Stock market’s brutal year leaves Wall Street with little faith in a rebound

(Bloomberg) — A brutal year for US equities is winding down with little conviction on Wall Street that the outlook is brightening anytime soon.

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After rebounding since October on speculation that the Federal Reserve is nearing the end of its most aggressive rate hikes in decades, stock prices have retreated over the past two weeks on renewed fears that tighter monetary policy will stifle economic growth in the first half of next year. The S&P 500 has lost almost 20% this year. Rate-sensitive growth stocks were hit even harder, sending the Nasdaq 100 down more than 30%.

“We are heading into a recession, but it will be a story of two halves next year, one that will likely see the stock market improve in the second half,” said Sam Stovall, chief investment strategist at CFRA. He expects the S&P 500 to retest its October lows in the first half of 2023, but end next year around 4,575, up nearly 19% from Friday’s close.

The key question facing Wall Street now is how close the Fed is to ending its rate hikes — a moment that has historically generated double-digit returns for stocks.

For Luca Paolini, chief strategist at Pictet Asset Management, tighter financial conditions are poised to shift investors’ attention next year from inflation to the risks posed by a slowing economy. He is bearish on US equities over the next three to six months and is watching three key factors that could end the bear market: a dip in corporate earnings estimates, a steeper bond yield curve and cheaper valuations. in the stocks most sensitive to economic cycles.

“We are still in a bear market,” Paolini said. “A spike in inflation is clear, but we expect equities to be weak next year. The fall in inflation could be slow and painful – certainly not strong enough for central banks to switch from tightening to easing. That’s why we don’t expect any rate cuts next year. I am much more concerned about growth than inflation in 2023.”

While the S&P 500 has priced in at least a modest earnings slump, higher borrowing costs and lingering economic uncertainty will likely reduce potential stock gains over the next year, according to Bloomberg Intelligence’s Fair Value Model. .

When the bottom will come, however, is a fierce debate. And there is a risk that earnings estimates are still too optimistic. Brokerage analysts’ overall 12-month target of 4,498 for the S&P 500 assumes earnings will rise 4.3%, significantly higher than BI’s model of an implied 2% decline.

Another sign of pessimism: This year’s beating has turned Wall Street strategists into bears for the first time in at least two decades, with the average analyst forecast calling for a drop in the S&P 500 in 2023. The stock bulls, however, hope that this could be a contrarian signal for stocks and that overly bearish sentiment is pointing to a market bottom.

In addition, the recent cooling in inflation gives cause for optimism. Since 1950, the S&P 500 has posted a total return of 13% on average over the 12 months following the 13 major inflationary peaks, according to Jim Paulsen, chief investment strategist at The Leuthold Group. And in the 10 instances where the index rose during the year following a substantial spike in inflation, the S&P 500 continued to deliver an average total return of 22% the following year, too. according to company data.

Although U.S. stocks will likely start to rally sometime in 2023, it could take more than two years for the S&P 500 to hit its January high again, according to BI. In fact, the need for the Fed to keep rates high in the face of persistently high inflation could weigh on earnings and keep average annual returns for the S&P 500 at 5.7% over the next three years, down from 12.7%. from 2010 to 2019, according to Gina Martin Adams, BI’s chief equity strategist.

Seema Shah, chief global strategist at Principal Asset Management, predicts next year will still be particularly challenging for tech stocks, whose lofty valuations are falling as borrowing costs rise.

“Granted, next year will be tough, but it will open opportunities for equity investors,” said Shah, who expects the U.S. economy to suffer a recession in the second half of 2023. “The Fed is unlikely to respond not an economic crisis”. slowing down without any relief. While this year has been marked by valuation compression, next year will be marked by declining earnings, so we expect further losses in the equity market.

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