Yesterday, the Dow Jones popped 1200 points, the S&P 500 jumped 5.5% and the Nasdaq Composite rose 7.4% on the back of cooler-than-expected October Consumer Price Index. This marks the biggest one-day rally since 2020. The strong rally sparked optimism amongst the investment community that we will have a strong trading period heading into year's end. We largely agree with this view. We see the S&P 500 trading up to $4100 between now and the end of the year. However, extending the outlook to 6-12 months, we remain cautious to bearish.

There are two reasons supporting our bullish view heading into year's end. First, we are in mid-term election year, with statistics supporting the likelihood of the stock market trading higher after the election. 17 of the 19 mid-term elections since 1946, the market performed better the 6 months after the election than the 6 months heading into it. This year, it had been anticipated that the Republicans would gain control of the House, creating grid-lock in Washington. In turn, this would be good for pharmaceutical, healthcare companies, as well as the oil and gas industry. No Democratic agendas would be passed, which is interpreted as friendly towards the fight against inflation.

Second, the cooler-than-expected CPI reading strongly suggests inflation has peaked and is cooling down. This likely means the Federal Reserve can slow down its pace of interest rate hikes. Currently, the Fed is expected to raise 0.50% in the December meeting, a step down from the past 4x 0.75% hikes. Any signs of "pivoting" from the Fed is interpreted positively by the market.

With Q3 earnings season mostly done, there are only two hurdles heading into year's end, and that is the November CPI reading and the Fed's FOMC meeting the day after. We believe from now until the CPI reading, the market has no obstacle to reach $4100 for the S&P500. The reason for the $4100 number is the 200-day Moving Average, which again and again this year has proven to be a stubborn overhead resistance for the S&P 500 (see chart below - attention to red line). If CPI and FOMC in December yield positive catalysts, we could see the S&P 500 attempting to trade above this overhead resistance.

We remain bearish for 2023

However, after this seasonally strong period, we will have to turn bearish on equities again. Short-term traders or narrow-view investors may see the cooler inflation number as a positive, and may be happy that the Fed will soon declare the conclusion of their rate-hiking cycle. However, taking a step back, this is actually not a good sign for the economy, certainly not good for companies' earnings, which are fundamental to stock price.  

Our bearish thesis concerns the corporate earnings picture. We spoke in details in our August call, when we stated that the effects of the Federal Reserve's rate hikes have yet to hit corporate earnings. The Fed started hiking rates in March of 2022, and by the end of the year the Fed's Funds Rate is expected to be at 4.50%. However, studies of monetary policy and its effect on the economy suggest that there is about a 6-month lag between a rate hike and when the economy starts to "feel" it. In other words, corporates and consumers will start to "feel" the effect of 4.50% interest rate around June of 2023. 

With that said, in the Q3 earnings season, when the rate hikes have not fully marinated yet, we have already seen corporate earnings starting to slow down, or fall in some cases. FactSet recently reported that the blended earnings growth for the S&P500 in Q3 2022 compared to Q3 2021 is only 2.1%, If this number holds up, this will mark the slowest earnings growth since Q3 of 2020 (-5.7%), during the recession that was the Covid pandemic. Looking under the hood reveals more trouble. The index's earnings growth mainly came from the energy sector, which continues to reap tailwinds from inflated oil and gas prices. The energy sector grew earnings by 120% year over year. On the other hand, Communication Services (think Meta, Disney) had earnings loss of 20%.

We believe the trajectory is worse from here, not better, and valuation is currently not reflecting that. Let's talk numbers. FactSet's consensus has estimates for S&P 500's 2023 earnings to be $230/share. Compared to 2022 earning estimates of $220/share, this represents a roughly 5% earnings growth. Given the current price of $3950 on the index, the 2023 multiple is 17.1 times. 

There are two problems. First problem: earnings estimates. We do not see any way that S&P 500's 2023 earnings can be $230/share, or grow by 5% compared to 2022. Remember, the Fed's steepest rate hike cycle in history has not hit the consumers and corporates with its fullest force yet. Even with the most optimistic lens we could find, we can hope for S&P500 earnings to stay unchanged year-over-year, if not the uglier scenario of falling year-over-year. If the economy does hit a recession in 2023, the average earnings decline for the S&P 500 during the past 10 recessions is 30%. This leads to the second problem: multiples. When earnings start to fall, sentiments become more negative, which leads to a decrease in earnings multiples. In other words, if investors are currently willing to pay 17 multiples for estimated 2023 earnings of $230/share, when that estimate number actually comes down, the multiple will come down with it.

Bottom Line

Despite being relatively negative on the overall S&P 500 index, we believe there are pockets in the market to weather the storm and potentially benefit. Remember, that's the reason why we try to be active stock pickers and not a passive index buyer. For example, the healthcare sector continues to be our focus, and we continue to overweight this sector. Healthcare companies that we own, such as Eli Lilly (the drug manufacturer), Johnson and Johnson (consumer staples product and drug manufacturer), United Health (health insurance) will continue to grow their earnings in 2023. These companies are largely recession-resistant, as their line of business is not heavily affected by cyclical turns in the macro economy.