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There is a clear division over the economy. Some (mainly in markets) think inflation is already well under way to coming under control, meaning that central bankers could do much damage if they keep doing what they are doing, while others (including many central bankers) believe that the inflationary regime has shifted, and that rising prices could easily become entrenched.

The last US consume price index was softer than anticipated. It was undeniably good news, but it doesn’t solve the underlying problem. Inflation remains far too high and, under the rates path currently projected by markets, the only hope for it to be contained is via a recession. Either way, stocks risk to have a hard time breaking out of their bear market during the first quarter in 2023 as, while they are no longer expensive, they are not yet cheap or discounted for the tough macro environment ahead (see the chart).

One of the things which we find dangerous is that many investors right now are myopically, painfully focused on the Fed — and the Fed only — and when its pivot is going to occur. And by doing so, they are not seeing the bigger picture. The problem is that memories of the swift, Fed-induced pandemic recovery are dominating the thinking of today’s investors, many of whom are so conditioned to the success of dip buying that they are ignoring a shaky foundation in equities (see the chart). As much as investors cheer the Fed pivot, the reality is that by the time rates come down the economy is usually too beat-up for stocks to go anywhere. Historical analysis suggests rallies in a falling market can be short-lived and create false impressions of a broader turnaround. During the last two major bear markets - following the burst of the dot-com bubble and the global financial crisis - interim rallies of 20% or more occurred and yet the market resumed declines afterwards. Starting a bull market part-way through a monetary tightening cycle, ahead of a potential recession and with all sorts of negative structural and geopolitical challenges would be very unusual!


The recovery cycle for stocks will probably begin in 2023, but it is likely to be a slog. An analysis of every bear market since 1960 suggests it could easily take over two years to recoup the index’s prior high, especially if recession plagues the near-term outlook. Since 1960, we count 11 distinct bear markets or near misses (declines over 19.5%). Among them, it took a median 1.9 years to recover the prior high, with the 1973-74 bear market taking the longest to recover, at 7.5 years. The shortest was the 2020 crisis, at only 181 days. Limiting the sample to just bear markets affiliated with recession resulted in 2.6 years to return to the prior high, while the three that weren't part of a downturn (1966, 1987 and 2018) took only 1.2 years. 

The recent rally in cyclicals seems premature in the context of the developing economic slowdown and not justified by current valuations which remain at risk given the lagged effects of monetary policy. While stocks have suffered massive valuation corrections, they are no screaming bargains, especially if profit estimates for 2023 keep falling. At the market’s low in October, the S&P 500 was traded at 17.3 times earnings. That is the highest multiple among all 11 bear-market troughs since the 1950s! After jumping about 14% since mid-October, the index’s price/earnings ratio has expanded to 19. The multiple has yet to reflect potential earnings drop next year as the median S&P 500 price/earnings ratio low reached during past Fed tightening cycles that took rates to 5% and above was 15.3 (see the chart)! Such ratio would imply a S&P 500 drop of 25%.


We are aware that markets will begin to look to the next cycle well in advance of the economic data improving. In fact, since 1960, the S&P 500 has bottomed an average of 6 months before the unemployment rate has peaked. In addition, the recent cooling of inflation offers reason 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 inflation peaks. As such, there is light at the end of the tunnel, but it is not clear how long the tunnel might be. Until we have that clarity, we prefer to keep a defensive bias by overweighting defensive stocks, especially those with low volatility and high dividend yield (such as Health Care), and value stocks (such as Financials which are boosted by higher rates).

In the fixed income market, higher-quality bonds can resume their role as a reliable diversifier against equities if a recession materializes (more comments in the bond section). Close to 3.5%, global high grade bond yields now are where high yield rated debt was trading at the end of last year!

Finally, we decided to reduce our exposure on commodities from overweight to neutral, by taking profit on Energy. The specter of recession and demand destruction in large energy-consuming parts of the world may continue to dominate near-term commodity market sentiment. The fear is that stronger anti-inflation medicine from the US and other central banks will squeeze demand. At the sectoral level, we also took profit on Energy (overweight => neutral) and we use the proceeds to increase the weight of the sectors in which we are already overweight (Health Care and Financials). After a stellar outperformance last year, an encore may prove difficult for energy stocks in 2023 as they face a downtrend in oil prices and increasing odds of a global recession.

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