Jan. 30, 2023: The market can’t have it both ways

This could be the most consequential week of the first quarter, with 20% of the S&P 500 reporting earnings, plus key inflation and labor market reports coming out. And, critically, the U.S. Federal Reserve (Fed) is expected to raise interest rates again even as markets bank on the idea of interest rate cuts in the near future.

“I believe the market is too enthusiastic around expectations that the Fed will cut rates in the second half of the year and that we navigate perfectly a soft landing,” said Matt Orton, CFA, Chief Market Strategist at Raymond James Investment Management. “I certainly think that the economy’s in better shape than it had been given credit for last year, but I don’t believe the immaculate deflation narrative or that a perfect soft landing will be as easy to pull off as a lot of people think. There is going to have to be some sort of economic pain to get out of a recessionary scenario, because if there isn’t the Fed’s not going to cut rates. You can’t have it both ways. So I would expect the Fed to push back against the market rally.”

Last week was another good week for the market, but it was a great one for the longer duration and more speculative assets that continue to reverse their challenging performance from last year. The Nasdaq Composite Index notched its fourth positive week in a row, up 4.7%, bringing its year-to-date return to 11.2%: close to double the 6.7% gains of the S&P 500 Index. Orton said it’s worth noting that there has been a nearly complete reversal of the factors that dominated last year, with momentum, profitability, and dividends all struggling while volatility, leverage, short interest, and earnings variability are all leading.

There is going to have to be some sort of economic pain to get out of a recessionary scenario, because if there isn’t the Fed’s not going to cut rates.

“I can understand some of the enthusiasm supporting the market reversal, primarily the notion that the economy is in better shape than many investors feared and that a hard landing isn’t a foregone conclusion,” he said. However, the character of the gains and the low-quality rally taking place also reflects a market convinced that the rate-hiking cycle is coming to a close. And that is a real risk heading into this week when Fed Chairman Jerome Powell might push back against the market’s refusal to price fully price in the consistent policy guidance provided at the Fed’s December policy meeting and by numerous speakers since.

One of the challenges right now is that economic data and earnings results can be used to support two very different outcomes, Orton said. Hard data has continued to hold up well: U.S. gross domestic product (GDP) growth was stronger than expected last week with a quarter-over-quarter rise of 2.9% while initial jobless claims are near cycle lows. However, under the surface the GDP rise masked sharp deterioration in consumer and business demand at the end of 2022. Inventory accumulation was the biggest contributor to fourthquarter growth, along with plunging imports (led by durable goods), suggesting the build is unwanted. Further, soft data also paints a mixed picture. The Institute for Supply Management’s Purchasing Managers’ Index for manufacturing and Services ISM^® Report on Business^® are rolling over; and the Conference Board Leading Economic Index^® is pointing to a sharp slowdown in the economy. Which side of the coin should we believe? On the earnings front, results have been worse than expected and margins continue to move lower, but guidance has generally held up and Orton said he would say that the results have been good enough. The market agrees and has been rewarding both earnings beats and misses more than usual. Interestingly, information technology and communication services have been the top detractors from S&P 500 earnings and revenue growth — yet both sectors have staged a very strong recovery. Being able to hold up in the face of bad news is generally positive, but Orton said he worries that the technicals are in control rather than the fundamentals. Healthcare and energy have actually been reporting earnings-per-share (EPS) and revenue surprises, but both sectors have struggled amid the momentum reversal.

Given the macroeconomic uncertainty that still exists coupled with a market that continues to fight the Fed, Orton said he can’t help but remain cautious in the near term. Financial conditions have eased considerably over the past few months and the labor market remains tight. While the Fed seems all but certain to downshift again with a 25-basis point (bp) interest rate increase, that doesn’t mean it’s done. Powell has reiterated that rates will remain higher for longer, and there is no reason to think we won’t get to at least 5% for the terminal rate.

We’ll have more clarity on Wednesday, Orton said, but if there is a hawkish tone, this will likely cause a sharp reaction in the market as the growth trade, which is predicated on rate cuts, and a perfect soft landing partially unwinds.

Momentum generally is the safety or low-beta trade during bear markets, Orton said. Once credit conditions peak, implied volatility starts to fall and the market begins to bottom – and momentum starts to unwind or crash. Losers become winners and are often the names most associated with high short interest and poor fundamentals. Momentum is unwinding, accompanied by easing credit conditions, he said. The question is whether this is warranted given the ultimate destination for the Fed’s monetary policy and potentially slower growth than currently priced by the market.

Across the market, non-earners and the most expensive names have been outperforming. Generally, this is how new bull markets are born, Orton said. But that’s usually because the prospects for these companies are starting to turn as revenue and earnings growth estimates are revised higher. Right now, Orton said he worries that many of these industries/sectors are still undergoing downward revisions. That’s not the say there aren’t some great opportunities. We just need to be very selective and not chase the broad market higher, he said.

Small caps remain attractive

Small and mid caps have been outperforming large year to date, and Orton said he continues to favor leaning into small caps for 2023. Valuations remain attractive both relative to large caps and on an absolute basis. Earnings forecasts have stabilized and levels meaningfully above large, and he said he would expect the weaker dollar and better credit conditions to provide additional support. The technical set-up is also quite attractive, he said, and we haven’t seen flows pick up into the space.

If there is a hawkish tone, this will likely cause a sharp reaction in the market as the growth trade, which is predicated on rate cuts, and a perfect soft landing partially unwinds.

What to watch

This busy week includes interest rate decisions from the Fed, European Central Bank, and Bank of England as well as a key Organization of the Petroleum Exporting Countries gathering and a flurry of heavyweight earnings. The macroeconomic calendar includes the unemployment report, which is expected to show a rise in nonfarm payrolls of 225,000, as well as the U.S. Consumer Confidence Survey^® and the ISM manufacturing Purchasing Managers’ Index.

This week's data releases

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Deflation is a general decline in prices for goods and services in an economy. It is typically associated with a contraction in the supply of money and credit.

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.

Factor investing is an approach to investing that selects securities based on characteristics associated with higher returns. These characteristics, or factors, can be macroeconomic factors or style factors. Macroeconomic factors are focused on broad risks across asset classes and include the rate of inflation: growth in gross domestic product; and the unemployment rate. Style factors include differences in growth versus value stocks; market capitalization, and industry sector. Factor performance refers to a focus on performance of securities within a particular factor or between groups of different kinds of factors.

Momentum investing is a strategy that aims to capitalize on the continuance of an existing market trend. It is a trading strategy in which investors buy securities that are already rising and look to sell them when they look to have peaked. It entails taking long positions on financial instruments with prices trending up and short positions on instruments with prices trending down.

Profit factor investing considers the gross profit of an investment divided by the gross loss (including commissions) for the entire trading period. This method is used to assess the amount of profit per unit of risk, with values greater than one indicating a profitable system.

Dividend investing is a strategy that seeks to invest in companies that pay out dividends and considers a company’s dividend yield, ability to grow and pay dividends over time, and dividend payout ratio, or the amount being paid out to shareholders in the form of dividends versus how much income the company retains.

Volatility investing is a strategy that seeks to take advantage of sudden changes in the price of assets in markets where prices are changing rapidly, erratically, or by large degrees when compared with their historical averages. Investments in securities with volatile prices can carry both high potential rewards and high risk.

Short interest is the number of shares that have been sold short and remain outstanding. 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 interest often is seen as an indicator of current market sentiment. Rising short interest signals that investors have become more bearish. Falling short interest signals that they have become more bullish.

Earnings variability is a factor, along with other financial metrics such as ratios of return to equity and debt to equity, that plays a key role in quality investing, a strategy that seeks to invest in companies with low debt, stable earnings, consistent asset growth, and strong corporate governance.

The Purchasing Managers’ Index (PMI) measures the prevailing direction of economic trends in the manufacturing sector. It is created by the Institute for Supply Management (ISM), and consists of an index summarizing whether market conditions as reported in a monthly survey of supply chain managers are expanding, staying the same, or contracting.

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 Conference Board Leading Economic Index^® for the United States is designed to signal peaks and troughs in the business cycle, to be highly correlated with real (adjusted for inflation) GDP, and to be a predictive variable that anticipates (or “leads”) turning points in the business cycle by around seven months. It is comprised from 10 components: Average weekly hours in manufacturing; Average weekly initial claims for unemployment insurance; Manufacturers’ new orders for consumer goods and materials; Institute for Supply Management^® Index of New Orders; Manufacturers’ new orders for nondefense capital goods excluding aircraft orders; Building permits for new private housing units; S&P 500 Index; Leading Credit Index^™™; Interest rate spread (10-year Treasury bonds less federal funds rate); Average consumer expectations for business conditions.

Technicals refers to technical indicators of historic market data, including price and volume statistics, to which analysts apply a wide variety of mathematical formulas in their study of larger market patterns.

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.

Basis points (bps) are measurements used in discussions of interest rates and other percentages in finance. One basis point is equal to 1/100th of 1%, or 0.01%.

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. 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.

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.

Beta is a measure of the volatility or systemic risk of a security or portfolio compared with the market as a whole.

Implied volatility is a measure of volatility levels based on the market’s assessment of likely future volatility. It is thus different from realized volatility, also known as historical volatility, which measures levels of volatility that took place in the past.

The 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.

Harmonised Index of Consumer Prices (HICP) inflation readings are compiled and released by the European Union’s Eurostat office for individual European Union member states including Spain, France, Germany, and Italy.

The U.S. Consumer Confidence Survey^®, published monthly by The Conference Board, reflects prevailing business conditions and likely developments for coming months based on consumer attitudes, buying intentions, vacation plans, and expectations for inflation, stock prices, and interest rates.

The Eurozone Harmonised Index of Consumer Prices is a composite measure of inflation in the Eurozone based on changes in prices paid by consumers in the European Union for items in a basket of common goods. The index tracks the prices of goods such as coffee, tobacco, meat, fruit, household appliances, cars, pharmaceuticals, electricity, clothing, and many other widely used products.

The South Korea Consumer Price Index, compiled monthly by Statistics Korea, measures the average change in prices for a fixed-market basket of goods and services of constant quantity and quality purchased by consumers.

The Caixin China General Services PMI, compiled by IHS Markit, tracks sales, employment, inventories, and prices in China’s services industry. It is based on data compiled from monthly replies to questionnaires sent to purchasing executives in more than 400 companies. Survey responses reflect the change, if any, in the current month compared to the previous month based on data collected mid-month. A reading above 50 indicates expansion, while anything below that points to contraction.

The Eurozone Services PMI (Purchasing Managers’ Index) is produced by IHS Markit and is based on original survey data collected from a representative panel of around 2,000 private sector service firms. National data are included for Germany, France, Italy, Spain, and the Republic of Ireland. These countries together account for an estimated 78% of Eurozone private sector services output.

The Eurozone industrial producer price index (PPI) tracks transaction prices for the monthly industrial output of various economic activities in the European Union. The index measures price changes from the seller’s perspective and serves as an early indicator of inflationary pressures in the economy and records the evolution of prices over longer periods of time.

The S&P 500 Index measures change in stock market conditions based on the average performance of 500 widely held common stocks. It is a market-weighted index calculated on a total return basis with dividend reinvested. The S&P 500 represents approximately 75% of the investable U.S. equity market.

The Nasdaq Composite Index is the market capitalization-weighted index of more than 2,500 common equities listed on the Nasdaq stock exchange.

The Russell 2000^® Index measures the performance of the 2,000 smallest companies in the Russell 3000^® Index, which represents approximately 7% of the total market capitalization of the Russell 3000^® Index.

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RJIM23-0060 Exp. 5/30/2023