Here’s What to Do When Everyone Sees a Recession in 2023

It looks like 2023 should get off to a bad start.

Consensus for early in the year points to recession-related weakness in earnings and this likely portends choppy equities. Mike Wilson from Morgan Stanley and David Kostin of Goldman Sachs, in fact, predict the S&P 500 will drop to 3600 or lower in the first half of the year, followed by a second-half rebound.

So, how should investors approach the new year?

Mike Wilson’s record on market direction has been remarkably prescient in recent years; his calls shape the current Wall Street consensus as other strategists follow his market outlook. Still, the case for upcoming weaker corporate earnings’ impact on the market is sound, and ought to be respected. The Fed seems intent on over-tightening, as it ignores what’s really happening with inflation in the consumer goods and commodity sectors. The Fed was too loose for too long; now, it’s determined to create the opposite effect. The history of an inverted-yield curve of this magnitude, with a widening negative spread between the two and ten-year treasuries, suggests a recession on the horizon. That’s also current base case on Wall Street.

Much like this past year, many investors will find the choppy markets ahead challenging to navigate. The key focus will be to tune out the noise and buy on significant weakness. Pundits will emerge with lower stock market targets, regardless of how far the markets have fallen. Look past the extreme calls for 3000 in the S&P, where the market will carry a 15 price-to-earnings on $200 in earnings. A contracting P/E on trough earnings is unlikely, especially with positioning on Wall  Street already light with high cash levels and lower leverage. Plus, the market has already discounted some adverse economic outcomes. It’s worth remembering that the market bottoms on bad news, especially when investors appear to throw in the towel.

By the second half of next year, the market will expect economic growth in 2024 as the Fed starts to ease, so buying first-half weakness will likely be rewarded.

By the second half of next year, the market will expect economic growth in 2024 as the Fed starts to ease, so buying first-half weakness will likely be rewarded.

Some wildcards may impact 2023. The war in Ukraine can drag on, with Russia’s floundering offensive getting desperate. The path of inflation will likely be uneven — yet, the lack of money supply growth, tame energy prices, and weaker housing all bode well for lower inflation next year. A weaker dollar — down over 5% in recent weeks — will provide a tailwind for the earnings of multinational companies and ease inflationary pressures abroad.

Cut No Slack to SPACs

Sentiment is apt to continue to vacillate between optimism for a soft landing and concerns about a deep economic contraction. These shifts in sentiment, compounded with Fed policy concerns and inflation indicators, have swung the market 10% to 15% at a clip — and will likely continue to do so.

What to avoid? In any scenario, the market will continue its sober path. The bubbles in the pandemic high-flyers have burst, including in those “blank check” special purpose acquisition companies, crypto, and cultish “meme” stocks. The most painful part of the bubble bursting has passed, but don’t expect much of a rebound in these groups. During the pandemic, Fed liquidity saved many companies from bankruptcy, often funding dubious business models. Companies that are cash-flow negative, and have to raise capital, ought to be avoided. Raising money will be too punitive for the shareholders, and some debt-laden companies might have to restructure.

In equities, Goldman recommends sectors that have historically benefited from decelerating inflation, such as medical equipment, semiconductors, software, retail stores, transportation, and banks. Investors who have been hiding in cash can at least now earn yield. It’s prudent to own short-term treasury exchange-traded funds, like the iShares Short Treasury Bond ETF (SHV) or SPDR Bloomberg 1-3 Month T-Bill ETF (BIL) , with a current yield close to 4%.

If the strategists are correct, and the U.S. does have the most predicted recession in history next year, the stock market won’t fall precipitously. Sentiment is already sour and funds are well-prepared to buy the dip with high cash levels parked in short-term treasuries yielding over 4%. A pull-back that retests this year’s low of 3500 or slightly lower will likely be the opportunity to buy of 2023.