Review the latest portfolio strategy commentary from Mike Gibbs, managing director of Equity Portfolio and Technical Strategy.
Equity markets have experienced a strong start to the year – the average S&P 500 stock is up ~8% YTD with outperformance coming from the higher-beta, harder-hit areas in last year’s decline. This is significant, as technical improvements often come well ahead of the fundamentals out of bear markets.
On one hand, the technical positives are becoming difficult to ignore. For example, the S&P 500 held its 200-week moving average at the October lows (a good level of long-term support). Investor sentiment and net positioning reached depressed levels, and selling conviction decreased at the October lows versus June lows. Additionally, the S&P 500 staged impressive breadth thrusts in the advance and broke above its 12-month downtrend with a risk-on tone. These are characteristics often consistent with a market attempting to turn out of bear market lows. We do view equities as overbought in the short-term and are due some consolidation.
On the other hand, we also believe that a glide path higher (V-bottom) is unlikely at this point. 2023 will be heavily influenced by the degree of inflation moderation, central bank policy, and ultimately the level of economic weakness inflicted (in order to bring inflation down). This week’s stickier-than-expected Consumer Price Index (CPI) and Producer Price Index (PPI) reports support our view that the path to inflation normalizing is unlikely to be smooth. Core CPI and core PPI rose 0.4% and 0.5% respectively – both likely to keep the Federal Reserve (Fed) uneasy and more restrictive. To be sure, we do believe the Fed will be successful in bringing inflation down, but this process will also take some time.
Market-implied Fed expectations have shifted toward a hike-and-hold Fed strategy over the past two weeks, rather than optimism for a dovish pivot in the back half of this year – and this is resulting in higher bond yields. The U.S. 2-year yield is back up to 4.67% (near cycle highs from early November), and the U.S. 10-year yield has risen to 3.85% (from 3.40% two weeks ago). This is a headwind to equities in our view, as P/E multiples have held a strong inverse correlation to bond yields over the past two years. Moreover, earnings estimates continue to get revised lower – and we expect this trend to continue as Fed tightening (which remains ongoing) works with a lag on economic growth.
The net result is a bottoming process and recovery that are likely elongated – with normal back-and-forth trading along the way. We believe that stocks will be higher over the next 12 months as investors gain clarity on inflation, Fed policy, and their impacts on economic growth. Multiple expansion will drive upside despite weak earnings growth (as stocks discount the future). However, that clarity needed for sustained appreciation is also likely to take some time. And with equities short-term overbought in our view, we recommend exercising some patience at current levels- using weakness as opportunity to accumulate favored stocks for the longer-term.
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The S&P 500 is an unmanaged index of 500 widely held stocks that is generally considered representative of the U.S. stock market.
The Dow Jones Industrial Average (DJIA) is a price-weighted average of 30 significant stocks traded on the New York Stock Exchange (NYSE) and the NASDAQ.
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