S&P 500: Bulls Can Fight The Fed And Win Big In 2023 (SP500)

Everyone should be familiar with the investing adage “Don’t fight the Fed” which stands as a warning to follow policy messaging, and not attempt to bet against the trend. The environment of ultra-low interest rates over the last decade worked as a strong signal to stay bullish on stocks. Anyone attempting to second-guess the Fed could be branded as outside the consensus and mostly fall into the “bearish on stocks” camp, seemingly waiting for an economic disaster.

Fast forward, many things in life end up coming full circle. As we close out 2022, our revelation today is that the tables have turned between the bears and bulls as to which side is now the Fed cheerleaders compared to a new crop of skeptics. Indeed, the Fed’s hawkish series of rate hikes in its attempt to address historically high inflation, along with official projections calling for a slowing economy, have provided fodder for doom-and-gloomers getting an apparent stamp of approval from the authorities.

There’s one group seemingly counting on the Fed’s actions to push stocks lower as a backdrop for the market outlook. It’s true the strategy worked in 2022 considering the S&P 500 (SPY) is on track to close down sharply lower, pressured by a mixed bag of indicators. Of course, nothing with investing always works, and it’s more important to start considering what’s next. It’s possible the bearish trend that began at the start of 2022 is nearing an end with the selloff already having discounted many of the imbalances.

The way we see it, there are plenty of reasons to be skeptical of what has evolved into the seemingly bearish consensus with the market nearly convinced of a deepening recession through a narrative of higher interest rates for longer. In other words, the Fed may end up being wrong – again, setting up a new bull market where conditions evolve more favorably across stronger growth while inflation surprises lower, sooner rather than later.

The Fed’s Credibility Crisis

Today’s Fed is hardly a bastion of credibility. Most will agree that it was a massive mistake to not hike rates sooner in the cycle with the embarrassment in 2021 of regularly downplaying inflation. That’s the backdrop for its stance today where we believe there is room to look through Fed statements.

Like a driver attempting to get across town after a few too many drinks with the rear taillight out and an expired tag, the Fed may be playing it extremely cautiously to not get pulled over. The result is the fire-and-brimstone messaging in an attempt to save face by driving the point home that the group is super serious about its mandate to get inflation under control with a whatever-it-takes approach. The bears have been lapping it up.

On the other hand, what that group may be dismissing is that the excess inflation problem may be on the way out and well-positioned to surprise to the downside. Favorably, the recent data shows inflation is actually dropping faster than previously expected, with many of the factors that sent the CPI to the cycle high of 9.1% in Q2 largely reversing, notably energy and supply chain disruptions.

It’s not just oil and gas prices, but “core” components and high-profile categories like “used cars” and “shelter” are trending lower reflecting a normalization compared to extreme pandemic conditions. There is a connection because companies no longer have that urgency to raise prices with the cost pressures easing.

We previously wrote about how the labor market is likely not a primary driver of inflation which means “good news” of ongoing job gains should be treated as such precisely because it brushes aside fears of a deeper recession which is the worst of two evils in our opinion.

The key here is to focus on the month-over-month figure that has averaged 0.2% since July which implies a forward annualized rate of just 2.4%, approaching that 2% Fed target. At this pace, the annual rate that gets all the attention will effectively crash from 7.1% in November over the next couple of months against the high benchmark of comps in Q1 2022 through the base effect.

All things considered, the Fed has been reluctant to even suggest some early success which we connect to its 2021 PTSD, hesitant to appear anything but “highly attentive to inflation risks”. That’s the opportunity we see with stocks right now. Connect some dots and read between the lines where the Fed isn’t yet willing to go.

Skeptical of the Fed

Continuing with our theme of poking holes into the market baseline, the last December FOMC statement still cited inflationary factors that could otherwise be seen as stale. It’s curious that the group noted energy prices and the impact of the Russia-Ukraine war as a major part of the inflation challenge.

Without sounding facetious, and recognizing the seriousness of the situation, it’s difficult to reconcile some of these points when the data reflects a different reality.

Major commodity groups from energy, metals, and agriculture are lower compared to levels at the start of the conflict in February. To be clear, it’s true that the initial surge of prices created global supply chain bottlenecks, and it’s possible there is still some lingering stress. Still, it’s hard to say those factors are contributing to “upward pressure” on inflation right now as a talking point.

From a purely economic perspective, inflation might actually be higher today if the war were not “weighing on global economic activity”. So that’s one inconsistency which was not a question addressed at the last press conference by Chairman Powell, although he made a point of guiding for ongoing increases in the target fed funds rate in order to return inflation to 2%.

What Happens Next?

The big headline from the December FOMC was an update to the 2023 funds rate projection, climbing to 5.1% from the 4.6% prior estimate. The implication here is that the Fed believes more hikes are necessary, with the forecast for PCE inflation across both the headline and core measures getting a bump higher for the final 2022, and 2023 figures. On this point, it’s telling that the latest November PCE following the FOMC came in cooler than expected and the annual rate of 4.7% is already under the Fed’s full-year estimate.

Separately, the group revised lower the GDP forecast for the year ahead to just 0.5% in 2023, from a prior 1.2% estimate. The expected unemployment rate also got a tick-up. Stocks saw a new round of volatility on this data although our take is that investors would be making a mistake to assume these estimates are written in stone.

Again, the Fed doesn’t have a 100% record of hitting these targets with the variance going both ways. Yet here we are with one side of the market really taking the projections as fuel for a more bearish forecast on stocks.

From there, it’s evident to us that inflation is the key that drives all the other forecasts. The possibility that the CPI and PCE keep surprising to the downside will ultimately support a revision lower to the fed funds rate target and be positive for GDP growth.

The trend would be reflected in 2023 with the fabled dot plot shifting lower officially by the next March update and through the real-time market-implied yield curve. Notice those two blue dots under 5.0%. In our opinion, that’s where the stock market bulls should place their chips. We don’t know exactly who those Fed governors are, but they’re the real mavericks in our book.

Let’s not forget the action in the bond market. It appears interest rates are already signaling a pending Fed pivot with the 2-year Treasury at 4.2% currently below the 4.5% upper limit of the Fed funds rates. Similarly, the 10-year Treasury yield at 3.7% demonstrates a yield curve inversion which is typically interpreted as a signal of a pending recession. The more mundane explanation is simply the lower outlook for inflation and long-term inflation expectations, which can be independent of economic growth.

In other words, the terminal rate has a downside not because the economy is crashing and demand collapsing, but because the inflation data begins to justify a shift in policy over the coming months based on the structural shift of normalizing inflation pressures. It may be that inflation as we have seen it really was transitory, just at a far different scale than originally imagined.

The Fed could have room to begin cutting rates by the end of next year with inflation at the target level without fear of jump-starting a resurgence. A 10-year yield settling around the current level as the curve normalizes is hardly restrictive for the economy or stocks by historical context.

S&P 500 Year-End 2023 Forecast

Putting it all together, there is absolutely room to fight the Fed with a view that they are overplaying their hand on inflation and entering the new year with an overly pessimistic outlook. The economy got bruised but can prove to be resilient. Over the next few months, room for a broader policy adjustment away from being uber-hawkish messaging would be positive for stocks and risk sentiment.

We started our note by bringing up the importance of the trend, but keep in mind that it’s all relative. The S&P 500 is still up over a 2-year basis and even 10% higher from its recent October low and up from levels in June. It’s hard for bears to take a victory lap considering the choppy trading action going on for the past seven months. Let’s ask ourselves where that trend is headed.

Looking at the chart. It will be important for the S&P to climb above the 4,000 index level corresponding to around $400 in the SPY ETF for the bulls to establish control. To the upside, the August high of around 4,300 could be in play over the next few months.

We’re setting a 2023 year-end S&P 500 target at 4,777, just about reclaiming the all-time high and representing a solid 23% return from the current level. Climbing above 4,300 would signal a technical breakout and likely force a wave of momentum from short covering as a technical buy signal and the old “fear of missing out”.

In other words, a break above 4,300 and its off to the races in our opinion with the real pivot to watch being bears flipping long at that point. We’ll agree that the target is ambitious, but keep in mind that when stocks make big moves, it’s only obvious in hindsight. The narrative could be completely different in 12 months. Crazier things have happened.

With data suggesting the S&P 500 is on track to reach a bottom-up EPS of $232 next year as an aggregate of all underlying constituents, our price target implies a 21x forward P/E multiple. This valuation ratio would likely narrow with an expectation consensus estimates for underlying stocks get revised higher as companies benefit from stronger margins as inflationary costs ease, interest rates stabilize, and macro conditions improve.

Ultimately a scenario where the 2023 S&P 500 EPS approaches $240, our forecast would result in a P/E of 20x by next year at our price which would be reasonable ahead of what could be an even stronger earnings environment for 2024. By sector, the big opportunities are in beaten-down tech with high-growth leaders that have been sensitive to interest rate changes likely able to lead the market higher in the bullish case.

Final Thoughts

The setup into Q1 2023, with a path for the “inflation remains elevated” and “higher interest rates for longer” narrative to fall apart would be massively positive for risk sentiment and stocks overall as evidence towards a soft landing scenario. The next major catalyst here will be in less than two weeks with the December CPI data set to be released on January 12th.

Finally, we don’t want to leave with the impression that we’re claiming to have a crystal ball. Everything above is our opinion, the same way a different forecast for the S&P 500 to crash under 3,500 as a new cycle low is up for debate. Our conviction here is that we ultimately end up higher from the current level.

We can point to the still volatile Russia-Ukraine war as likely the biggest risk to any optimism. A scenario where the conflict extends into Europe would likely cause a resurgence of supply chain disruptions and sharply higher commodity prices as a new tailwind for inflation. On this point, oil prices are a key monitoring point, but our take is that any level under $100 a barrel is still manageable.

Editor’s Note: This article was submitted as part of Seeking Alpha’s 2023 Market Prediction contest. Do you have a conviction view for the S&P 500 next year? If so, click here to find out more and submit your article today!