Don’t Fear the Bull Market. Why Stocks Are Headed Higher.
The case for optimism as a resilient market continues to disappoint the bears.
By Jacob Sonenshine
The stock market has climbed a wall of worry to start the year and is nearing a bull market.
Now the fun part begins.
Entering 2023, doubters argued that stocks were expected to take a fall as the “bear-market rally” off the October lows faltered.
The Federal Reserve had been rapidly lifting interest rates, raising the cost of capital for everything from start-ups to banks.
The economy was slowing to the point that a recession had become a question of when, not if.
Corporate profits had stagnated, and stocks outside a handful of large technology names had floundered.
Despite the underlying weakness, the S&P 500 SPX 0.11% index appeared expensive, particularly given where profits appeared to be heading.
Adding to the sense of unease, the index couldn’t seem to crack 4200, suggesting some unknown risk limiting the market’s upside.
Yet through it all—the debt-ceiling standoff, a banking minicrisis, and a potential earnings slump—the market has held its own and then some.
And what the bears have apparently forgotten is that stocks are always looking forward, not back.
All of the hand-wringing over a possible recession can’t hide the fact that the S&P 500 already suffered through a bear market in 2022.
Valuations, meanwhile, could hold the line if the Fed stops raising rates and earnings begin to recover.
Even the 4200 barrier has been broken.
The S&P 500 is now up 19.5% from its Oct. 12 low, just a touch away from entering a bull market.
And with economic growth proving resilient, the Fed nearing a pause, earnings set to reaccelerate, and the average stock ready to join the rally, it’s one that might have legs.
“The notion that we’re in a bull market has become more compelling and harder to argue against,” says Yardeni Research’s Ed Yardeni.
Strangely, that argument starts with a recession, which may be unavoidable.
The Fed has raised rates from near 0% to a range of 5%-5.25% over the past 15 months, and those rate hikes are being felt throughout the economy.
Their impact can also be seen in the housing market, which has been hit by higher mortgage rates, and in the banking system, where the collapse of Silicon Valley Bank, First Republic Bank, and Signature Bank has led to a tightening of lending standards.
But a possible recession doesn’t mean the market has to collapse.
Ed Yardeni, founder of Yardeni Research. CHRISTOPHER GOODNEY/BLOOMBERG“We…know that the market bottoms while the economy is still in recession and begins a recovery,” says David Donabedian, chief investment officer of CIBC Private Wealth US.
“The second half of [2023] will have lousy economic headlines but the beginning of a more durable bull market.”
Investors are positioned for the worst.
The American Association of Individual Investors’ survey shows that bears outnumber bulls by nearly eight percentage points; bulls usually outpace bears by 6.5 points.
What’s more, since Covid-19 hit, investors have never been more than 30 points net bullish, according to RBC Capital Markets, well below the typical prepandemic peak of about 50.
Positioning, too, remains bearish, with leveraged funds nearly as short as they were during the pandemic.
The only problem: They may be positioned for a bear market that already occurred.
And the higher the S&P 500 goes—it’s already up 11.5% in 2023—the more likely it is that bearish investors will have to start buying, helping to push the market up even more.
“The carnage [selling] that we got in the S&P last year was already baking in a recession,” says Lori Calvasina, chief U.S. equity strategist at RBC, who recently raised her S&P 500 target to 4250.
“Take advantage of pullbacks if you’re a longer-term investor.”
Investors have plenty of dry powder to do just that.
The average portfolio manager, in a Bank of America survey of managers overseeing trillions of dollars of assets, now holds almost 6% of the portfolio in cash after all of the selling, up from below 4% in late 2021 and near the average peak of just over 6%.
And they have plenty of stocks to choose from.
It’s a badly kept secret that the S&P 500’s gains have been driven by shares of Big Tech companies, including Apple, Nvidia, and Meta Platforms.
The seven biggest stocks gained 77% this year through the end of May, while the average stock in the index dropped 1.2%.
That “bad breadth,” as it’s known on Wall Street, has many investors waiting for the market to collapse when tech finally falters.
It doesn’t need to play out that way.
It’s possible that Apple, Microsoft, and the rest will run out of steam, but the stocks that have underperformed—and there are a lot of them—could catch up with the market, helping to boost the overall index, says BMO Capital Markets Chief Investment Strategist Brian Belski.
He notes that when five stocks outperform the S&P 500 by the extent they have in 2023, the S&P 500 goes on to gain 11% over the next 12 months.
Brian Belski, chief investment strategist at BMO Capital Markets. VICTOR J. BLUE/BLOOMBERG“[Our] work shows that once relative performance of these megacaps has subsided…the broader market has historically held up just fine, with gains being more common than losses,” Belski explains.
Fundamentals also appear to be coming around, if only just.
Much of the drop in earnings forecasts may have happened already, with 2023 S&P 500 earnings-per-share estimates down almost 12% in the past year, according to FactSet.
That has started to stabilize, with EPS estimates up almost 1% in the past month.
Now, analysts are penciling in earnings growth next year, with S&P 500 aggregate EPS expected to grow 12%, to $245, in 2024.
Some of that growth will be driven by Nvidia, Microsoft, Meta, and Alphabet (GOOGL), which should grow at a 36% annual rate in aggregate over the next three calendar years, according to our calculations of FactSet’s analyst consensus estimates.
But it will also be driven by EPS growth in consumer discretionary, industrials, and other sectors.
“The 2023 EPS recession is known,” says Victor Cossel, a macro strategist at Seaport Research Partners.
“As the year progresses into the second half, the market will shift to discounting an EPS rebound.”
There are risks, of course.
Morgan Stanley strategist Mike Wilson, who called 2022’s bear market, argues that earnings could suffer a 16% decline this year, to $185 a share, as companies struggle to raise prices to keep up with cost inflation.
If he’s right, the S&P 500 could fall to 3700.
“[That] reacceleration in earnings growth is now built into consensus expectations on both the sell side and buy side,” Wilson writes.
“Suffice it to say, we respectfully disagree with that conclusion.
With inflation falling, and Fed governors such as Philip Jefferson making the case for a pause, the federal-funds futures market was pricing in just a 25% chance of an interest-rate hike at the June 13-14 meeting of the Federal Open Market Committee.
A pause would be good news for the stock market because it would give the economy, earnings, and valuations a chance to stabilize.
But the Fed might choose to raise rates anyway this coming week, or take a one-meeting break before resuming the increases.
“We would be careful not to give in completely to FOMO (fear of missing out), as a skipped hike is not a pause, inflation still handcuffs the Fed…and a U.S. recession remains on the horizon,” writes Benjamin Bowler, head of global equity derivatives research at BofA Securities, who recommends using call options to get upside exposure.
But if the Fed does stay on hold through the remainder of 2023, it could solve a lot of the market’s problems, including what appears to be the S&P 500’s steep valuation.
The index trades at 18.6 times 12-month forward earnings, down from 21.5 times at the end of 2021 but still above its 20-year average of 15.7.
If the Fed pauses, it would allow price/earnings ratios to stabilize and perhaps even grow.
Belski’s 4550 year-end target for the S&P 500, for instance, calls for the index’s earnings to rise just 0.4%, to $220, but for investors being willing to pay 20.7 times for those earnings.
The best opportunities might be in economically sensitive stocks, known as cyclicals, which have been hit particularly hard this year.
The SPDR S&P Bank exchange-traded fund (KBE), home to JPMorgan Chase (JPM), Citigroup (C), and other large financial institutions, has dropped 26% since peaking in February, as higher interest rates caused depositors to look for higher-yielding alternatives to checking and savings accounts.
The big banks, though, aren’t the ones seeing depositor money walk away, and even regionals have been hit so hard that they are starting to look interesting.
What’s more, at 7.9 times 12-month forward earnings, the bank ETF is trading well below its five-year average of 10.8 times.
Oil stocks also look poised to rally if the economy holds up better than expected.
The Energy Select Sector SPDR ETF (XLE), home to oil majors Chevron (CVX) and Exxon Mobil (XOM), is down about 14% from its peak in 2022.
Oil prices are the key to a rally.
West Texas Intermediate crude oil, the U.S. benchmark, has fallen 11% this year amid concerns about a recession in the U.S. and slower-than-expected growth in China.
But if oil can hold support and head higher after having bottomed out at about $66 a barrel this year, it would boost earnings estimates for energy companies and boost their stocks, as well.
Other economically sensitive stocks, including materials and industrials, could also get a boost.
“Weak sentiment [and] attractive normalized valuations…support a case for new money to be put to work in cyclicals,” says Citigroup strategist Scott Chronert.
The market figures out the future pretty quickly.
Blink once and you could miss the bull market.
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