2022 reset that picture, and from today’s starting point, potential future investment returns look more appealing than they have in some time. The only way to capture that full return is to not panic out of the market in the midst of chaos and stay the course. As one of the most prolific investors of all time, Peter Lynch, said, “people who succeed in the stock market also accept periodic losses, setbacks and unexpected occurrences. Big drops do not scare them out of the game.”

Fourth Quarter Review

The broad stock market rebounded nicely in the fourth quarter, despite a rough December to close out the year. The quarter started out with news that the Fed would begin easing, UK Prime Minister Liz Truss would be stepping down, squashing her proposed stimulus/tax cut plan, and that China was finally reopening. Combined with what appeared to be oversold market conditions in the third quarter, October and November combined for a nearly 14% return for the S&P 500.

The Santa Claus rally faded in December as central banks around the world remained committed to aggressively hiking rates and economic data showed clear signs of slowing, raising near-term recession concerns. At the December Fed meeting, Jerome Powell indicated he expected the fed funds rate to move above 5% which was higher than previously anticipated. Then, mid-December economic data for manufacturing and retail sales showed the economy was indeed slowing. Stocks fell nearly 6% in the month of December, capping off the worst year since 2008 for stocks and the worst year on record for bonds.

The year ahead

Entering 2023, the same question being asked for months remains: will inflation fall faster than economic growth and corporate earnings? The markets battled this the second half of 2022 and it will likely be the determining factor of if the S&P 500 moves back above 4,000 or gets pushed back down to the October lows.

If earnings and growth fall faster than inflation, the economy will likely enter a stagflationary recession and at a minimum the markets could retest the 2022 lows. Worst-case scenario, if inflation remains stubborn throughout 2023 and the Fed must continue hiking rates, corporate earnings will likely fall throughout the year and the S&P 500 could see a level of 3,200 or lower.

If inflation falls faster than growth and earnings, the Fed will be able to pivot and stop hiking rates in 2023. This will represent a soft landing and win for the Fed and likely the markets. In this scenario, growth is still on track to slow, but earnings can move upward, and the S&P 500 will likely be able to sustain and surpass the 4,000 level.

The stock market is currently hinting that the former scenario is likely and that there could be more downside to the markets in the near-term. The losses in stocks and bonds last year were a product of decades high inflation and a Fed that was behind the eight-ball, forcing them to hike rates at a record pace. As we enter 2023, the market is approaching an important transition period that should ease both inflation and the pace of interest rate hikes. The Consumer Price Index (CPI) fell from 9.1% in June to 7.1% in November and most other inflation metrics have come down as well. Obviously, nobody is celebrating 7% inflation, but the market is always more concerned with improving/worsening rather than good/bad. In December, the Federal Reserve indicated that the peak interest rate was .75% higher than the current rate, which could easily be reached in the first quarter of 2023. If price pressures continue to fall that will present a clear positive for the market and economy. While economic and earnings growth are expected to slow, these expectations are likely built into today’s stock market prices. If the economy remains more stable than forecasted (which it has been for years), it may spark the start of a new bull market or at least significant upside from today’s prices.

The media is currently (as always) focused on recent losses and current risks, which do include earnings and recession fears. The market is forward looking. It isn’t priced based on today’s reality, but rather tomorrow’s expectation. There are absolutely challenges ahead in 2023, but the risks we know about are at least partially priced into today’s prices and there are positive headlines on the horizon.