Based on the initial market action of 2023, it looks like investors’ New Year’s resolutions looked like this: keep Big Tech in the penalty box, place bets on foreign stock outperformance, while feasting of bonds of all kinds to capture healthy returns and now some hope that an economic soft landing remains possible. Nobody needs to be reminded that year-end resolution 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 beat utilities by seven percentage points in the first week of 2022 alone. From then through the rest of the year, utilities outperformed financials by 17 percentage points. Still, markets revealed some clear early preferences, some of which simply rolled over from 2022. These include the continued unwinding of the massive valuation premium and overly optimistic investor sentiment in the Nasdaq giants. The tech unwind continues Ongoing since November 2021, this deflation of tech favorites recently entered a new phase with the upward trend in Apple shares and the urgent liquidation of Tesla, which cost it about three quarters of the 1,800% rise the stock enjoyed in the two years before its peak at the end of 2021. It is common to frame this stock as a response largely to higher interest rates, which reduce the value current distant cash flow. But rates have always been only part of the story, up and down. In fact, since the 10-year Treasury yield peaked on Oct. 24, the Nasdaq 100 has fallen nearly 4% while the equally-weighted S&P 500 has gained 8%. Falling earnings forecasts clashing with still-rich valuations tell the most relevant story. Since mid-2022, Amazon’s consensus earnings forecast for 2023 has fallen by 30%. For Alphabet, that’s nearly a 20% drop. These companies once had seemingly reliable growth when growth was scarce, they over-hired thinking the good times would last, and analysts over-extrapolated the pandemic-era growth spurt. Arguably, most of the technological computing has now taken place. The forward price-to-earnings ratio on the Nasdaq 100 has fallen from 31 a year ago to less than 21 today. Some stocks that led the way lower have arguably gone completely leached and cheap. Some investors clearly entered the year thinking that, for example, Meta Platforms and PayPal belonged to this category of bankrupt “de-risked” growth stocks, each of which was up 8% last week. Yet the Nasdaq 100’s premium to the broader S&P 500 remains at 25% – higher than at any time in the decade before the Covid pandemic. And the history of past tech crashes, such as after the market peak of 2000, suggests that this band may have a long stretch in the wilderness even after it has stopped falling, lagging the broader band for years. Foreign rather than American stocks? And the broader band, as measured by the equally-weighted S&P 500, continues to outperform the heaviest overall index. This egalitarian basket, purchasable via the Invesco S&P 500 Equal Weight (RSP) ETF, is up 16% from its fall low, is down less than 12% from its all-time high and reached a new cycle high against the traditional S&P 500. The poor positioning and poor performance of large growth stocks also explains the emergence of a preference for foreign markets. The US dominance of tech stocks has been a big part of the vast outperformance of US indices against the rest of the world over the past 15 years or so. There are now hints of a potential reversal. Non-US markets as a group — see the iShares ACWI ex-US ETF (ACWX) — rose more than 4% last week versus 1.5% for the S&P 500. The dollar is close to a seven-month low. China is reopening and European markets are geared towards value sectors and exporters. Bank of America global strategist Michael Hartnett has called for “buying the world” against the United States for these and other reasons. Citi’s global strategists downgraded U.S. stocks to underweight on Friday, saying European stocks, in particular, are valued more for a potential drop in earnings than U.S. stocks. Such calls for an international comeback have been made repeatedly over the past decade, with little success, although the time may well be riper now. That the US earnings forecast is too high is a widely held and reasonable view, although it is not certain that the market is unaware of it. Low Expectations Morgan Stanley shows this chart plotting the S&P 500 consensus forward earnings tally against the index’s forward P/E as evidence that earnings will fall significantly. That may be the case, although this can also be read as the market generally anticipates changes in the earnings trend, and likely that much of the compression in valuations over the past year reflects a risk that earnings have more downside. It’s also worth noting that Wall Street’s current projection of 4% S&P 500 earnings growth is, somewhat surprisingly, the lowest forecast for the year ahead in at least 35 years, according to Deutsche Bank. And that includes a number of years where earnings ended up being negative – and in some of those years stocks didn’t go down (1998, 2012, 2015, 2020). Put that on the record of proof that, whatever the problems in this market, optimistic expectations are not one of them. Bears have outpaced bulls for 40 straight weeks in the AAII survey of retail investors for the first time ever, active managers in the NAAIM positioning survey showed historically low equity exposure of 39% last week and the final weeks of 2022 have seen significant flows out of equity funds. None of this means that the market has absorbed all that a delicate macroeconomic environment must throw at it. Stocks celebrated lower service-sector wage and price growth on Friday, after three weeks of tightly wound sideways trading at the 20% lower level of 3,800 for the S&P 500. There remains a bullish trend. decline, until proven otherwise and the Federal Reserve could certainly once again push investors away for prematurely celebrating the potential end of the tightening measures. Still, high consumer incomes and low household and corporate debt service obligations are buffers, keeping the soft landing scenario going for now. Can housing and manufacturing shrink a little to decompress the economy, while overall activity is doing? No one knows, but no one can rule out that chance either. Henry McVey, head of global macroeconomics at KKR & Co., wrote on Friday: “We are in a bottoming process where supply, sentiment and valuation (especially on the credit side) look somewhat attractive, but unrealistic margin assumptions and a strong US dollar mean this process will take much longer than normal to unfold.” The attractiveness of credit is factored in, with massive inflows into bond funds absorbing a massive rush of new corporate issues last week, a healthy sign that the circulatory system of capital markets is working well. Higher yields, with higher quality indices offering 5%, are generally said to present fierce competition for stocks. Superficially, yes. But the presence of safe yield – or, in fixed-income lingo, “carry” – in a portfolio can also serve to buffer stock volatility and, in fact, allow investors to better shoulder risk. actions carry with them. Recession predictions, based on a long history of data relationships involving the yield curve and leading economic indicators, also cannot be disproven, leaving the tape stuck between a tough-talking Fed and a watch for the economy gives way. At the very least, however, the starting point for 2023 is better for an investor than it was a year ago. At the time, you were buying the S&P 500 at 21 times expected earnings, you couldn’t grab more than 1.8% yield on 10-year Treasuries, and the Fed had all its tightening ahead of it. Now the S&P is below the 17yr and the 20yr average, the 10yr offering double the yield and the Fed is almost done raising rates. That doesn’t mean things are cheap and future returns attractive, but it’s worth remembering that when prices and asset valuations fall, risk is removed from markets and potential future returns are restored.
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