We wish everyone a happy and healthy new year!
The S&P 500 declined -0.14% this week with Friday's close at 3,839.50. The index finished 2022 on a sour note, declining for the fourth consecutive week. In terms of price action, one can certainly say we limped into 2023.
Trading was quiet throughout this holiday-shortened week, with the index climbing as high as 3,858.19 and as low as 3,780.78, a high-low range of just ~2%.
The week recorded as an "inside week", meaning this week's high was lower than last week's high and this week's low was higher than last week's low. This leaves the weekly open-high-low-close (OHLC) bar "inside" the prior week's OHLC bar. "Inside weeks" reflect indecision, or uncertainty, as the price of the S&P 500 doesn't even trade back to "test" the prior week's high and low. We often write that the price action of the S&P 500 has an uncanny ability to maximize uncertainty, and the trading this week, and really throughout the month of December, does exactly that.
The biggest takeaway from the recent price action the last few weeks was the S&P 500's downside reversal from the ~4,100 price region.
Referencing the chart above, we can see the brick wall of resistance that's formed at the ~4,100 region, noted by the red shaded rectangle. Nothing truly good happens for the S&P 500 until it can break through that wall of resistance.
However, it's also important to note that the S&P 500 still hasn't violated any material levels of "support" and has found buying interest in the mid- to high ~3,700s.
The lows of each of the last two weeks record at 3,764.49 and 3,780.78, but the index closed back near the ~3,840 level. With hindsight, the popular narrative regarding the "JP Morgan Collar" trade now appears prescient (click here). But the point is that the index has at the least stopped going down at and around the 50% Fibonacci retracement level when connecting June's lows to December's highs. The pattern is analogous to taking two huge steps forward and one huge step back, which is a common way in which the S&P 500 advances over time.
So, the glass half-empty crowd will see the S&P 500's downside reversal from the ~4,100 level as a sign that we're going to trade back down to retest the October lows in January, while the glass half-full crowd believes the 50% retracement is a sufficient pullback that's recharged the battery, maximized uncertainty, and set the stage for another run back toward the ~4,100 level in January. We won't pretend to have any real conviction about what lies ahead in the short term, but since the primary trend is down, or "bearish", we do believe the glass half-empty crowd at least has the upper hand.
Using closing prices, the S&P 500 closed December almost exactly in the middle of our most recent closing swing high (4,080.11) and low (3,577.03). In theory, one could draw a horizontal line across ~4,080 and ~3,577 and call it a day, meaning there's no true "signal" until the S&P 500 trades and sustains outside of this range. Here's what it looks like:
One area of the market is already retesting its October closing lows and that's the Nasdaq 100 Index (NDX). NDX closed Wednesday at 10,679.34, a new year-to-date closing low but just a few points below November's closing low at 10,690.60.
This "retest" is off to a good start though as NDX finished the week back at 10,939.76, a gain of 2.33% off Wednesday's closing low (red shaded circle below). NDX is comprised of the largest of market capitalization companies that collectively have the largest attribution within the S&P 500, so it's imperative NDX holds its October and November closing lows for the S&P 500 to have any chance at finding its way back to the ~4,100 level.
From our view, the technical fate of the S&P 500, whether the next 200-300 points are higher or lower, depends mostly on near-term fundamentals: Specifically, how market participants believe the four-headed monster of inflation, Fed policy, interest rates, and the United States Dollar Index will evolve over the months ahead.
The four-headed monster is directly related to the future state of the economy (i.e., the severity of the impending recession), and therefore it has a direct impact on forward- looking corporate earnings (i.e., the profitability and collective earnings per share of the S&P 500). This is mostly a fancy way of saying soft vs. hard landing, economically speaking. That's the question we believe market participants are trying to "price in" at the moment.
As for the week ahead, we're on to 2023! We're eager to see how market participants will trade 'em this week since there's a mountain of economic data coming forward, data that will help participants shape an answer to the question of discounting a soft vs. hard landing. We'll get a plethora of manufacturing data, we'll hear from the Fed via Fed minutes from their December meeting, and we get the jobs report on Friday.
S&P 500 Primary Trend - Down
The S&P 500 finished the month of December on Friday, falling by -5.90% for the month. This marks the 5th time in 2022 that the S&P 500 has fallen -5% or more in a single calendar month, which ties 2008 and 2002 as calendar years with the most -5% monthly declines for the S&P 500.
The index traded as high as 4,100.51 on December 1 and 4,100.96 on Tuesday, December 13, but prices didn't stay there. Given November's surge to the upside, we wrote in early December about how pivotal December's price action would be. From our Update on 12/4:
"The S&P 500 managed to close the month of November back above its 10-month simple moving average. Should the S&P 500 close the month of December above its 12-month simple moving average, and above the ~4,130 level, we'll be looking at a fresh six-month high close for the index. That will rotate both short- and long-term momentum strategies back to "risk-on". So, December is a "prove it" month for the S&P 500."
This is particularly disappointing considering the "2 & 10% Price Thrust Reversal" that recorded into November's monthly close, mostly because of the parallels it draws back to the 2002-2003 cycle. Consider:
- November of 2002 saw the S&P 500 record a "2 & 10% Price Thrust Reversal" and then declined -6.03% in December, and November of 2022 saw the S&P 500 record a "2 & 10% Price Thrust Reversal" and then declined -5.90% in December.
- In 2002 the S&P 500 plunged in September, roared higher in October and November, and then got beat up in December. Last year (2022) saw the exact same thing. In fact, both calendar years saw each of the final four months of the year move by +/- 5% on a monthly closing price basis, something that's extremely rare.
Ultimately, 2002 declined -23.37% while 2022 saw the S&P 500 fall -19.44%. So there are striking similarities in the price action across both 2002 and 2022.
Now, we do not believe what happened in the 2002-2003 cycle has any influence as to what happens in the 2022-2023 cycle.
The S&P 500 will do whatever it wants over the months ahead, regardless of what happened in the first quarter of 2003. But it is interesting to note that market participants, collectively, were behaving in a strikingly similar manner across the final four months of 2022 to the final four months of 2002. This creates intrigue about the possibility of this behavioral parallel continuing, and thus the price action parallel continuing, and if that is indeed what occurs then we have a lasting market bottom coming over the months ahead.
From the end of 2002 to March of 2003's bottom the S&P 500 declined -10.33%. With 2022's close at 3,839.50, a -10.33% decline would mark a trade down to ~3,442. Given the S&P 500's October low at 3,491.58, this would mark a nice "double bottom" with a somewhat textbook false breakdown. Should this unfold in February or March panic would likely be in the air, the oversold conditions would probably be spectacular, and the ingredients would be there for a lasing market bottom. We'd sign up for that.
Interestingly, calendar years like 2022 do tend to have a rocky start the following calendar years, at least historically speaking. This too then jives with the 2003 parallel.
Since 1950 there are eleven prior calendar years that saw the S&P 500 decline -10% or more. Of those eleven, five in a row and seven of the last eight then saw the S&P 500 close the first quarter of the next year in the red.
If we look at the average maximum drawdown and drawup columns on the table above we can note that the S&P 500 trades down, on average, -16% from the prior year's close and trades up, on average, 18% from the prior year's close following calendar years where the index declined -10% or more. This would set a range for 2023's trading between ~3,224-4,530.
Now, there is nothing that says that both of these prices can't be reached in 2023 and nothing that says neither of these prices are reached in 2023. Further, there is nothing that speaks to the sequence of either of these prices being reached in 2023. If we had it our way, we'd be more than comfortable with the S&P 500 trading down to the ~3,200 region in Q1 2023 and trading back above the ~4,000 level in Q4 2023. That's fine by us, but it is a fairly consensus opinion, admittedly...just ask Art Cashin (click here).
As always, nobody truly knows where the price of the S&P 500 is headed next and over the course of 2023. Our mantra as we head into 2023 is to position as if the worst is yet to come while being prepared in the event the best is somehow just around the corner.
2022 Review and Scorecard, 2023 Preview
The year 2022 is in the books and it's a year that most investors, and investment managers, are happy to put in the rearview mirror. An overview of broad asset class and investment performance in 2022:
- The S&P 500 price only index fell -19.44%, the Nasdaq Composite fell -33.10%, and the Dow Jones Industrial Average fell -8.78%.
- The SPDR S&P 500 Index Fund (ticker symbol SPY) fell -18.18%.
- The Dow Jones Corporate Bond Index fell -16.85%.
- The iShares Core U.S. Aggregate Bond Index Fund (ticker symbol AGG) fell -12.83%.
- CME CBOT 30-year U.S. Treasury bonds fell -22.03%.
- The Reuters/Jefferies CRB Index gained 19.53%.
- The Dow Jones U.S. REIT Index fell -27.60%.
- Gold fell -0.13%
- The Vanguard Balanced Index Fund, a proxy for the traditional 60/40 investing methodology, fell -16.98%.
- The top performing sector was S&P 500 energy sector as it gained a whopping 59.04%.
- The worst performing sector was the S&P 500 communication services sector, it declined -40.42%.
What's not listed on the table above is cash, and in 2022 cash was king.
It doesn't even matter if your cash was held under a mattress, it performed better than virtually everything listed above (in both nominal and real terms).
In terms of strategy, active and alternative strategies mostly had their day in the sun. Managed futures, long/short strategies, and tactical asset allocation strategies all mostly outperformed.
The narrative behind why asset prices fell in 2022 points directly to the inflation story.
Inflation ascended on a year-over-year basis to levels we haven't seen since the 1970s, a surge of more than 9%. Why? A perfect storm of both gigantic fiscal and monetary policy stimulus dating back to 2020 driven by a global pandemic that disrupted supply chains, thus fueling a gigantic increase in the capital available to buy a finite, and descending, number of goods available.
This led the Federal Reserve to take a drastic turn in their policy stance and to move to what is best described as ultra "hawkish" as early as January of 2022.
January's Fed minutes kicked off a sharp downturn for the S&P 500 as participants had to "correct" their assessment of what monetary policy would look like here in 2022. In total, the Fed went on to raise the federal funds target rate more than 400 basis points in 2022, moving the benchmark from 0-0.25% to 4.25-4.50%. Coming into the year, participants were only expecting 50-100 (0.50%-1%) basis points increases to the funds rate.
This then led market participants to sell bonds like mad, almost all year long, driving the yields on 5-, 10-, and 20-year Treasury bonds to levels we haven't seen in more than a decade.
We lived in an era of "ZIRP" (an acronym for "Zero Interest Rate Policy") from 2008 through 2021, but that ended in 2022.
Simultaneously, the United States Dollar Index (DXY) was ripping to levels we haven't seen in two decades. Broadly speaking, a rising DXY is a headwind for the profitability of large multinational corporations. We read the phrase the "U.S. Dollar Wrecking Ball" more than we wanted to this year.
And that's the story of how the "four-headed monster" crushed risk assets in 2022. It was a hefty dose of worse than expected and it's human nature to panic when receiving news that's worse than expected.
But the next chapter, the chapter we'll read in 2023, is all about the lasting implications of the Fed's response to inflation, the evolution of "four-headed monster", and the impact to the economy and corporate profitability.
For example, where does the inflation story head next? There's evidence to suggest that what the Fed has already done has been quite effective at bringing an end to rising prices. The headline Consumer Price Index (CPI) is only higher by a cumulative 1.02% over the last five months. That's an annualized pace of inflation right in line with the Fed's target.
But what's happened the last five months isn't a crystal ball, it can't tell us where CPI is headed next, and therefore it's difficult to asses where Fed policy and the four-headed monster is headed in 2023. It's why it is difficult, actually impossible, to know the answer to the question of soft vs. hard landing in 2023 as of today.
At the moment, market participants believe the Fed's hiking cycle is almost done.
It's the same story with the rest of four-headed monster. Interest rates across the curve are well off their 2022 highs and DXY has gotten absolutely crushed the last four months. But will this continue over the next few months? That's the question, that's the unknown.
If the inflation story is truly behind us then we believe that it will continue, meaning rates and DXY will continue to fall and the Fed can then "pause" sooner rather than later in 2023.
This is the soft landing scenario, economically speaking, and it's in this scenario where we believe the S&P 500 will roar back toward the ~4,300 region in the first quarter of 2023.
By contrast, the four-headed monster will worsen in any scenario where there's a few twists and turns left in the inflation story.
We believe this will bring us a major case of deja vu in 2023 where if inflation is higher than expected then the Fed will be forced to tighten more than expected and we'll once again see higher interest rates across the curve and a stronger DXY. This is the hard landing scenario and it's easy to then envision the S&P 500 trading down toward the ~3,000-3,200 level if this is what's in store. Naturally, we'll write it one more time here in 2022, the inflation story still holds all the cards (potential escalation on the geopolitical side holds some of the cards too...)
Finally, the antidote to all of the uncertainty that lies ahead is the certainty found in having a plan to govern the ongoing management of your investment portfolio!
An investment policy statement, or a document that is clear, concise, and details how your portfolio will be managed on a forward-looking basis establishes rules, creates structure, and instills discipline in the ongoing management of your portfolio. It doesn't even truly matter what your plan is, there are hundreds if not thousands of good plans out there.
What matters is your ability to stick to your plan through thick and thin, through the good times and bad. That's how long-term investors win over time, not by attempting to consistently predict the unpredictable, but by consistently predicting their own behavior with their portfolio (i.e., following the rules of their investment policy statement).
Like they teach us in kindergarten, when you follow the rules you stay out of trouble!
Here's to a great 2023!Steve & Rick
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