The Fed Still Appears to Hold All of The Cards

The Fed Still Appears to Hold All of The Cards

January 11, 2023

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There is an age-old saying that I have often quoted in my weekly missives, “Don’t fight the Fed.” This still seems to be holding. They have both the rule book and the printing press. They can raise or lower interest rates and they can adjust the supply of money that is printed and injected into the system. In recent memory, COVID 2020, the Fed put its foot on the gas to reignite the economy by infusing money and lowering interest rates. Last year, to cool inflation, they aggressively raised interest rates and decreased the money supply. Now we appear at a crossroads. Is the rate of inflation slowing at a pace to have the economy aligned with the Fed’s inflation targets, or is there still more belt-tightening to go? In late December we saw signs of economic slowdowns, and this week we will have the Consumer Price Index (CPI) and Consumer Sentiment Index to deal with. See three clear illustrations of the effects of Fed tightening in 2022 below:

I could provide many clearer illustrations but suffice it to say that Powell and the Fed are getting their wish, at the expense of the US economy. The negative manifestation of this has been equity prices which contracted in every sector except oil in 2022. But now that we are in the second week of 2023, what could we expect? If the past is any guide, it is highly unlikely that we should expect two back-to-back down years for the stock markets of the world. To begin with, equity prices are a discounting mechanism. We might see negative earnings announcements and negative economic indicators on the horizon, yet stock prices should begin to recover. This is just the way markets work! They move based on expectations 12-18 out, not based on history as earnings reports and economic indicators reflect what “has” happened, vs. what is “expected” to happen.

It would not surprise anyone to see the market's churn for a bit at the beginning of 2023 as there could be some spillover from 2022. Since 1950, there have been 19 instances of a negative S&P 500 return year. In the following year:

  • Stocks were flat only 11% of the time.
  • Stocks were up over 20% 53% of the time.
  • Following a negative year, stocks have a double probability of an up year.
  • Very rare to see two back-to-back down years.

So, the logical question becomes, what are the factors that we are looking for that could support an up 2023?

1. The Santa Claus Rally did indeed happen. Granted it wasn’t much of one, and it sure did not feel like one, but the major indexes closed up the last five sessions of 2022 and the first two of 2023. We will be paying close attention to make sure January holds the December lows.

2. We believe that current inflation measures are lower than the Fed’s consensus, by a wide margin. We think the December CPI report could show CPI lower than forecast. We could be moving to a period of disinflation.

3. Despite what looks like a strong jobs market, leading indicators already suggest wage gains are set to slow. It is visible even in leading surveys, as suggested by Goldman Sachs Economists.

The next point to make is to look back in history (virtually every year back to 1900) and see if any years looked at all like 2022 and then what happened next. According to Adam Turnquist, LPL Chief Technical Strategist, 1962 checks the box as the closest comparison with a 0.82 correlation (a correlation of 1 would be exact, so this is pretty darn close to perfect). This being the case, see below what the market did in 1963 following the decline of 1962:

Needless to say, this dovetails with the historical precedent of recovery following tough years. I realize that this year could be very different than previous examples, but I am more confident given that the House has already begun to block measures by the Democratic Administration to increase spending as evidenced by their shooting down the $80 Billion to be spent on increasing the IRS.

If inflation begins tempering, wages slow their rate of ascent, and employment continues to show difficulties due to the slowing economy, we could be close to the end of the Fed taking away the punchbowl and the equity markets could begin their recovery. Most importantly, investors should not wait for the Fed to begin retrenching in long-term positions. This could be tough as economic reports could continue to be dire, yet markets could do the opposite. Looking back to the 1980s Volker era, markets bottomed months before the Fed topped rates:




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