The Independent Market Observer

Looking Back at the Markets in December and Ahead to January 2023

Posted by Brad McMillan, CFA®, CFP®

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This entry was posted on Jan 6, 2023 10:37:02 AM

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Looking Back and AheadDecember saw a sell-off, reversing some of the bounce from October and November and leaving markets up for the quarter. Unfortunately, that only reversed a small part of the damage done earlier in the year. 2022 closed as one of the worst years in recent memory for financial markets.

Looking Back

Stock markets. U.S. stock markets were down between 4 percent and 9 percent for December, ranging between a small loss for the Nasdaq and a 16 percent gain for the Dow for the quarter. U.S. markets were also down for the year—7 percent for the Dow and 32 percent for the Nasdaq. International markets did better in December but had similar results for the quarter and the year. Even fixed income was down for both the month and the year.

Interest rates. The reason for the universal pullback was the significant rise in interest rates during the year. With inflation running at a 40-year high, the Fed increased the federal funds rate from 0.08 percent at the start of the year to more than 4 percent at year-end. Higher interest rates typically mean lower stock and bond values, which is just what we saw. Looking back at last year, there really was no place to hide. While the Fed is expected to continue to raise rates, those increases will likely be much smaller than what we saw in 2022, limiting future damage.

Economic improvements. While financial markets performed poorly, the economy did well in 2022. We saw two quarters of negative growth during the year, but the declines were small and largely due to adjustments from global trade. The fundamentals remained solid, with job growth running stronger than expected and consumer spending continuing to increase. Business sentiment and investment also improved. Looking back, it was almost as if the economy and the markets were completely disconnected.

Looking Ahead

Recession worries. Looking forward, the economic news is likely to be less positive. Job growth, while still healthy, has been trending down. Business sentiment has also slipped, with the manufacturing sector, in particular, moving into recessionary territory. A recession is expected to start sometime this year, but based on the strength of the labor market, any recession we get is likely to be fairly mild.

Rates and valuations. Slower growth, recession or not, is likely to convince the Fed to slow or even pause its rate increases, providing potential support for both the economy and markets in 2023. We saw rates begin to stabilize at the end of 2022 as inflation started to roll over. Stock valuations dropped substantially and are now at more reasonable levels. With a more stable macro outlook, both rates and valuations should be much steadier, leaving the market more dependent on fundamentals, especially earnings.

Earnings. Here, the news is likely to be better than expected. Earnings outperformed expectations in 2022, but that improvement was offset by the decline in valuations. With valuations stopping their decline, improvements in corporate earnings should provide a cushion for markets in 2023 and maybe even engineer some gains. Per Bloomberg Intelligence, as of December 30, with 99 percent of companies reporting actual earnings, the blended earnings growth rate for the S&P 500 in the third quarter was 4.6 percent, up from estimates for a 2.6 percent increase at the start of earnings season.

This solid result followed better-than-expected earnings growth in the first and second quarters of the year and showed that businesses successfully operated throughout the year despite economic headwinds. With the consumer economy expected to remain healthy, that trend should continue in 2023.

International risks. 2022 was not just about economics. The Covid-19 pandemic in China is resulting in more lockdowns and supply chain disruptions, and the war in Ukraine is still weighing on markets. Political turmoil in the U.S. also remains a concern. And, of course, there are the risks we don’t see yet. So, looking forward, we can expect more volatility throughout the year.

Reasons for optimism. The rapid increases in interest rates, the most damaging factor of 2022, are likely behind us. The strong labor market should keep supporting the economy, making any recession fairly mild. And stock valuations are now lower and more reasonable than they were last year.

Looking forward, the prospects for the coming year look much better than what we saw in 2022. Most of the adjustments to the economy and markets may have already been done. And with slower growth and inflation, we could see valuations stabilize and improve further. We may even see some appreciation as fears about earnings growth moderate.

Growth on the Horizon

Looking back at last year, we saw the market tank as the Fed got inflation under control and normalized interest rates. Despite that, the economy continued to move forward. Looking ahead, we should see the same kind of economic resilience without market damage. On the economy and earnings, while growth may be slower, we are growing—and that will help earnings and the market.

2023 has its own challenges ahead. But, at this point, they look better than what we saw in 2022. And after a tough year, things are looking up as we move forward—and that is a good way to start the new year.

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