Market FIRE Commentary: December 2022

Since StockMarket-FIRE.com’s November 2022 Market Commentary, the predicated November post-election market rally has materialized, and as of the writing of this article in mid-December 2022 this rally also appears to have faded. Indeed, the post-election rally appears to have been accelerated by having been condensed within the weeks following the election, such that the typical end-of-year “Santa Clause Rally” may have been front-loaded. Indeed, during November the S&P 500 went from around 3700 to almost 4100 in a matter of about three weeks, before then declining to the present 3900 level.

Macroeconomic Backdrop: Finally Progress in Lowering Inflation, With Continued Recession Concerns

The economic backdrop for this end-of-year 2022 Market Commentary is two consecutive monthly Consumer Price Index (CPI) readings that have finally shown overall inflation to have entered a downward trajectory, albeit still at near record levels (going from nearly 9% to just over 7%). Nonetheless, aspects of inflation continue to remain high, including rents and wages, even as fuel, materials, and supply-chain related costs have lessened. Jobs figures remain robust, foreshadowing perhaps continued persistent above-average inflation combined with an economy that may still be resistant towards recession. Even as the jobs figures remain robust, recent figures have shown retail spending and manufacturing output to have been declining, after recent prior increases. A “soft-ish landing” from the inflation crisis, as described by Federal Reserve Chairman Jerome Powell, again has become at least a plausible, if still not likely, scenario.

Nonetheless, even if a deep recession is avoided, the most likely scenario is continued weaker than average economic growth and continued high inflation that exceeds the 2% target even as it decreases below its current 7% level. Whether or not the economy as a whole enters a recession, large sectors of the economy may slow or enter a “rolling recession.” Interest rates may need to be “higher for longer,” though perhaps not as high as feared when the rate of annual inflation was still increasing. If so, then stock market price/earnings multiples will also need to be more contracted for longer. The most uncertain variable remains how much lower corporate earnings will become in the face of an economic contraction or slow-growth period.

Catalysts for Short-Term Market Rally Have Been Triggered and Front-Loaded, Followed By Onset of Bearish Sentiment

In our November 2022 Market Commentary, we foresaw two near-term catalysts for an end-of-year market rally: (1) a forecasted Republican victory restoring divided government in Washington, and (2) a slower rate of Federal Reserve interest rate increases. These predictions were generally accurate but only in part. Unlike our prediction from before the Election, the Republicans did not experience the often-predicted “Red Wave” and instead enjoyed a much smaller political boost, winning only the House of Representatives by a small margin but losing ground in the Senate. Though this shift in government is not as decisive as predicted, the Republican House still should be expected to prevent any additional inflation-inducing fiscal stimulus from being enacted, as well as blocking additional sweeping social legislation that could be unsettling for business. Still, continuing uncertainty about whether Kevin McCarthy has sufficient votes from his own Conference to win the Speaker’s Election will continue until the actual election for Speaker in in January 2023, which will cloud the outlook for leadership in the House until at least that time.

As I write this article, the other part of the predicted near-term catalysts for Market appreciation has materialized, in that the Federal Reserve just days ago has announced its decision to slow the rate of interest rate increases, with a 0.50% federal funds rate increase for Dec. 2022 instead of the recent tendency for multiple 0.75% increases. This policy shift had been well-telegraphed in the weeks before the actual announcement, with the resulting market reaction having been largely front-loaded. At the same time, the Federal Reserve has also indicated that its “terminal interest rate” that represents the maximum rate to which it intends to increase interest rates, has increased by 0.25% to approximately 5.00% to 5.25%.

The logical implication from these combined policies is that the Federal Reserve is willing to slow future rate increases in order to allow past increases to have their effect on the larger economy before considering the pace and extent of future rate increases. This means that rates may not have to increase as much or at least as quickly if inflation continues to decline, but also that the Federal Reserve will need to see more of a sustained pattern of inflation decreases before lowering interest rates in the future.

Year-End Forecast: Bearish Short-Term Ahead, With Truncated “Santa Clause” Rally and Market Poised for Sentiment Correction to Upside in New Year

With the well-telegraphed adjustments in Federal Reserve policy, near-term market sentiment seems to have shifted its concerns away from inflation and towards fears of recession, resulting in post-Fed announcement declines in market prices. With the post-election rally that has already occurred, the much-hoped-for end-of-year “Santa Clause rally” will likely be truncated and occur, if at all, only during the final week of the year rather than being spread throughout the month of December.

Given the recent decline in inflation and likely decreased future inflationary fiscal policy risks given the return of divided government, StockMarket-FIRE.com believes that current short-term bearish market sentiment is markedly overdone. Even as longer-term macroeconomic and corporate-level risks remain on the horizon, there is still no evidence that a severe recession is on the horizon, particularly with signs that inflation may have been contained before reaching the prior forecasted terminal interest rates. The year-ahead market levels are more likely to be a “sideways bear market” that trades in a tight range rather than one that declines precipitously. Call me contrarian, but after as negative a year as 2022 has been for the overall stock market, at least a slight increase in overall market levels is also not implausible as part of an eventual sentiment stabilization.

Market FIRE investors should consider deploying available capital to acquire additional long shares in reasonably valued companies with near-term and longer-term secular growth prospects. These new or expanded long stock positions may include energy, stable technology, financial, and travel-related companies. On the options-end of a portfolio, Market FIRE investors should strongly consider writing available covered call options using strike prices that are higher than recent options and distinctly out-of-the money so as to protect capital in the event of a sentiment correction that may lead to a sustained market rally. In the event of a downturn, such options will become profitable more quickly than options with lower strike prices and can be closed and re-written as appropriate.