Dec. 5, 2022: Can the gains sustain?

Price action last week was once again dominated by the U.S. Federal Reserve (Fed) — or, more accurately, investors’ insistence on parsing every word in every speech from every Fed board member to try and glean some insight into the ultimate path of interest rates.

“Markets surged to end November following a confusing reaction to a speech from Fed Chairman Jerome Powell that really offered no new information,” said Matt Orton, CFA, Chief Market Strategist at Raymond James Investment Management. “This has happened a number of times throughout 2022, and in nearly every case, the initial knee-jerk reaction has been wrong.”

That streak continued on Friday following better than expected jobs data that poured cold water on the dovish market reaction. Many investors continue to focus on the more dovish peak inflation narrative, but Orton said we should all be able agree that low labor force participation rates and strong wage growth are exactly the sort of things that the Fed has been worried about. Powell has put the labor market front and center in the Fed’s inflation problem, and now seeing continued negative labor supply dynamics raises the bar on the labor demand destruction required to restore balance.

While I’m very optimistic on select emerging markets in 2023, it just seems too early in the cycle for global equities to begin a new bull market.

There is no historic parallel for this environment, and Orton said perhaps that is why the price action has been so erratic on a daily and even intraday basis. While peak inflation certainly helps to build a floor for the market, Orton said he is skeptical about the sustainability of any upside breakouts, particularly with the Consumer Price Index (CPI) report and Federal Open Market Committee (FOMC) meeting looming next week. To be sure, the market is short and the year is coming to a close so we could see some upward pressure on further short covering. Cash balances are also incredibly high, and following an abysmal year, Orton said he would hazard a guess that more than a few investors will be inclined to punt on a Santa Claus rally. We need to be respectful of the price action, and he said he believes there’s a decent chance that it pushes the S&P 500 Index higher if the data continues to keep the peak inflation narrative alive. But Orton said he continues to believe this is a market to rent rather than own. Coming into this week, the market looked overbought with the 14-day relative strength index approaching 70 and 91% of S&P 500 stocks trading above their 50-day moving average (DMA). The Chicago Board Options Exchange (CBOE) Volatility Index, or VIX, also has moved sharply lower, breaching a level of 20 for the first time since August, which has tended to result in a jump higher looking back over the past 12 months.

The character of the rally in November also makes Orton wonder whether the market can reach escape velocity. Market breadth remains strong, but most recently the gains have been led by the most cyclical sectors. Materials, industrials, communication services, and financials, in particular, led the way higher last month, with gains of 11.50%, 7.57%, 6.85%, and 6.83%, respectively, versus the S&P 500’s November gain of 5.59%. Given the concerns about a slowing economy, both here in the United States and globally, Orton said it’s interesting to see these sectors as the leadership. He said it’s also interesting with rates moving lower that information technology simply performed in line with the rest of the market. The underperformance of the mega-cap complex certainly played a big role (as well as within the consumer discretionary sector), but broader performance across the sector IT outside of semiconductors wasn’t too impressive. If rates continue to drift lower, seeing improvement going forward, given the weight of the IT sector, could be cause to get more excited about the sustainability of the rally past the start of 2023, he said.

December tends to be the strongest month of the year, and a benign CPI report next week could be the catalyst for markets to take off higher into year-end, Orton said. There are certainly a number of headwinds, but while he sees risks skewed to the upside, Orton said this remains no time to chase the market higher.

Orton's key themes for 2023

Central banks certainly look to be downshifting the pace of tightening, but there is still uncertainty over the ultimate level of terminal rates, Orton said. As a result, he said there is still a risk for rates to the upside, which means it’s too early to be reaching for growth or adding too much duration. But he said he believes the first quarter of 2023 will mark a turning point with core inflation falling below terminal rates, suggesting a shift in market dynamics. Once disinflation is evident and the terminal rate is known, markets will likely redirect focus onto growth deterioration and rate cuts, leading to a resteepening of the U.S. 2/10 curve, which measures the difference between the rates of the 10-year U.S. Treasury note and the 2-year Treasury note. Additionally, Orton said he believes the focus on slower growth also could be the time for higher quality growth to outperform. For now, he said he continues to favor remaining more defensive in positioning and leaning into quality, particularly within dividend growth and growth at a reasonable price (GARP) by:

1. Maintaining a core defensive bias. Orton said he continues to believe in sticking with what has been working: leaning into higher quality companies. Within this, dividend growth and GARP continue to outperform the broader market, and he said he expects that to continue. As he has noted recently, these higher quality, more defensive parts of the market have outperformed along with the most cyclical sector leadership. He has pointed out emerging leadership in these sectors (i.e., materials and industrials), but fundamentally he said they look a bit stretched now. He said he favors sticking with healthcare and energy, but sees new buying opportunities growing within financials.
2. Opportunistically adding to U.S. small caps. Small caps have been underperforming the broader market over the past few weeks but remain in a solid uptrend. Valuations and underperformance in November make small caps even more attractive relative to large caps. The post-CPI bounce was historic, with more than 20% of the Russell 2000^® Index jumping by more than 10%, and Orton said this tends to be positive going forward for index returns. Additionally, small caps tend to outperform in periods of extended sideways to modestly up markets, which is where he said he believes we’ll be stuck well into 2023, given the tug of war between the central bank downshift and weakening economic growth. Interestingly, the higher-quality index of small companies, the S&P 600 Index, has actually outperformed both the Russell 2000 and the broader market. Orton said this fits with his bias toward leaning into high quality. Valuations for small caps already capture more severe recessionary conditions, he said.
3. Considering being active overseas. You may have missed the strong outperformance of global markets in November, but it’s worth highlighting. The MSCI EAFE® (Net) Index was up nearly 11.3% in November and the MSCI Emerging Markets^® Index did even better, up nearly 15% (versus the S&P 500, which was up 5.6%). “While I’m very optimistic on select emerging markets in 2023, it just seems too early in the cycle for global equities to begin a new bull market,” Orton said. “If you’re going to invest overseas, it’s critical to be active to avoid value traps and to lean into the countries, sectors, and industries that can grow despite looming macroeconomic headwinds.” He said that’s particularly true for Europe, despite optically cheap valuations. The market is still very early in pricing in the earnings downgrade cycle across the Eurozone, Orton said, and that makes him wary of using valuation as the only reason to be investing. Looking at the broader STOXX^® Europe 600 Index (including the U.K.), if we apply a peak-to-trough fall in earnings per share of about 33% (close to the usual recessionary fall in this region’s earnings), the 12-month forward price to earnings (P/E) ratio rises from 12x to 18x, which he said would be “not so cheap anymore.” If the peak-to-trough fall were 20%, the P/E still would rise to 15x, which would be above its long-run average of 14x. “At some point European equities will likely be an attractive recovery play,” Orton said, “but we are not there yet.”

What to watch

Global central banks will be in the spotlight with the Reserve Bank of Australia and the Bank of Canada both expected to raise rates. FOMC members are in a blackout period ahead of the Dec. 14-15 meeting.

This week's data releases

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Hawkish, dovish, and centrist are terms used to describe the monetary policy preferences of central bankers and others. Hawks prioritize controlling inflation and may favor raising interest rates to reduce it or keep it in check. Doves tend to support maintaining lower interest rates, often in support of stimulating job growth and the economy more generally.

Centrists tend to occupy the middle of the continuum between tight (hawkish) and loose (dovish) monetary policy.

The U.S. Consumer Price Index (CPI) measures the change in prices paid by consumers for goods and services. The U.S. Bureau of Labor Statistics bases the index on prices of food, clothing, shelter, fuels, transportation, doctors’ and dentists’ services, drugs, and other goods and services that people buy for day-to-day living. Prices are collected each month in 75 urban areas across the country from about 6,000 households and 22,000 retailers.

Core inflation, as measured by the “Consumer Price Index for All Urban Consumers: All Items Less Food & Energy” is an aggregate of prices paid by urban consumers for a typical basket of goods, that does not include food and energy. Core CPI is widely used by economists because food and energy typically have very volatile prices.

Short is a term used to describe a strategy in which investors anticipate that prices of securities will fall in the short term, so, typically, they sell securities with plans to repurchase them later at a lower price.

Short covering refers to buying back borrowed securities in order to close out an open short position at a profit or loss. It entails buying the same security that was initially sold short and handing back the shares initially borrowed for the short sale.

Overbought is a term used to describe a security believed to be trading at a level above its intrinsic or fair value.

A relative strength index (RSI) is a momentum indicator that tracks the magnitude of recent price changes to analyze overbought or oversold conditions in the price of a particular asset. Typically, RSI values of 70 or higher indicate that an asset is becoming overbought or overvalued. RSI values of 30 or below suggest oversold or undervalued conditions.

A daily moving average (DMA) is a calculation that takes the arithmetic mean of a given set of prices over the specific number of days in the past; for example, over the previous 15, 30, 100, or 200 days.

The Chicago Board Options Exchange (CBOE) Volatility Index, or VIX, is a real-time market index that represents the market’s expectation of 30-day forward-looking volatility. Derived from the price inputs of the S&P 500 index options, it provides a measure of market risk and investors’ sentiments.

Cyclical stocks have prices influenced by macroeconomic changes in the economy and are known for following the economy as it cycles through expansion, peak, recession, and recovery.

The federal funds rate, known as the fed funds rate, is the target interest rate set by the Federal Open Market Committee of the Federal Reserve. The target is the Fed’s suggested rate for commercial banks to borrow and lend their excess reserves to each other overnight.

The terminal rate is the rate at which the U.S. Federal Reserve stops raising the federal funds rate in an attempt to bring down inflation.

Equity duration is the cash-flow weighted average time at which investors can expect to receive the cash flows from their investment in a company’s stock. Long-duration stocks include fast-growing technology companies, including those that may not pay any dividends in their early years, while short-duration stocks tend to be more mature companies with higher ratios to dividend to price.

Disinflation refers to the temporary slowing of the pace of price inflation and describes what happens when the inflation rate is marginally lower over the short term. Disinflation refers only to the rate of change in the rate of inflation. In this, it is distinct from inflation and deflation, which describe the direction of prices.

A yield curve is a line that plots yields (interest rates) of bonds having equal credit quality but differing maturity dates. The slope of the yield curve gives an idea of future interest rate changes and economic activity. Investors and market analysts watch certain yield curves for signs of inversion, when yields for longer-term debt instruments fall below yields on short-term debt with the same credit quality. Inversions are watched as potential signs of a weakening economy and in certain cases, a harbinger of recessions.

The U.S. 2/10 Curve measures the difference between the rates of the 10-year U.S. Treasury bond and the 2-year Treasury note. Measured in basis points, it is watched as an indicator of where the U.S. economy is in the business cycle, as it the spread typically narrows as the economy moves through the cycle, reaches a low point and may go negative near the onset of a recession, then widens again during and after a recession.

Defensive stocks provide consistent dividends and stable earnings regardless whether the overall stock market is rising or falling. Companies with shares considered to be defensive tend to have a constant demand for their products or services and thus their operations are more stable during different phases of the business cycle.

Growth at a reasonable price (GARP) is a stock investment strategy that seeks to combine tenets of both growth and value investing in the evaluation and selection of individual stocks. GARP investors look for companies with consistent earnings growth above broad market levels but try to avoid companies with very high valuations. By trying to avoid the extremes of either growth or value investing, GARP investors often end up focusing on growth-oriented stocks with relatively low price-to-earnings multiples in normal market conditions.

A value trap is security that appears to be inexpensive because it has been trading at low valuation metrics, such as multiples in terms of price to earnings ratios for an extended time period. The low relative historical valuations can attract investors who see a value, but then become trapped when the security languishes or drops further after the purchase.

Earnings per share (EPS) is calculated as a company’s profit divided by the outstanding shares of its common stock. The resulting number serves as an indicator of a company’s profitability.

Price-to-earnings (P/E) ratios measure a company’s current share price relative to its earnings per share. The ratio is used to help assess a company’s value and is sometimes referred to as the price multiple or earnings multiple.

Forward price-to-earnings (forward P/E) is a version of the ratio of price to earnings that uses forecast earnings for the P/E calculation. The earnings used in this ratio are an estimate and therefore are not as reliable as current or historical earnings data.

The Services ISM^® Report on Business^® is produced by the Institute for Supply Management (ISM) and is based on data compiled from purchasing and supply executives in a wide variety of industries nationwide. Survey responses reflect the change, if any, in the current month compared to the previous month in supplier deliveries along with seasonally adjusted business activity, new orders, and employment.

The China Caixin Services Purchasing Managers Index is compiled from responses to questionnaires sent to purchasing executives in more than 400 private service sector companies.

The Mortgage Bankers Association Weekly Applications covers mortgage application activity that includes purchase, refinance, conventional, and government application data, weekly data on mortgage rates, and indices covering fixed-rate, adjustable, conventional, and government loans for purchases and refinances.

A balance of payments is a statement of all transactions in goods and services made between all individuals, companies, and government agencies in one country and the rest of the world over a defined period, such as a quarter or a year.

The Mexico Consumer Price Index, released monthly by the Instituto Nacional de Estadística Geografia e Informática (INEGI), tracks prices paid by consumers for a range of goods and includes core and non-core components. Non-core components are subject to higher price variability as in some cases they can be influenced by factors such as international references for certain livestock products, government administrative decisions on vehicles, property, or gasoline, and weather conditions affecting agriculture.

The U.S. Producer Price Index (PPI), published monthly by the U.S. Bureau of Labor Statistics, measures the average change over time in the selling prices received by domestic producers for their output.

The University of Michigan Index of Consumer Sentiment is based on monthly telephone surveys in which at least 500 consumers in the continental United States are asked 50 questions about what they think now and what their expectations are for their personal finances, business conditions, and buying conditions. Their responses are used to calculate monthly measures of consumer sentiment that can be compared to a base value of 100 set in 1966.

The China Consumer Price Index (CPI), released monthly by the National Bureau of Statistics of China, measures changes over time in prices of goods and services in eight categories and 268 basic divisions covering consumption by urban and rural residents, including food; tobacco and liquor; clothing; residential costs; household articles and services; transportation and communication; education, culture, and recreation; healthcare; and other articles and services.

Brazil’s Extended National Consumer Price Index (IPCA), calculated by the Brazilian Institute of Geography and Statistics, measures the inflation rate for selected retail products and services, including food and beverages; housing; household articles; wearing apparel; transportation; health and personal care; personal expenses; education; and communication. The index is constructed to cover 90% families living in 13 geographic zones: the metropolitan areas of Belém, Fortaleza, Recife, Salvador, Belo Horizonte, Vitória, Rio de Janeiro, São Paulo, Curitiba, Porto Alegre, as well as the Federal District and the cities of Goiânia and Campo Grande.

RJIM22-0149 Exp. 4/5/2023