Following a strong run since last autumn, the U.S. equity market has been wobbly. Uncertainties that had previously receded have come back to the fore, generating volatility and downside in major U.S. indexes. While the S&P 500 shot up almost 17 percent from the October 2022 low through early February, it has pulled back 4.5 percent since then. As of Wednesday’s close, the index is 16.8 percent below the all-time high reached in early 2022.
The U.S. market continues to work through headwinds
S&P 500 Index
Line chart showing the S&P 500 peaked on January 3, 2022 at almost 4,800. While it had fits and starts in 2022, it ultimately fell to 3,577 in mid-October. After that it rallied through early February to 4,180. But since then it has pulled back to just under 4,000.
Source - RBC Wealth Management, Bloomberg; daily data through 2/22/23
The negative influences
Market participants are once again mulling over the possibility that:
- The Fed’s rate hike cycle could persist into the summer, with a higher probability of the fed funds rate rising another 75 basis points (bps) to 5.50 percent between now and the central bank’s June or July policy meetings, according to futures market positioning. Resilient consumer spending, the strong labour market, and higher-than-comfortable near-term inflation projections have contributed to this sentiment. The Fed’s institutional biases are also playing a role. Just a couple months ago markets were contemplating only 25 bps more in hikes.
- Rates could stay higher for longer, impacting corporate borrowing costs and limiting business capital investment.
- If inflation lingers above normal for longer, the market’s valuation could become more difficult to justify. The S&P 500 is trading at a price-to-earnings (P/E) ratio of 17.9x the forward 12-month consensus earnings forecast, above the 20-year average of 15.7x. Typically, inflation needs to be low or at least demonstrating that it is moving toward sustainably low levels for the market’s P/E to be able to hover at the high end of the historical range for any meaningful period of time. Additionally, U.S. equities now look pricey compared to bonds based on equity risk premium analysis. This is the reverse of what occurred in recent years.
- If the Fed ends up overtightening, the economy could ultimately tip into recession. There is a fine line between the optimal number of rate hikes and overdoing it. As the Fed continues to fight inflation and the tight labour market at a time when some economic indicators have already weakened, RBC Capital Markets, LLC’s Chief U.S. Economist Tom Porcelli is becoming more concerned that Chair Jerome Powell’s Fed will overdo it. Porcelli thinks the central bank should have already stopped hiking rates.
- Corporate margins and earnings could face additional pressure. The consensus earnings forecast for 2023 has fallen to US$223 per share from US$252 per share last May. By some metrics, the current Q4 2022 earnings season is the weakest quarter in the past 24 years except for those during recessions, according to our national research correspondent. At this stage, the consensus forecast is for only 2.2 percent year-over-year earnings growth for 2023, and we think there is downside risk to this estimate—especially if a recession materializes.
The market’s valuation is now above average
S&P 500 price-to-earnings ratio based on forward 12-month consensus estimates
Line chart showing the S&P 500 P/E ratio since 2003. It began around 16.0x the forward consensus estimate and drifted up to almost 18.0x by the end of that year. It later drifted lower, until bottoming at around 10.5x in 2011. It moved higher until 2017 to around 18.0x, and then pulled back in 2019 to 14.6x. From then it spiked until late 2020 when it peaked at over 22.0x. After that it fell to 15.3x by September 2022. But it has risen recently to 17.9x. Since 2003, the average level was 15.7x; +1 standard deviation was 18.3x; -1 standard deviation was 13.0x.
- P/E ratio
- ±1 STD
Source - RBC Wealth Management, Bloomberg; quarterly data except for the final data point that is from 2/22/23. “STD” stands for “standard deviation.”
It’s not unusual for a number of uncertainties to linger after big selloffs like the one that occurred in 2022, and for issues that had previously caused volatility to create angst once again. This typically happens when equity markets are in transition. As the major indexes work their way through bear market declines and get closer to beginning a sustainable bull phase, there are usually a number of fits and starts. Given the lingering headwinds, investors should expect more volatility this year—this would be normal market behaviour.
The positive influences
Even if volatility persists in the coming weeks and months, we continue to see reasons why the S&P 500 can deliver positive full-year returns, once all is said and done.
- Inflation should push lower this year. The path downward will likely be bumpy and it could take longer than is comfortable for inflation to get back to the Fed’s two percent target. But price trends for commodities and goods, and projections for rents are pointing toward notably lower inflation by year end, according to RBC economists’ forecasts.
- The earnings outlook looks “less bad”—warts and all. We think 2023 S&P 500 earnings could end up at US$210–US$220 per share, lower than the current US$223 per share consensus estimate. This would be roughly equal to or slightly down from the 2022 estimate of US$218 per share. Such an outcome would be “less bad” than previous recession periods. We think this is possible because household spending should be relatively more resilient this cycle than in recent economic contractions. Household balance sheets appear to be in better shape due to sturdier employment trends and high savings levels when this period began. Both will likely erode, but not as much as in previous recessions.
- Investors should heed the long-standing axiom, “As goes January, so goes the year”—aka the “January effect.” In January 2023, the S&P 500 climbed 6.2 percent, the Dow Jones Industrial Average rose 2.8 percent, and the small-cap Russell 2000 rallied 9.7 percent. According to Stock Trader’s Almanac data since 1950, when the S&P 500 rose in January and was up during the first five trading sessions of the year and there was a “Santa Claus rally”—all of which occurred this time around—the market posted gains for the full year 90 percent of the time; the average gain was 17.5 percent. Following bear market years (like last year), it rose on 100 percent of occasions. Furthermore, it would be rare for the S&P 500 to deliver back-to-back negative return years; that has occurred only twice in the post-WWII era.
We think these positive factors, balanced by the lingering headwinds, argue for Market Weight exposure to U.S. equities, with an eye toward becoming more aggressive with sector and industry positioning or more constructive overall should the market pull back further.
In Quebec, financial planning services are provided by RBC Wealth Management Financial Services Inc. which is licensed as a financial services firm in that province. In the rest of Canada, financial planning services are available through RBC Dominion Securities Inc.
Vice President, Portfolio Analyst
Portfolio Advisory Group – U.S.