wage component worth examining for any signs of slowing salary growth. Rising wages have been a huge inflation driver.
Last week, investors received a mixed outlook on inflation data, and that will place more emphasis on the importance of January’s payrolls, PPI, and CPI.
Specifically, the Personal Consumption Expenditures (PCE) price report for November showed core PCE prices with energy and food stripped out up just 0.2% month over month, down from 0.3% in October and 0.5% in September. PCE inflation is now up 4.7% versus 5% in October. That provided more evidence that the lower inflation trend in the October and November CPI reports wasn’t a mirage.
On a less positive note, Personal Income rose 0.4% in November, indicating that strong wage growth continues. That’s great news if you were one of many who received a generous raise like the 4.6% the federal government just announced for its workers. It’s not such good news, however, if you’re the Fed trying to cool the economy or a corporation trying to preserve slipping margins.
So that’s where we stand on the price picture in a nutshell as the old year closes and January begins. Overall inflation is slowing a bit, which is encouraging, but the wage component, driven in part by a shortage of workers for available jobs that’s showing little improvement, remains a high-alert issue for the Fed and companies.
January’s ‘Watchlist’
What, besides inflation, should investors look for in January? Unfortunately, that’s where some of the negatives start to come in.
Overhanging everything is the start of Q4 earnings season in mid-January, which could leave the entire market vulnerable to falling expectations.
As of late December, analysts expected Q4 S&P 500 earnings to fall 2.8% year over year, according to market research company FactSet. That’s down sharply from the September 30 projection for 3.7% earnings growth in Q4 and reflects a number of problems in the economy that just didn’t go away over the last few months.
Strip away the energy sector and Q4 earnings would look a whole lot worse, according to FactSet. They’d be on pace for a 7.3% decline instead of a 2.8% drop.
Margins are one issue as wages continue to surge, eating into many companies’ ability to deliver expected levels of profit after two years of margin improvement for S&P 500 companies. Despite many companies being able to raise prices as inflation surged, Q4 profit margins are expected to be the worst in two years, FactSet said.
Then there’s the issue of softening demand, both from consumers and businesses. We saw that the week before Christmas when two major companies reporting earnings—semiconductor-maker Micron (MU) and used-car retailer CarMax (KMX)—cited challenges in their recent quarters.
“The industry is experiencing the most severe imbalance between supply and demand … in the last 13 years,” said Sanjay Mehrotra, president and chief executive officer of Micron, in a press release last week. He added the company would take measures to cut costs and operating expenses.
For its part, KMX paused its buyback plan for investors, which raised new worries on Wall Street about a possible trend in that direction after seeing profit fall 86% in its fiscal Q3 amid declining product demand.
“We believe vehicle affordability challenges continued to impact our third-quarter unit sales performance, as headwinds remain due to widespread inflationary pressures, climbing interest rates, and low consumer confidence,” CarMax said in a press release.
These are two very different industries both struggling with demand issues. They can’t be alone.
When January begins, many Wall Street analysts and companies could likely erase what’s on their white boards and get out the red markers. And not just for Q4 but for the full year ahead.
In calendar year 2023, analysts expect 5.3% earnings growth for S&P 500 companies but watch the FactSet reports each Friday to see how quickly that number is likely to descend once January begins. It could be a market driver. Many market observers think 5.3% is far too optimistic in the current rate and demand environment, especially as consumers eat through the last of their pandemic savings and companies conceivably lose some of the pricing power that allowed them to grow earnings in 2022 as inflation started to bite.
How bad could earnings get? We’ll discuss that further in our Q4 earnings preview next week. For now, a lot depends on whether you think the economy will enter recession in 2023 or if the worst can be avoided. January won’t bring us every answer.
Central Bank Remains Central
Fed expectations will also drive the new month. There’s some concern the market may not be fully pricing in just how hawkish the Fed is. Last week, the 10-year Treasury yield (TNX) rallied sharply to 3.7%, up from the December low of 3.4%. That could be a sign that investors are beginning to accept the Fed’s promises to keep rates higher for longer. But the CME FedWatch Tool still predicts rates staying under 5% in 2023 despite the Fed promising to go above that.
Rising yields as investors factor in a more hawkish Fed could provide another January speed bump for stocks.
The Fed is starting to really have a negative impact on certain sectors, especially in high-growth, interest-rate-sensitive areas like info tech, semiconductors, and small-caps. That’s one reason mega-caps, the Russell 2000 (RUT) small-cap index, and technology have struggled so much recently compared with the rest of the market. The Fed isn’t likely to pivot and has strong resolve. It may be willing to weather an economic slowdown along the way if it has to. This is something the market began to price in during December as the SPX fell three straight weeks, and it could cause earnings sentiment to retreat in January.
The Fed doesn’t meet until the very end of January, so earnings season and the data calendar will likely drive stock market action during the month. As noted earlier, the Q4 stock performance actually looked pretty decent if you look past the mega-cap and info tech sector’s weak performances, perhaps giving stocks a decent place to start from.
December’s been a tough month for the major indexes, but they’ve shown some resilience too, finding buying interest on each pullback. Bargain hunters have started showing up. It may not be a rerun of the 2021 “buy the dip” scenario because that was a very different time when investors could pretty much count on the Fed having the market’s back. The Fed’s done a 180 since then.
Despite the Fed’s tight grip, here’s what else might give stocks a bit more pep in January:
- There’s the idea that lower price-earnings ratios could attract buyers; something that may already be happening.
- We’re now at the end of the old year and the massive “tax-loss harvesting” effect that’s weighed on stocks most of December. The old common wisdom is that after investors dump their losers in December, they often put money back to work in January. This is called the “January effect,” but studies of the markets can’t determine if this is more of a real factor or a psychological one. Whatever the case, the last three Januarys were losing months, so maybe the January effect has lost some of its meaning.
- There’s also the “January barometer,” an old bit of market wisdom that suggests a strong January for stocks most often leads to a winning year, and vice versa. Again, actual results may vary. The last time the January barometer was positive, back in 2019, the market did have a good year. But January was weak in 2020 and 2021—and both of those years saw stocks rise.
- Overseas, there’s a bit more optimism about China as Beijing emerges from its “zero-COVID” policy, though rising cases also suggest risk for China’s economy. So far, the markets seem to be taking a “glass half-full” approach to this news. Also, there were noises from Russia recently about willingness to negotiate over Ukraine. That seems far-fetched knowing what we know, but anything more serious in the way of easing that tragic situation would be welcomed by Wall Street.
As an investor, hopefully you’ve spent a bit of time in December going over your financial plans, checking your asset allocations, and maybe exiting some losing positions. January 2023 may not end up being a repeat of January 2019, but if you made it through 2022 without tearing out too much of your hair, perhaps you’ll be ready to weather a few hair-raising moments we’re likely due in the month and year ahead.
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