Every market strategist seems to have the same outlook going into 2023: The market will struggle in the first half of the year, then rally toward the end. There is some difference in the degree and actual year-end estimates for the value of the S&P 500 index, but directionally, this is the forecast from every strategist we have heard.
This groupthink alone should be taken as evidence that there is a high probability of this forecast being wrong. When everyone on Wall Street agrees, then usually that means everyone is wrong…but not always. Just because it is the consensus doesn’t necessarily mean it is wrong. So, let’s try to figure this out for ourselves.
The almost universal reason for this forecast is the belief that we simply must have a recession in 2023. The argument goes that because the Fed is raising interest rates, the economy must go into a recession. If we go into a recession, then corporations will make less money; therefore, earnings estimates need to drop, and when they do, the stock market will fall. This has been the steady drumbeat of market strategists for at least nine months now. The only change is that they keep getting frustrated by the fact that analysts’ earnings estimates are not dropping, or at least not dropping fast enough.
Why the disconnect between the earnings estimates of Wall Street analysts and the views of Wall Street strategists? I believe the disconnect comes from having very different perspectives. First, some translation into English would be helpful.
A strategist on Wall Street is someone who uses economic and market data to project the big picture of where the market (usually defined as the S&P 500) is going. They are often (though not always) trained economists. They look at the financial world from the top-down.
An analyst on Wall Street is someone who studies companies. Usually, they will follow every company in a specific industry. They look at each company from the bottom-up.
The strategist community sees the current situation as driven by the actions of the Federal Reserve. The theory goes that the Fed raising rates will cause economic activity to slow down, and the economy will go into a recession. When that happens, companies will make less money, and their stock prices will fall. They believe this will occur in the beginning of this year, and when it is over, the stock market will rebound.
This argument seems logical, but it ignores a significant factor and makes some assumptions that might not hold true. First, it ignores the fact that the market has already dropped well into bear market territory in anticipation of this very event; this seems to not matter to the strategist. Bad news should be priced into the stock market already, but strategists deny this. Secondly, it assumes that Fed actions have a significant impact on the real economy. There simply does not seem to be much evidence for this belief.
Let’s think this through. The Fed’s actions have been to raise interest rates. How much of your personal consumption is impacted by interest rates? Hopefully, none of our readers are borrowing money for monthly expenditures. If one is in the market for a new car or a house, then interest rates would have an impact, but most of us are not borrowing money to buy a new shirt or go to a movie.
How does the increase in interest rates impact companies? There are two possible ways: 1) If they sell a product that requires most customers to use financing. Housing and the mortgage business are certainly hurting with higher interest rates, but most businesses do not sell products that are so expensive that their customers must finance them. 2) If it has to borrow a great deal of money to run its operation. The interest expense on that debt would cause earnings to go down.
In the 1970s and 1980s when we last dealt with high inflation and an aggressive Fed, our economy was based on manufacturing. Manufacturing requires big warehouses and factories with lots of expensive equipment, which were usually financed, and therefore companies carried significant amounts of debt and were sensitive to the cost of borrowing money. Today our economy is based on services. Most companies do not carry a large amount of debt and interest expense is a relatively small item.
This brings us to the view of the Wall Street analysts who keep frustrating their strategist colleagues by not lowering earnings estimates enough. They view the world from the bottom-up. They are looking at individual companies and saying that the actual companies are doing just fine. They are not blind to what the Fed is doing, but most companies just are not seeing a significant impact, so the earnings estimates remain far more positive than the top-down strategists believe.
Who is right? Truth be told, neither group has the best track record, but if forced to pick one over the other, I will go with the ones who see the world from the bottom-up; that is how prudent investing is done – analyzing each investment on its own merits and not guessing where the entire market is going.
Our view is that 2023 may get off to a rough start (though the first two weeks would not indicate this) simply because so many on Wall Street believe the first half will be rough. We believe that by the second quarter, the realization will hit home that the most-forecast recession in history isn’t going to happen, or if it does, it will be so mild that no one will notice. Then we rally for real. If anything, we may be too pessimistic. I for one will be very surprised if 2023 is not a good year for investors. Happy New Year!
Chuck Osborne, CFA