December Market Update - The Next 6 Months

Welcome to the final month of the year. I want to go over what we expect from the market over the next 6 months and what indicators we are basing our outlook on. We are going to get a little more technical than usual with this update, but I believe that it's important to show you how we are coming to the decisions we are.

Overview

In our last few updates, we have outlined our expectation for the market to move higher into the end of the year and then probably turn back lower starting next year. So far this has been the case. The market has moved from an S&P low of around 3500 on October 14th to around 4000 as of Dec 1st. We do think that possible gains into the end of the year are likely limited from these levels in the market. We also believe that sometime between now and the end of Q1 2023 the market will experience a potential pullback to retest the 3500 lows and potentially break them and go lower towards the 3200 range. I will share details around why this is our outlook below.

Earnings

Stock prices are valued based on their earnings per share multiplied by what we call a multiple or P/E ratio. Simply put, good stocks will have higher multiple than less favorable companies. The price for a stock is determined by its earnings per share X its P/E ratio (multiple)

For example: A stock with a multiple of 10 that also earns $10 per share has a share price of $100.

The overall market has a multiple as well. In times of low interest rates, the multiple tends to get higher. In times of higher rates, the multiple gets lower. Right now the S&P multiple is 21.8 (higher than usual). Next year the average earnings for the S&P are expected to be $231, but most private banks and investment firms are expecting $200-$210. In our view, the estimate of $231 per share does not consider the slowing of earnings growth due to the economy slowing down and potential recession next year.

Optimistic Outlook Earnings do not fall much, and S&P has a multiple on the higher end of average. S&P multiple: 17. S&P earnings: $210.

17x210= 3,570 level for S&P which is about 15% lower than we are today.

Pessimistic Outlook Earnings fall to the lower end of estimates and market P/E on the lower end of average. S&P multiple: 17. S&P earnings: $210.

15x200= 3,000 level for S&P which is 25% lower than we are today.

Our guess is we end up somewhere in between.

So, we think the earnings estimates for next year are elevated and unlikely to be accurate. We also believe that A 21.8 multiple is unlikely to be maintained with a slowing economy. The math for both of those issues leads to a lower market next year.

Inverted Yield Curve

Another very accurate signal for an impending recession is an inverted yield curve. An inverted yield curve is when a shorter-term bond has a higher yield than a longer term bond. Normally, the longer the bond, the higher the yield, which makes sense because you are being asked to lock up your money for longer. However, when people are worried about economic conditions in the future, they buy more long dated bonds which causes their prices to go up and their yields to go down. The most common pair of bonds to evaluate this are 2 yr treasury and the 10 yr treasury. Currently, the 2yr treasury yield is higher than the 10yr treasury yield. The difference in the two yields is at its highest level in 50 years. An inverted yield curve has predicted the last 10 recessions.

In addition, you can look at any pair of short and long dated bonds to check the yield curve; 3mo/1yr, 1yr/2yr, etc. Another reliable indicator of impending recession is when at least 52% of these indicators are inverted. Today there are 82%.

Technical Analysis

We use a variety of technical indicators that help us understand where a stock or the market might go. Below is a simple trend line indicator on a chart of the S&P. This chart is roughly a 3-year time frame. The peak of the chart is the November 2022 high of the market, and the downward sloping right side is the path of the market in 2022.

The green lines are the trend line. You can see that the trend line is ascending during the first half and declining in the second half. We can use trend lines as indicators for when the market might change course. Our thoughts are that the market will again start to reverse now that we are close to the well-defined downward sloping trend line.

Plan of Attack

Like I mentioned earlier, we believe that the market may trend higher into mid-December and maybe even late December, but then we believe the end of December and the first quarter of 2023 will be rough. We have already taken steps to make our portfolios more defensive and we will continue to do so as we get closer to 2023. Unless our outlook changes, we will be very defensive entering 2023 and do our best to minimize the downward volatility.

So far, this update has been pretty doom and gloom. There are more negative indicators, but I think you get the picture. But not to worry, we have good things to look forward to.

Here is the good news:

Our 24-month outlook is the year 2023 ends with the S&P in the 4,000 area. However, we expect the market to correct back to the 3,200-3,400 range before recovering back to the 4,000 range. Looking back 10 years from now it may look like not much happened in 2023 since our thoughts are that the year will finish around where it started. But in reality, it could be a wild ride. We will do our best to avoid as much of the downside as possible, but if we do get a big market correction down to S&P 3200-3400 we will want to switch to a more aggressive stance because 2024 is still looking like it will be good to great. The first half of 2023 will be all about mitigating downside risk and we have a variety of tools to do this that were not viable options in the first half of 2022. The second half of 2023 will be about capturing gains on the upside if our most likely scenario ends up playing out. The second half of 2023 and all of 2024 could end up having significant upside in the market. We just need to get through these next 6 months.

The average return for the stock market in the 12 months after a bear market is over is 46%. We may see those 12 months start in mid next year.

Drew Sweetman CIO - Element Squared Private Wealth

Sources: Marketwatch.com, WorthCharting.com, CNBC.com, SeekingAlpha.com

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