Volatility has been the norm in 2022, and on the face of it, don’t expect 2023 to be much different. But the hardest part for investors is trying to bet how much stocks will go down and when a new bull market might start. Dive too soon and you risk, as the famous saying goes, trying to “catch a falling knife”. But wait too long and you might regret taking the opportunity to buy downed stocks on the cheap. No one has a crystal ball, but analysts point to a few key economic indicators that can give investors an idea of where stocks are heading in the future.
Examining how the market has behaved in the past can provide valuable insight into what the future holds. Based on historical trends, the market tends to rally before end of recessions. Since 1950, the S&P 500 has peaked about six months before a recession, and it has bottomed on average three months before a recession ends.
Still, analysts have pointed out that the number one macroeconomic factor that will affect the market’s continued slide is whether a recession hits, and how painful and prolonged it is. Quincy Krosby, chief global strategist for LPL Financial, stressed that he was watching “the depth and the pain” to determine the market outlook.
“The recession we are likely to enter will be more classic cyclical,” said Sean Bandazian, senior investment analyst for Cornerstone Wealth, referring to the age-old pattern of stocks becoming overvalued and then falling. “So it shouldn’t be as painful as [the 2008 Great Recession]he said, which was so bad because it was caused in part by the collapse of the housing market. The recession caused by the pandemic was also an example of an age-old market factor driving the economic downturn.
Bandazian explained how the market could potentially fluctuate on a mild recession timeline: “Typically the market in this classic type of recession will drop a quarter or two after we enter a recession. So maybe we are looking at the end of 2023 or 2024,” Bandazian explained.
Krosby noted that the labor market and consumer spending are the most important indicators that show how the recession is affecting different sectors of the economy. “We live in a consumer-driven economy,” she explained. Peter Cohan, professor of commerce at Babson College, also pointed out that these two parameters are important to monitor in determining the duration of the recession. “If the numbers get bad, that is, if the unemployment rate goes up and consumer spending goes down, then the recession will be deeper and longer.”
The bottom line: Although the recession will probably be moderate and the market will not collapse like in 2008, your portfolio may still experience losses in the coming year. “I don’t expect a very bad market scenario. But I expect a reasonably bad market scenario. “It could be 15% or 20% from here,” explained Charles Lemonides, CIO of hedge fund ValueWorks LLC. Bandazian agreed, noting that he predicted the market was likely about 10% to 20% higher until it bottomed out.
Clearly, sentiment is a huge driver of the stock market. And when stocks are overvalued (as they were in 2022), that leaves more room for the market to fall when investor sentiment turns. Some analysts say the market doesn’t have a huge downside ahead as much of the pessimism and recession fears are already impacting the market now. “I think we factored in a huge amount of negativity here, almost universal degrees of pessimism in terms of sentiment,” said Mark Hackett, head of national investment research. “Assuming earnings are even close to what’s currently estimated, I don’t think the market has much to do,” Hackett said.
Lemonides acknowledged that lower valuations will mitigate the drop, although he believed the market would continue to fall around 15-20% from current levels. “The good news is that at current prices, stocks are not overstretched,” he explained. “There was a large portion of the market that was in bubble territory in terms of price and valuation, but those stocks were mostly down,” he explained.
The bottom line: Because stock prices are not inflated by a bull market in the same way as they were last year, the market has, to some extent, a cushion against the blow of the recession. While Hackett is optimistic that this will prevent a bottom well below current market rates, other analysts forecast that the market will likely fall to a range of 10-20% below current levels.
Federal funds rate
Federal Reserve policy has been largely blamed for the recent market slump, and it’s true that rising interest rates have weighed on consumers. Yet, longer term, Fed policy is moving closer to what was in a more normal range a few decades ago. “Stocks go up because people have money to buy them, and they go down if people don’t have money to buy,” Lemonides said. “So when the Fed drains liquidity from the system, people will have less money to buy and stocks will likely go down.”
According to Lemonides, Fed policy might be something investors need to get used to, at least as long as inflation-friendly macroeconomic conditions hold true. From this historical perspective, higher interest rates are more the rule than the exception. As the economy recovered from the 2008 financial crisis, rates rose again before falling again during the pandemic-induced economic crisis. “[The past two years when rates were so low] was really a hiatus from becoming a normal time and that the Fed is now doing things to get us back to normal,” Lemonides explained.
Still, Fed policy will be a driver of near-term market sentiment, and investors will remain cautious as long as the Fed signals that it will continue to rise. “I really think the stock market will come back up as soon as everyone is convinced that the Fed is going to start cutting interest rates. That’s key,” Cohan said.
The bottom line: Investors will likely remain timid as long as the Federal Reserve continues to raise interest rates. Yet, from a long-term perspective, the basic expectation of extremely low interest rates is more of an exception than the norm.
Despite forecasts of further market turbulence in the future, analysts have pointed out that the underlying macroeconomic health of the market is not as dire as the level of market volatility might indicate. “Where we are right now gives me more confidence,” Hackett explained, pointing to depressed market valuations and the market’s seasonal stance. ” As the [saying] goes, ‘Time to be optimistic when everyone else is pessimistic.’ That’s the direction I’m leaning in these days,” he said.
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