Stock Market’s Brutal Year Leaves Wall Street With Little Faith in a Rebound

(Bloomberg) — A brutal year for US stocks is drawing to a close with little conviction on Wall Street that the outlook is brightening anytime soon.

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After charting a rebound since October on speculation the Federal Reserve is nearing the end of its most aggressive rate hikes in decades, stock prices have retreated over the past two weeks on renewed concern that the tighter monetary policy will smother economic growth through the first half of next year. The S&P 500 has lost nearly 20% this year. Rate-sensitive growth stocks have been hit even harder, driving the Nasdaq 100 down more than 30%.

“We are headed for a recession, but it will be a tale of two halves next year, one that likely sees improvement in the stock market in the second half,” said Sam Stovall, chief investment strategist at CFRA. He expects the S&P 500 to retest its October lows in the first half of 2023 but end next year around 4,575, a nearly 19% rise from Friday’s close.

The key question now facing Wall Street is how close the Fed is to ending its rate increases — a moment that historically has delivered double-digit returns for equities.

To Luca Paolini, chief strategist at Pictet Asset Management, the tighter financial conditions are poised to shift investors’ focus next year from inflation to the risks posed by a slowdown in the economy. He’s bearish on US stocks over the next three-to-six months and is watching three key factors that could bring an end to the bear market: a trough in corporate earnings estimates, a steeper bond-yield curve and cheaper valuations in stocks most sensitive to cycles in the economy.

“We’re still in a bear market,” Paolini said. “A peak in inflation is clear, but we’re expecting equities to be weak next year. The decline in inflation could be slow and painful — definitely not strong enough for central banks to shift from tightening to easing. That is why we don’t expect rate cuts next year. I’m much more worried about growth than inflation in 2023.”

While the S&P 500 has priced in at least a modest earnings recession, higher borrowing costs and persistent economic uncertainty will likely suppress potential gains in stocks over the next year, according to Bloomberg Intelligence’s fair-value model.

When the bottom will arrive, however, is a fierce debate. And there’s a risk that profit estimates may still be too optimistic. Brokerage analysts’ aggregate forward 12-month target of 4,498 for S&P 500 assumes that earnings will rise 4.3% — starkly higher than BI’s model of an implied 2% decline.

Another sign of pessimism: This year’s drubbing has turned Wall Street strategists into bears for the first time in at least two decades, with the average analyst forecast calling for a decline in the S&P 500 in 2023. Stock bulls, however, hope that could be a contrarian signal for equities and that the overly bearish sentiment points to a market bottom.

In addtion, the recent cooling of inflation offers reason for optimism. Since 1950, the S&P 500 has posted a total return of 13% on average over the 12 months following the 13 major inflation peaks, according to Jim Paulsen, chief investment strategist at The Leuthold Group. And in the 10 instances where the index rose in the year following a substantial inflation spike, the S&P 500 went on to deliver an average total return of 22% in the year after that, too, data from the firm show.

Although US stocks are likely to begin recovering at some point in 2023, it may take more than two years for the S&P 500 to reach its January high again high, according to BI. In fact, the Fed’s need to keep rates elevated in the face of still high inflation may weigh on earnings and hold average annual returns for the S&P 500 to 5.7% for the next three years, compared with 12.7% from 2010 to 2019, according to Gina Martin Adams, BI’s chief equity strategist.

Seema Shah, chief global strategist at Principal Asset Management, anticipates that next year will still be particularly challenging for tech stocks, whose elevated valuations become pulled down as borrowing costs rise.

“Certainly, next year will be challenging, but it will open up some opportunities for equity investors,” said Shah, who expects the US economy to undergo a recession in the second half of 2023. “The Fed likely will not respond to an economic downturn with any relief. While this year was about valuation compression, next year will be about an earnings downturn, so we are expecting further losses in the equity market.”