Equity Market Outlook 2023 – Forbes Advisor

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It’s official, 2022 was the worst year for the S&P 500 in more than a decade.

The index is on track to end the year down more than 17%. This is the S&P 500’s first double-digit percentage annual loss since the Great Recession, when the index fell 38.4% in 2008.

But if you take a long-term view, years like these are aberrations and can even be excellent long-term buying opportunities.

To put that into perspective, the S&P 500 hasn’t seen consecutive down years since the dot-com bubble burst in 2001 and 2002. The index has typically produced an average annual gain of 9% since 1996.

Unfortunately, the double headwinds of high inflation and interest rate hikes from the Federal Reserve won’t go away anytime soon. But if the Fed can keep inflation in check and navigate a soft landing for the US economy, analysts say 2023 could be a much better year.

The Fed’s War on Inflation

At the onset of the Covid-19 pandemic, the Fed cut the federal funds rate to zero to avoid an economic catastrophe.

In 2021, a combination of supply chain disruptions, pent-up consumer demand, record-low unemployment, and record-low interest rates caused inflation to spike the likes of not seen in decades.

Fed policymakers initially dismissed the price spike as transitory inflation. But higher prices have stayed much longer than expected, forcing the Fed to raise interest rates in March 2022.

After two modest rate hikes in early 2022, the consumer price index (CPI) peaked at 9.1% in June. The Fed implemented four giant 75 basis point (bp) rate hikes in the second half of the year, extending the range of federal funds target rates to between 3.75% and 4%.

As of October, annualized CPI growth has dipped to 7.7%, suggesting the Fed’s war on inflation is starting to yield victories.

There were also casualties. Higher interest rates increase the likelihood of an economic slowdown or even a recession. During uncertain economic times like this, investors tend to sell stocks and other risky assets, compressing equity earnings multiples and weighing on stock prices.

Going into 2023, the main question on all investors’ minds is whether or not higher interest rates will cause a recession.

Has the stock market already bottomed out?

While interest rates are likely to rise a bit more in 2023 despite the spike in inflation, the other big question from investors is: Has the stock market bottomed yet?

Professional investors see an 86% chance that Fed interest rates will rise another 1% by June 2023, according to CME Group. Meanwhile, Wall Street analysts expect S&P 500 earnings to fall 1.7% in the fourth quarter of 2022, up just 1.7% in the first quarter of 2023.

Despite the dismal near-term outlook, the S&P 500 has not made new 52-week lows since falling to 3,491 on Oct. 13.

Equities could also benefit from short-term gains from the US midterm elections. Since 1945, the S&P 500 has experienced an average gain of 6.1% in the fourth quarter of midterm election years and another 7.5% gain in the first quarter thereafter.

But here’s the good news for investors. The stock market is forward-looking. Price economic rebounds and earnings growth well in advance.

Heading into 2023, investors are already anticipating lower inflation, expecting a Fed pivot. A pivot with a pause in interest rate hikes should help earnings rebound.

Sameer Samana, senior global market strategist at the Wells Fargo Investment Institute, says the Fed slowdown and eventually rate hike will be bullish for investors in 2023 and should help the stock market in more ways than one.

The end of the rises means that the multiples can stop falling. From an earnings perspective, smaller hikes, and eventually no hikes, should ease the headwind the economy faces later in the year, Samana says.

Outlook for 2023 for equities

Higher interest rates are bad news for stock prices. They raise the cost of capital, which discourages companies from borrowing and investing to expand their businesses.

The bad news for investors is that earnings growth tends to stagnate. There is also a negative impact on discounted cash flow valuations, which can hurt high-growth stocks.

Growth actions

It’s been a tough year for stock prices across the board in 2022, but the rate hike has been especially tough on growth stocks. Indeed, the Vanguard Growth ETF (VUG) significantly underperformed the S&P 500, generating a total return of -27.8% year-to-date.

Since 2000, growth stocks have outperformed value stocks overall by a wide margin. But growth stocks underperformed value stocks from 2003 to 2007, another period of steep interest rate hikes.

Valuable shares

While growth in stock valuations has plummeted in 2022, value stocks have held up relatively well. Indeed, the Vanguard Value ETF (VTV) has generated a total return of just -1.7% year-to-date.

With regards to market volatility, geopolitical and economic uncertainty and rising interest rates, investors will likely continue to seek relative safety in value stocks.

Thomas Shipp, quantitative equity analyst for LPL Financial, says value stocks will likely continue to outperform until interest rates drop significantly from their current levels.

“A slower pace of smaller rate hikes, and ultimately a pause in the hike cycle, will be headwinds to relative value performance,” Shipp says. “But until there is a clear path that indicates inflation is heading sustainably towards the Fed’s 2% long-term target, value has a good chance of outperforming growth.”

Shipp notes that LPL’s Strategic and Tactical Asset Allocation Committee continues to lean toward value from an asset allocation perspective.

Sectors of the stock market

High inflation and rising interest rates have hit some sectors of the stock market harder than others.

Global energy shortages related to the Russo-Ukrainian war have helped the energy sector post record gains. The S&P 500 Energy sector grew 70.3% in 2022 and is the only market sector that has generated positive gains since the beginning of the year.

In addition, defensive market sectors with relatively stable earnings prospects (consumer staples, utilities and health care) all fell less than 6% for the year.

Darren Colananni, wealth management consultant at Centurion Wealth Management, says the S&P 500 may struggle to gain much traction in 2023 as interest rates remain elevated. Colananni’s 2023 year-end S&P 500 price target is just 3,700, about 7% below current levels.

Colananni says investors should focus on sectors that have the most expected earnings growth in 2023. In particular, he is bullish on consumer discretionary and industrials stocks.

“For the discretionary consumer, we think of companies like Starbucks, McDonald’s, Amazon and Disney. For industrials, we think of companies like 3M, FedEx and Waste Management,” says Colananni.

Wells Fargo expects a weak economy in the first half of 2023. Samana prefers the earning power of energy, technology and health care stocks.

“These companies have strong quality and profitability characteristics that should help them weather the rate hike and recession that we will see in the first half of next year,” he says.

While recession may be a scary word for investors, Wells Fargo sees light at the end of the tunnel in the second half of 2023. The company’s year-end S&P 500 price target is between 4,300 and 4,500, implying an increase of about 10% compared to the current levels.

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