Predicting the future is hard.
Few people predicted 2022’s most significant events including the War in Ukraine, inflation crossing 8%, and the FTX collapse.
But it wasn’t all bad. Even I had a few predictions from last year come true, including the S&P 500 falling into a bear market and healthcare stocks being a top performing sector.
And while my 2023 predictions aren’t as provocative as the former Russian President Dmitry Medvedev…
…I have a good feeling about them.
So without further ado, let’s dig into my top five predictions for 2023.
Prediction #1: The S&P 500 Falls Another 15%
2022 was the worst year for US stocks since the Global Financial Crisis in 2008.
The 2022 bear market was defined by something called “multiple compression.” Think of a stock’s “multiple” as how many dollars you’re paying for each dollar of a company’s sales, earnings, or cash flows.
If Apple (AAPL) has a price-to-earnings multiple of 20, you are paying $20 for every $1 of earnings Apple generates.
When interest rates rise, the “multiples” stocks trade at falls. And since the Federal Reserve just raised interest rates at their fastest pace in 40 years…
…multiples also contracted at their fastest pace in years:
But while 2022 was defined by this multiple contraction, I expect 2023 to be defined by an “earnings recession.” Stocks are priced based on expectations of future earnings. Analysts currently expect S&P 500 earnings to grow 4% in 2023 to $229.
I am not so optimistic. S&P 500 earnings tend to fall 20% during recessions. While I expect the coming recession to be mild, I still expect S&P 500 earnings to fall 15% in 2023 to $184.
Combined with the earnings multiple of 17, that leaves us with an S&P 500 fair value of 3,300 which is 15% below the current level.
Prediction #2: The Fed Will Not Cut Interest Rates More than 50 Basis Points
The Federal Reserve raised interest rates by their fastest rate in decades last year.
However, investors currently expect the central bank to cut interest rates (also known as a “pivot”) by the summer:
I disagree with this outlook. While I don’t expect the central bank to raise interest rates much more than the current level, I believe Chairman Jerome Powell when he says he aims to keep interest rates “higher for longer.”
Powell does not want to repeat the Federal Reserve’s mistakes in the 1970s-1980s.
In 1971 and 1975, the Federal Reserve thought inflation had been squashed and lowered interest rates too early. This led to a resurgence of inflation even worse than before:
I could see the bank giving a small interest rate cut towards the end of 2023. But that’s only because…
Prediction #3: The US Officially Enters Recession in 2023
I can already hear many of you saying, “aren’t we already in a recession?”
While it’s true we have had two straight quarters of negative GDP growth (a common recession definition) the reality is more nuanced.
The unemployment is currently near cycle lows of 3.7%. A labor market that’s this strong would be extremely unusual for a recession.
But the Federal Reserve is actively trying to raise the unemployment rate. This is to stem inflation. But much to the Fed’s chagrin, even the fastest interest rate hikes in 40 years have not increased the unemployment rate.
I expect that to change in 2023. As we’ll discuss next week, the yield curve inversion –the market’s best recession indicator – has been flashing red since April.
I don’t think this time is different. That means we will have a real recession in 2023, including a spike in the unemployment rate.
Prediction #4: The Unemployment Rate Climbs Above 5%
The US economy has so far been resilient to higher interest rates.
The best way to explain how interest rates affect businesses and the economy is to think about climbing a mountain.
At the base of the mountain you can breathe easily. But as you hike higher and higher, the air begins to thin. It becomes difficult to breathe and – at a certain point – you need to take short breaks from merely walking.
Interest rates work the same way. When interest rates are 0%, money is free and businesses can spending as much as they like. When rates climb, it becomes more difficult and less profitable to run a business.
Interest rates just rose at their fastest pace in 40 years. We went for a decade of 0% interest rates to 4.5% (and rising). It’s harder for businesses to breathe, and the result will be payroll cuts and a higher unemployment rate.
Prediction #5: Bonds Will Be the Best Performing Asset, Crypto Will Be the Worst
The Federal Reserve has ramped interest rates up to 4.5% in 2022 and looks like the will continue raising into 2023.
With many corporate bonds yielding 8% - the long-term average S&P 500 return – investor capital will flock to the bond market like never before. That’s in addition to “safe haven” buying in the event of a recession or further downside in stocks.
Crypto will continue to struggle. The sector is the embodiment of speculative excess (along with high-growth stocks and meme stocks), which I don’t expect to return for another few years.
Let’s Keep Analyzing Together
Forecasting what will happen over a 12-month period is extremely difficult.
There are simply too many variables to make informed predictions over that period. However, we can analyze the market conditions and extract probabilities for outcomes from those conditions.
That’s exactly what I did today, and is what I’ll continue to do in this newsletter.
And I hope you take that journey with me.
Stay safe out there,
Robert
As a 25 year licensed financial advisor with 100s of sources of commentary…. I must say. Very nice work. Your simplicity and use of few words is refreshing. Also love the straightforward charts. I’ll be back!
Is it crazy to think that the market is already aware of these conditions and has already been affected thusly? I guess what I mean is, do the markets react in real time or on forecasting. I would think forecasting. If so, then the market should stabilize, since the “experts” are already aware of the doom and gloom on the horizon. Not sure if this makes sense…