What's Ahead:
- Another year of elevated market volatility could be in store according to some indicators.
- Corporate earnings declined in last year’s fourth quarter, and forecasts from major multinationals were not positive.
- 2022 was a bearish year on so many metrics, and retail investors are downbeat on stocks—could that be a bullish sign?
Interestingly, 2022 was a year fraught with market-rocking trends, but without a single major volatility spike. The VIX Index, Wall Street’s so-called “fear gauge,” rose to just shy of 40 on a few occasions but settled near the above -average zone throughout the year. Now that the Federal Reserve (Fed) is nearly through its rate-hiking cycle, and with some hope for resolution in the offing on the Russia/Ukraine front, it’s natural to think that big market swings driven by macro headlines might subside.
The market thinks otherwise. As we continue through 2023 and look ahead to the next phase of the economic cycle, the VIX futures forward curve—a glimpse into how traders are placing their bets on broad market volatility—suggests significant up-and-down days on Wall Street will persist through at least the middle of the year. That’s about the time when Chairman Powell and the Fed are expected to finish raising interest rates, but new expectations suggest the final hike might not happen until September.
Another viewpoint that suggests “higher for longer” volatility is seen when comparing the VIX index to movements in the federal funds rate. With much higher short-term rates (lagged), we see that the S&P 500 level of implied volatility often rises in a commensurate way. The chart below from J.P. Morgan illustrates some of the same trends that plagued the market over the last 18 months may persist over the coming quarters.
Higher Short-Term Interest Rates May Portend Higher Volatility Ahead
Looking back on 2022, it was indeed a year fraught with losses and heightened daily swings, creating anxiety for many investors. According to Bloomberg, the typical 60/40 stock/bond portfolio suffered a loss, through late December, of almost 17%—the worst since the 2008 Great Financial Crisis (GFC), a 23% loss if you include inflation. What’s more, the year featured 39 daily declines of 1% or more (data through December 25), which topped ‘08’s total of 34 for the most since 2002, according to Charlie Bilello.
Stocks and Bonds Suffer in 2022 Amid Rising Interest Rates and Macro Risks
Heightened volatility and lots of red on investors’ account statements leave many folks wondering what the rest of 2023 might bring. Is another painful year of returns on tap after a January rally, or is a sustained recovery possible? We can look at historical return patterns to get a sense of how things could shake out in the months ahead.
According to data put together by Ben Carlson at Ritholtz Wealth Management, the average return following an up year in the S&P 500 is 9.8%. Not bad. The average return following a down year? Nearly the same at 9.2%. So, there is little clarity we can garner from assessing a single year’s return as to what the subsequent annual performance may be. The good news is that after a major yearly decline (more than a 10% loss) like we saw in 2022, the ensuing year’s return has been historically strong.
Stocks Return About the Same After an Up or Down Year
S&P 500 Calendar Year Returns
1928-2021
So, what should investors watch for in the near term to see how the balance of 2023 unfolds? A tepid fourth quarter earnings season did the bulls no favors, as the S&P 500 reported its first year-on-year earnings per share (EPS) drop since the third quarter of 2020. As it stands, market expectations for full-year EPS on the S&P 500, plotted below, have retreated from around $250 to $225. Many market strategists suggest that even that lower figure must come down further. Some on The Street call for EPS closer to $200 per share.
If you were to place a typical price-to-earnings (P/E) multiple of 15 on that, then it’s conceivable that there’s room to the downside toward 3000 on the S&P 500. Bulls counter by saying we have not seen a material drop in earnings yet and that using a recession-level P/E ratio and earnings figure is extreme. Moreover, if 2024 earnings indeed arrive in the $240 to $250 range (current consensus is $250) while using a recovery-level P/E of 18, then there’s a case to be made that equities should recover into the mid-4000s before long.
S&P 500 Earnings Per Share Consensus Forecasts for 2022, 2023, and 2024
Corporate earnings are not the only source of uncertainty that could warrant a higher VIX this year. Another variable that causes ire at the Fed is of course inflation. There’s some good news here, but also a highly uncertain outlook. While the 12-month look back on the CPI rate remains alarming—up 6.4% from January 2022 through January 2023—forward indicators suggest a return to near-normal inflation is in the cards, but they are also well off the lows seen earlier in the year.
According to the market’s five-year breakeven inflation rate using the yield on TIPS compared to the yield on comparable-maturity nominal Treasury securities, inflation should hit near 2.65% annually through 2028 while average annualized inflation from 2028 through 2033 is forecast at 2.3%.
Inflation Breakeven Pricing Suggests Tame Inflation Over the Next Five & 10 Years
More upbeat news for market optimists out there is also seen in some sentiment pulses. There is a weekly survey put out by the American Association of Individual Investors (AAII) that reveals what so many of us feel full well.
The AAII “Bull-Bear” gauge simply measures the difference in the number of members who see stocks heading higher or lower in the next six months. From early 2022 to the start of this year, just one lone week saw more bulls than bears. Some analysts interpret that as a cue to be long stocks in 2023 since everyone is just so bearish.
AAII Bull-Bear Spread Illustrates Main Street Investors’ Sour Outlook on Stocks
AAII Bull-Bear Spread
The bears can counter with data on actual investor positioning. NDR put out a chart on current household equity allocations. The data reveal that folks, while perhaps quite gloomy, still hold ample amounts of shares. The bearish narrative says that equities won’t bottom out until we see a true washout in which retail investors sell out stocks, as we saw in the latter stages of the GFC. Maybe that would coincide with a final spike higher in the VIX above the noted 40. Of course, that’s just speculation and what you might hear from bearish guests on financial TV.
Retail Investors Remain Heavily Allocated to Stocks Even After a 2022 Beating
Household Stock Allocation Down From Record But Remains High
The Bottom Line
Volatility likely sticks around for the rest of the year. There’s no shortage of macro risks that might prop up volatility in the months ahead. As the Fed gets a grip on inflation, recession risks grow. And we can’t turn our backs on the debt ceiling debate that could come to a head this summer. That’s why a portfolio that includes some protection from the possible downside ahead while offering upside participation could continue to work as this uncertain year unfolds.
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