In a year of slippery markets, the tape has shown itself to be surprisingly sticky. Sure, the indexes lost their footing last week, the S & P 500 skidding 3.4 percent from exactly the perch the skeptics would have bet it would, the level just above 4000 that marked the invisible but so far impenetrable downtrend line from the Jan. 3 market peak. Yet where it spent most of the last week and in fact the past month, was a familiar spot, between 3900 and 4000, closing at 3934. This is within a half percent of where it settled Nov. 10, the day stocks rallied on a softer-than-forecast consumer price index release. This is almost exactly where the index stood May 12, just about seven months ago. Sideways for seven months, during which the Federal Reserve has lifted rates another three full percentage points, S & P 500 earnings forecasts for 2023 have fallen 8%, the Fed balance sheet has shrunk by $400 billion and bitcoin prices – not to mention a few big crypto dealers – have collapsed. Assessing the risk/reward bargain for the market heading into 2023 comes down to whether this stickiness seems more like resilience that demands respect or complacence which advises caution. And, by extension, it means making a judgment about whether the now-prevailing view that a recession awaits by mid-2023 is both correct and not yet priced into financial markets. Mixed messages The indecisiveness of the markets mirrors the mixed macro messages swirling around. Longer-term Treasury yields are down hard in the past month, the 10-year sinking from 4.2% to a low last week under 3.5%, as bond traders have all but moved beyond the inflation scare – taking both a strong monthly wage-growth number and upside surprise to producer price inflation in stride – to elevate the economic-growth outlook to the status of top worry. Adam Crisafulli, founder of investment-research firm Vital Knowledge, says, “My bottom line for this market is determining whether the outlook for disinflation is improving at a faster rate than the prospects for growth and earnings are deteriorating – if this continues happening, it’s hard to get super bearish.” As the interplay described here suggests, the path to a positive outcome is pretty delicate, with multiple variables having to cooperate in a timely way. Certainly plausible, at least relative to how markets are priced. Plenty of strategists and risk managers are perfectly willing to assume a bearish stance nonetheless, fixated on the drop in leading economic indicators and steeply inverted Treasury yield curves as reliable – if sometimes uncomfortably early – harbingers of an economic downturn. Bank stocks have buckled to a new relative low versus the broad market and oil is defying the energy bulls to fall into a year-to-date decline. This sums to a picture of a broadly slowing economy, and yet the starting point was such a high level of activity – of goods demand, of consumer savings, of corporate profitability, of employment – that conditions can worsen without getting truly bad for some time. As just one example, Bank of America customer data show that while credit-card usage has picked up quite a bit this year, borrowers are still utilizing a significantly smaller percentage of their credit limits than they were before the Covid economic crisis. This matches up with a variety of other metrics, from continuing jobless claims (a new cycle high last week but lower than almost any time between 1973 and 2020) to the still-sizable “excess savings” in bank accounts to the broad ratio of household financial obligations to disposable income . Things are tougher than they were at their easiest last year, but not all that hard in aggregate compared to normal times. Meantime, there are offsets: Treasury yields’ decline have pulled mortgage rates down from their recent highs, while gasoline prices are down by a third from their mid-year highs. What’s priced in? The macro debate won’t be settled for a while. The prospect of a recession on the horizon is not disprovable in advance, which will probably continue to keep animal spirits in abeyance, and the struggle is to figure out what’s priced in. To get a read on this, it’s useful to reach back to the moment when the S & P 500 first rose to its current level just under 3950: March 2021, some 21 months ago. Here is how the valuation of the Nasdaq 100, the S & P 500 and the equal-weighted version of the S & P 500 has shifted since then. Even now, the current setup fits no one’s definition of a cheap equity market enjoying a fat margin of safety. Yes, as just about everyone says, there is downside risk to profit forecasts into next year, though cost-cutting by spooked CEOs, a falling U.S. dollar and overall high levels of nominal GDP could keep the cuts from going too deep. Still, this shows the valuation excess, to the extent it’s still in the market, resides in the very largest stocks atop the Nasdaq and S & P. There’s a way to write the story of 2022 on Wall Street as one long reset and payback year: several years’ worth of deferred interest-rate normalization imposed over nine months, valuation excesses in speculative tech and crypto purged, supply chains healing, pulled-forward demand for hard goods reverting to the mean. Yet not many market handicappers are deploying this argument as a reason to herald brighter times in 2023. A pretty tight consensus has developed among strategists that the S & P 500 will see little to no upside, with a nasty run to new bear-market lows in early 2023 before a recovery once a recession is underway, the Fed turns friendly or both. Just because this view is popular doesn’t mean it’s not plausible. In fact, it’s popular because it’s plausible. But if nothing else it suggests that for all the challenges facing this so-far resilient market, a dangerous complacency doesn’t seem to be among them.
