For those of you who would prefer to listen:
After a dismal 2022 for investors, the start to 2023 brought some green to the Market, not to mention a whole lot of rain to the Bay. It is Friday the 13th in the 2020s. We have to stay nimble and on our toes. You never know what’s coming next…
Both stocks and bonds have been in rally mode. The stocks that got beat up the most last year have largely been leading the charge in this young year. The Dow and S&P logged back-to-back weekly gains. It has been nice to see this reversion. We don’t think it lasts though. There’s more work to be done in our minds to establish a defined bottom for the Stock Market. It’s a process. We are prepared for more volatile price action in 2023, but we sure are enjoying this burst of green to start the year.
Earnings drive stock prices. Q4 Earnings Season has begun. This time it coincides with the NFL Playoffs. As most of you know, I love sports analogies. It’s Wildcard Weekend, which generally means anything can happen. That sounds applicable. Expectations build. Higher-seeded teams have home-field advantage and are usually expected to win. But regular season records no longer matter. Once the whistle blows, the time for talk is over. How the team executes will determine success or failure. Upsets happen all the time. That’s what makes competition so great. It’s why they play the game.
Yesterday is gone. It’s all about what happens today, which sets the course for tomorrow. The ultimate outcome is measured by the scoreboard. Some teams have a strong offense. Others play great defense. The great teams do both. Play to strengths and account for your weaknesses. Anticipate. Successful teams always make adjustments. Good strategies are flexible. You act and then you react, rinse and repeat. Inclement weather tends to favor the defense. It is commonly known, Defense wins championships.
There are many parallels here for the Market. Earnings reports are like Corporate America’s quarterly scorecards. It’s the true measurement of how companies performed in the previous 3 months with a keen insight as to how things look ahead. The landscape matters. Bear Markets are like bad weather. Things get sloppy. Offensive strategies get de-railed. Shrewd investors slow down and focus on defense while trying to minimize mistakes. 2022 was all about defense.
Stocks generally are rewarded for revenue and profit growth. But like a point-spread for football games, analysts on Wall Street project earnings estimates. Expectations build. For stock prices to move higher, they generally have to beat those expectations which have already been priced in. Some compare the Stock Market to gambling. We are not among them. We make informed decisions and manage risks. We take our research and strategies very seriously. But since the Stock Market is a discounting mechanism which prices in expectations in advance, “good” or “bad” earnings reports aren’t as measurable as “better” or “worse.” The Stock Market is driven by better or worse. Stocks have moved higher so far in January, and part of it seems to be pricing in earnings that are less-worse than previously thought. Less-worse equals better. Now we get to see the results in the days and weeks ahead, for better or worse.
Companies accounting for roughly 80% of the S&P 500’s total index value will be reporting earnings in the next 4 weeks. The Street expects S&P earnings to decline 4.1% in Q4, compared to last year. This would be the first contraction since Q3 of 2020, when things really collapsed due to Covid. For perspective, earnings grew 31% in Q4 of 2021. Those were record all-time high levels for earnings. It’s a high bar. Those are some tough comparisons. The decline also reflects the slowing demand and high inflation. With so many downside pressures and little clarity for a near-term recovery, it’s quite unlikely for any CEO to raise guidance or speak optimistically about the outlook. Besides, some on the Street might still be too high with their expectations. Even though the bar has been lowered a bit for Q4, it still seems pretty high for the rest of the year.
The Big Banks always kick things off. It happened Friday. The results were largely mixed. Some beat estimates. Others missed. What was most significant was the outlook for the year. JP Morgan, Bank of America, Wells Fargo and Citigroup all lowered expectations for their net interest income in 2023. They highlighted increasing recessionary pressures as the source, negating the benefits of the higher interest rates. Since the Fed has kept increasing interest rates, banks have been able to charge more for loans. But the increased cost of money has slowed IPOs, mergers and acquisitions, and other deals, which are businesses that are most profitable on Wall Street. Bank stocks initially sold-off upon earnings release, but those losses turned to gains leading the Market higher into the weekend. Better than expected seems to be the answer.
Inflation keeps slowing, as evidenced by the December CPI report. It was released this week. Inflation actually contracted by 0.1% month-over-month. The year-over-year increase was 6.5%. That is the 6th consecutive decline from the peak 9% reported in June. Inflation is still high, but you can see it moving back in the right direction. There are definite signs that it has peaked. But there are ways that prices could go back up too. Historically, low unemployment and the continuation of war are recurring pressures for higher prices. Those boxes are still checked today. There’s also the issue with eggs. The USDA shows the average price for a dozen eggs in California was $6.72 this week. That is double what it cost in July. The reason behind the spike in prices? Bird flu. So, there’s that too.
Most important to the Market is what the Fed decides to do with this data. This is all rear-view mirror stuff. The trend continues to be lower for inflation. But it’s still high. The Fed is likely to keep talking tough and keep rates high. It wants to see unemployment tick up, likely to the 5% level. The Market expects not only a pause in rate hikes by mid-year, but it is pricing in a reversal with actual rate cuts by year-end. The Bond Market is rallying because it clearly does not believe the Fed.
The Fed’s aggressive tightening has increased the risk that the Economy falls into a recession this year. Banks have been bracing for it by increasing their reserves for expected losses as credit quality typically suffers during economic downturns. Importantly, the reserves were less than some anticipated, suggesting the Banks are feeling better, or more comfortable with what lies ahead. The Market is now pricing in a 94% probability that the Fed will only raise interest rates by a ¼-point at its next meeting in a couple of weeks. Despite the recent declines, inflation is still high compared to years passed. It’s taken a toll. Consumer spending accounts for 70% of GDP. Wallets are tightening. That was evident in the subdued Holiday Season. The key question is: How long can Americans absorb these high prices? Another key question: How long can companies continue at this pace before significantly cutting costs?
The Tech Titans report earnings the first week of February. It will definitely be Market moving. Their stocks have been hit. Cost-cutting is the theme. Tech companies have aggressively laid people off of late. They were amongst the largest job creators during Covid. They overdid it. Both Google and Amazon doubled their employee base. Now they’re cutting. It won’t stop there. Tech accounts for just 8% of America’s workforce. Small businesses and companies in other industries have not been letting employees go. That is likely to change.
Back to the Market: The S&P is knocking on that old rusty door of resistance around the 4,000 again. It closed just under it Friday. Its last attempt was during November’s rally. The S&P initially pushed through it but got knocked back at the 200-Day Moving Average(DMA) at 4,100. The only difference is the 200-DMA has declined enough over the last few weeks that it sits just below the 4,000 level now.
The S&P trades at 17.5X this year’s earnings estimates. That’s in-line with the average for the last 10 years. It’s higher than the average multiple of earnings measured over the last 30 years. The difference is, interest rates and inflation are the highest they’ve been in the last decade. That generally leads to lower multiples, which on average has been 15X over the longer period. The Market tends to trade at a higher multiple when money is cheap and earnings are growing. It’s the opposite now; Earnings are slowing, and money is no longer cheap. There’s also the concern that Street estimates are still too high. That indicates the Stock Market is still expensive.
The Debt ceiling is going to be a critical issue in 2023. It already is. On Friday, the Treasury Secretary said we are hitting it now. That is earlier than expected. Secretary Yellen said that the United States can keep paying its bills thru June, but it will take some extraordinary measures. The Market didn’t even flinch on this. Part of it is because this is such a hot political topic, and the Treasury Department wants to get in front of it. The other reason the Market isn’t concerned yet is because a flood of tax revenue will come into the Treasury coffers in April which will likely extend its ability to pay the bills. This is clearly an important issue. It’s early days and Washington will no doubt play its political games. We study the Bond Market for clues. Treasury yields didn’t even move, suggesting no crisis, yet. And over the past 2 months, money has poured into the long end of the Treasury Market, pushing yields down from 4.2+% down to 3.50% today. That’s a big move in short order and likely wouldn’t be happening if the debt ceiling was going to be a real problem, vs a political football. We’re all over this.
The Volatility Index (VIX) is back to low levels not seen since August’s Stock Market peak. This indicates complacency has crept back into investor psyche. There’s nothing like price to change sentiment. The number of Bulls has increased with this new year rally. The number of Bears has shrunk. That’s a contrarian indicator that this rally could be running out of steam. The excessive Bearishness to close out 2022 gave us some optimism for a strong start to the new year. We got it. We are now back to playing defense. The landscape remains challenging. The issues that plagued 2022 are still here in 2023. Bedell Frazier played aggressive defense in 2022. We plan to do it again in 2023. Remember: Defense wins championships.
Have a nice weekend. The Market will be closed on Monday, in honor of Dr. Martin Luther King Jr. Our office will be closed in honor of Dr. King as well. We’ll be back, dark and early on Tuesday.
Go Niners. It’s going to be wet out there. They know how to play defense.