Review the latest portfolio strategy commentary from Mike Gibbs, managing director of Equity Portfolio and Technical Strategy.
The equity market has been resilient to begin the new year (up 5% YTD) and we believe that it is attempting to turn.
When considering the equity market outlook, on one hand we have an economy that appears set to weaken. For example, the yield curve is deeply inverted, leading economic indicators are negative, banks are tightening lending standards and demand surveys are pointing lower. We believe the odds of economic contraction are high, which will lead to lower corporate earnings. This view is supported by company comments regarding their earnings outlooks during Q4 earnings season. For example, the banks are increasing reserves on expectations of higher loan delinquencies, technology companies are citing broad-based weakness, and the rails are noting muted volume growth.
On the other hand, stocks discount the future and are likely to bottom well ahead of the economy and fundamentals. This is where technical analysis can help, and the positive developments are stacking up. Recent additions to the list are relative strength breakouts of high beta versus low volatility and equal-weight consumer discretionary versus consumer staples. This risk-on tone bodes well for the underlying backdrop of the market. Additionally, the percentage of Russell 3000 stocks making new 4-week highs recently moved above 50%. This bullish reading did not occur in the bear market rallies of the 2001 dotcom bubble and 2008 financial crisis and adds further support that the worst of this bear market may be behind us.
That said, we do not believe that equities are ready for sustainable upside quite yet. A disconnect lies in Federal Reserve (Fed) expectations in our view. The market-implied federal funds rate bakes in ~50 basis points (bps) worth of hikes left in the first half of 2023, followed by ~50bps worth of cuts in the second half. We believe that the Fed will be hesitant to begin cutting rates and risk disrupting the moderation in high inflation. They wish to avoid the stop-and-go policy of the 1970s that led to a prolonged period of high inflation and was very damaging to the economy. Thus, we believe they will be tighter for longer than the market currently expects, in order to bring inflation down to their target. Updated Fed comments come at next Wednesday’s FOMC meeting, which along with a full slate of economic data and Q4 earnings season will be catalysts over the coming week.
The result is a bottoming and recovery process that may be more elongated this cycle. We expect volatility to persist and for the S&P 500 to trade in more range-bound fashion over the coming months (potentially between ~3700-4300). Longer-term, we believe that equities present attractive risk/reward for investors and that stocks will be climbing by year-end. But for those investors trying to be timely, we recommend pragmatism and patience. Accumulate favored stocks over time as the trend evolves, refrain from chasing the rally periods, and use the weak periods as opportunity within a long-term perspective.
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Index Definitions
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