“And They Are Off”
With 2022 behind us (thankfully), 2023 is starting off with a welcome dose of optimism. US stocks are up 2-8% depending upon the index one references. Macro-economic trends have shifted during the past year. In 2022 inflation was surging in an uptrend in the March 2022 quarter prompting the Federal Reserve “FED” to increase interest rates at the fastest pace since the 1950s. The FED typically raises interest rates in ¼% increments when the economy shows signs of overheating. However, in this cycle the FED clearly was caught behind the curve and had to play catch-up. In 2022 the FED raised the Fed Funds rate from 0.00% to 4.5% in 14 months, with five ¾% increases. On February 1, 2023, the Fed cooled its increase to ¼% and gave markets cause to believe its “hawkish talk” peaked. While the FED provided guidance that it will increase the Fed Funds rate to 5.00% to 5.25% and hold. The bond market is “pricing in” interest rate cuts in the second half of 2023. FED guidance suggests it will be able to guide the economy to a “soft landing”, while the bond market indicates the US economy may be in contraction during the second half of 2023. Time will tell which scenario plays out.
US large-cap stocks currently trade at 18.1x forward 12-month earnings estimates and 16.4x 2024 estimates – very close to historical averages. We expect 2023 will be the year when inflation declines substantially; but this does not mean that economic and corporate earnings growth will return to normal (pre-pandemic). In our opinion, productivity will be the key to economic and corporate earnings growth during the next few years. The US labor supply is well below demand which will keep downward pressure on economic growth. However, productivity enhancements would improve the outlook for both economic and corporate earnings growth. After several quarters of disappointing productivity reports, the economy exhibited a strong 3.0% productivity gain in Q4 2022. Our economy needs a public policy to encourage business investment and reverse policies that pay people not to work.
Small-cap stocks look especially attractive from a valuation point of view with their P/E’s at a 25% discount to large-cap stocks. Small-cap stocks are substantially more volatile than large-cap stocks, so they offer way more risk and profit potential. Earnings growth estimates for 2024 for these small-cap stocks are 14% compared to 11% for large-cap stocks. For clients with a risk appetite, these stocks may be ideal for portfolios in the next 12-18 months. One caveat – be aware of the risk especially if our economy slides into recession.
AS always – We recommend only investing in the stock market with a long-term view (3+ years) and having cash available for emergencies and spending needs for the short term 2-4 years.
PLAN FOR THE LONG TERM
PREPARE FOR SHORT-TERM STOCK MARKET DECLINES!