Based on the initial market action of 2023, it appears investors’ New year’s resolutions were something like this: Keep Big Tech in the penalty box, place some bets on foreign-stock outperformance, while feasting on bonds of all kinds to capture healthy yields and maintaining some hope that the elusive soft economic landing remains possible. No one needs the reminder that turn-of-the-year resolve often dissolves in the face of changing circumstances. Recall that at the start of last year, the popular bet was for a smooth and painless rotation from expensive growth stocks to financials and cyclicals. It didn’t last: The S & P financial sector trounced utilities by seven percentage points in just the first week of 2022. From that point through the rest of the year, utilities outperformed financials by a yawning 17 percentage points. Still, the markets have revealed some clear preferences in the early going, some of which have simply carried over from 2022. These include the continued unwinding of the massive valuation premium and over-optimistic investor sentiment in the Nasdaq giants. Tech unwind continues Underway since November 2021, this deflation of the tech favorites entered a new phase recently with the topping pattern in Apple shares and urgent liquidation in Tesla , which has cost it some three-quarters of the 1,800% surge the stock enjoyed in the two years leading up to its late-2021 peak. It’s been common to cast this action as largely a response to higher interest rates, which reduce the present value of distant cash flows. But rates were always just part of the story both on the way up and down. In fact, since the 10-year Treasury yield peaked on Oct. 24, the Nasdaq 100 is down nearly 4% while the equal-weighted S & P 500 has gained 8%. Sinking profit forecasts colliding with still-rich valuations tell the more relevant story. Since mid-2022, consensus forecast 2023 earnings for Amazon have declined by 30%. For Alphabet , it’s close to a 20% drop. These companies once had reliable-seeming growth when growth was scarce, they over-hired believing the good times would last and analysts over-extrapolated the pandemic-era growth surge. One could argue that the greater part of the tech reckoning has by now occurred. The forward price/earnings ratio on the Nasdaq 100 has indeed tumbled from 31 a year ago to under 21 today. Some stocks that led the way lower arguably became thoroughly washed out and inexpensive. Some investors clearly came into the year feeling that, for instance, Meta Platforms and PayPal fell into this category of busted “de-risked” growth stocks, each of them up 8% last week. Yet the Nasdaq 100 ‘s premium to the overall S & P 500 remains at 25% — higher than at any point in the decade before the Covid pandemic hit. And the history of prior tech busts, such as after the 2000 market peak, suggest this group can have a long period in the wilderness even after they stop going down, lagging the broader tape for years. Foreign stocks over U.S.? And the broader tape, as measured by the equal-weighted S & P 500, continues to act better than the top-heavy headline index. This egalitarian basket, buyable via the Invesco S & P 500 Equal Weight ETF (RSP) , is up 16% from the autumn low, is down less than 12% from its record high and has broken to a new cycle high against the traditional S & P 500. The big growth stocks’ poor positioning and performance is also a factor in an emerging preference for overseas markets. American tech-stock dominance was a big part of US indexes’ vast outperformance over the rest of the world for the past 15 or so years. There are now hints of a potential reversal. Non-U.S. markets as a group — see the iShares ACWI ex-US ETF (ACWX) — was up more than 4% last week against 1.5% for the S & P 500. The dollar is near a seven-month low. China is reopening and Europe’s markets are skewed toward value sectors and exporters. Bank of America global strategist Michael Hartnett issued a call to “Buy the world” versus the U.S. for those and other reasons. Citi’s global strategists Friday downgraded US equities to underweight, saying European stocks, in particular, are priced more for a potential profit slide than are American shares. Such calls for an international comeback have been made many times in the past decade to little avail, though it could well be that the moment now is more ripe. That U.S. profit forecasts are too high is a widely shared view, and a reasonable one, though it’s hardly a sure thing that the market is oblivious to this. Low expectations Morgan Stanley shows this chart plotting the forward consensus S & P 500 earnings tally against the index’s forward P/E as proof that profits will fall a good deal. Perhaps so, though one can also read this as the market generally anticipating turns in the earnings trend, and likely a good part of the past year’s compression in valuation reflects a risk that profits have more room to fall. It’s also worth noting that the current Wall Street projection of 4% S & P 500 earnings growth is, somewhat surprisingly, the lowest year-ahead forecast in at least 35 years, according to Deutsche Bank. And this includes a number of years when earnings ended up negative – and in some of those years, stocks did not decline (1998, 2012, 2015, 2020). Put this into the file of evidence that, whatever this market’s problems, upbeat expectations are not among them. Bears have exceeded bulls for 40 straight weeks in the AAII retail-investor poll for the first time ever, active managers in the NAAIM positioning survey showed an historically low 39% equity exposure last week and the final weeks of 2022 saw heavy flows out of equity funds. None of which means the market has absorbed all that a tricky macro environment has to throw at it. Stocks celebrated evidence of declining wage growth and services-sector prices on Friday , after three weeks of tightly coiled sideways trading right at the down-20% level of 3800 for the S & P 500. It remains a downtrend, until proven otherwise and the Federal Reserve could certainly once again push investors back on their heels for prematurely celebrating a potential end to tightening moves. Yet strong consumer incomes and low debt-service obligations among households and companies are buffers, keeping the soft-ish landing scenario alive for now. Can housing and manufacturing retrench for a bit to decompress the economy, while overall activity muddles through? No one knows, but neither can anyone foreclose on the chance. Henry McVey, head of global macro at KKR & Co., wrote on Friday, “We are in a bottoming process where supply, sentiment and valuation (especially on the credit side) appear somewhat attractive, but unrealistic margin assumptions and a strong U.S. dollar mean that this process will take a lot longer than normal to play out.” The attractiveness of credit is being heeded, with heavy flows into bond funds absorbing a massive rush of new corporate issuance last week, a healthy sign that the capital-markets’ circulatory system is functioning well. Higher yields, with investment-grade indexes offering 5%, are popularly said to present tough competition for stocks. Superficially, yes. But the presence of safe yield – or, in fixed-income parlance, “carry” – in a portfolio can also serve to cushion against equity volatility and in fact allow investors to better shoulder the risk that stocks bring with them. The recession predictions, based on a long history of data relationships involving the yield curve and Leading Economic Indicators, can’t be disproved either, leaving the tape caught between a tough-talking Fed and a vigil for the economy to give way. If nothing else, though, the starting point for 2023 is better for an investor than it was a year ago. Back then, one was buying the S & P 500 at 21-times expected earnings, could grab no more than 1.8% in yield from 10-year Treasuries and the Fed had all of its tightening ahead of it. Now, the S & P is under 17 and at the 20-year average, with the 10-year delivering double the yield and the Fed just about done lifting rates. It doesn’t mean things are cheap and forward-returns compelling, but it pays to recall that when asset prices and valuations fall, risk is coming out of the markets and potential future returns are being restored.
