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2023 Outlook: Strong Belief in Corporate America

| January 04, 2023
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Happy New Year! Welcome to 2023! Our attempts to predict stock values for this year are more difficult than normal because ripple effects from the unprecedented COVID-19 relief efforts still leave a wide range of possible outcomes. Our readers know how we start with our capitalized profits model, which takes the government measure of corporate profits from gross domestic product (GDP) reports and discounts it by the 10-year Treasury yield to calculate a fair value for stocks.

Profits rose 2% in the third quarter, resulting in a year-over-year increase of 7.8% from the third quarter of 2021 through the third quarter of this year. Interestingly, while profits rose 7.8%, inflation came in at 7.1%. Thus, real profits were 0.7% on an inflation-adjusted basis – not that great.

That shows the role price increases can play. The current uncertainty around inflation is part of the reason forecasting 2023 is more challenging.

Still, using a 10-year Treasury yield of 3.6% to discount current profits suggests a fair value for the S&P 500 at around 3,700. In past posts we’ve discussed how the bond market is the tail wagging the equity market dog. As such, if the 10-year yield heads north of 4.0%, stocks’ fair value would decrease significantly. If the 10-year yield dipped lower, stocks’ fair value would rise.

Another variable to track is recession. Some think it’s our destiny. Others aren’t so sure. The CFS base case is that our economy may enter a mild recession in the summer. However, stocks look forward and could bottom within the first few months of the year as investors realize this isn’t a panic-laden situation like in 2008-09.

Investors should take note how companies have effectively managed their bottom lines through a tough 2022. We think it’s realistic to expect a roughly 10% increase in GDP nationwide profits. Should that occur, our capitalized profits model predicts a fair value of around 4,050 for the S&P 500, or about a 5-7% gain for the year.

The biggest story for stocks last year was suffering due to higher interest rates. The greatest variable in 2023, which is hopefully a tailwind, is corporate profit durability. If firms can grow profits in 2023, it will show the work done in 2022 to manage the bottom line also has longer-term positive impacts.

We think firms will grow their profits as they did last year. In other words, we have a strong belief in corporate America.

Themes for 2023

We’ll roll out a full 2023 preview in the coming weeks. But to give a sneak preview, here are three key themes to watch play out this year.

Energy will still be a strong play in 2023

While this may seem a bit obvious, it’s worth noting that energy’s runway looks quite long in terms of the energy sector’s potential for strong future business and financial performance. Within the S&P 500 last year, energy stocks surged from about 2.0% of the index in January to near 6.0% by the end of the year. Going forward, we expect that growth to continue, perhaps significantly.

The jury is still out on the recent $60-per-barrel price cap on Russian oil due to the Ukrainian war. Some say they could have great effects. Others say the Russians will sidestep them. Opinions aside, it’s possible the sanctions could push the price of energy up, perhaps by a lot. While that’s not great for consumers, it would benefit investors.

Additionally, the Biden administration will need to stop draining the Strategic Petroleum Reserve. Recently, 180 million barrels were drained, leaving about 382 million barrels (down from 593 million at the start of 2022). The artificial suppression of oil prices is likely over.

Lastly on the energy front, China throwing in the towel on COVID-19 lockdowns will increase energy demand. That should coincide with the traditional springtime oil rally, which could push prices to around $100 per barrel.

The Federal Reserve’s Interest Rate Drama Will Continue

After the Fed’s Dec. 14 rate hike, the federal funds rate is now roughly on par with the two-year Treasury note yield and well above the 10-year yield. Historically speaking, that means we don’t need any more interest rate increases.

But Fed Chair Jerome Powell refused to acknowledge progress in the fight against inflation, even though core inflation excluding food and energy is finally improving (especially when viewed quarterly). Thus, he appears to be at odds with market rates and the dramatic decline in Treasury yields in the fourth quarter.

Either way, the Fed can only fight the market for so long. So, we think it is likely close to its last rate hike. When Wall Street realizes that the Fed will stop raising rates, it could be the basis of a big relief rally. However, that may not take place until the latter part of this year.

Bad News is Actually Good News

Oddly, we are in an environment in which strong economic news is bad for us. Why is that?

Well, investors want the Fed to stop increasing key interest rates. The Fed is raising them to cool off the economy and lower asset prices. So, if the economy and asset prices keep flourishing, the Fed will keep throwing water on the fire. But, if the economy stumbles, the Fed’s attempts are working, and the interest rate hikes will have a sunset in sight.

In that spirit, here are some traditionally bad economic data points that are now viewed favorably.

The Commerce Department reported that durable goods orders plunged 2.1% in November 2022. That figure was much lower than economists predicted (a 0.6% decline). Transportation orders declined 6.3%. Personal spending only rose 0.1% in November 2022, compared to the upwardly revised 0.9% in October 2022.

For a consumer-centric economy, these are not very promising figures. But in today’s world, this is great news. Hopefully this is enough to continue cooling inflation and keep the Fed hawks at bay.

Current S&P 500 Sector Rankings

Lastly, we want to highlight the importance of understanding sector leadership going into 2023. With the help of our friends at MAPsignals, here is the ranking of S&P 500 sectors by MAP Score (a MAPsignals calculation of overall strength based on fundamental and technical analysis):

We should see continued leadership from sectors like energy, industrial, and staples, which also make up the top three sectors by MAP Score. Of course, that’s until the Fed stops raising interest rates.

Once that occurs, it will allow for consumer discretionary and technology stocks to move back up the list. If that happens, we don’t expect it until closer to 2024. But it will be a welcome shift because it would indicate a more growth-oriented long-term economic setup.

*The S&P 500 is an unmanaged index of 500 widely held stocks that is generally considered representative of the U.S. stock market.

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Securities sold through CoreCap Investments, LLC.  Advisory services offered by CoreCap Advisors, LLC.  Cornerstone Financial and CoreCap are separate and unaffiliated entities.

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