There will be no change in valuation in 2023

Investors have had a challenging year in 2022. The challenges have been driven by rising interest rates, but they may soon be replaced by declining earnings estimates.

Whatever the challenge -- rising interest rates or declining earnings estimates -- valuation matters all year long. That won't change in 2023.

What Has Changed

The S&P 500 traded at 21.5x forward 12-month earnings in 2022. Despite the Fed's target range of 0.00-0.25%, the 10-year note yield at 1.51%, and the Federal Reserve continuing to buy $40 billion per month of Treasury securities and $20 billion of agency mortgage-backed securities, the Federal Reserve kept the fed funds rate at 0.00-0.25%.

The Fed estimated PCE inflation in 2022 to be 2.6% and core inflation to be 2.7%. A terminal rate of 2.1% was estimated during that period.

A decade makes such a difference.

The Fed funds rate target range is now 3.75-4.00% (and headed higher), the 10-year note yield is 3.51% (although it was as high as 4.23%), and the Federal Reserve is letting $60 billion per month of Treasury securities and $35 billion per month of agency mortgage-backed securities roll off its balance sheet.

It's a sticking point since earnings estimates for the next 12 months aren't static. We predict that they will be revised downward due to the lag effects of Fed rate hikes, employee layoffs, a weak housing market, declining personal savings, and the fact that other countries are also suffering from rising interest rates, high inflation, and a reduction in discretionary spending.

Are you talking about the recession?

In contrast to the economy, the stock trading market has had a tough year in 2022. Despite weak government spending and inventories in the first and second quarters, the economy contracted at a time when the job market was undeniably strong. There was an average unemployment rate of 3.8% in the first quarter and 3.6% in the second quarter.

It is noteworthy that the unemployment rate was lower in June (3.6%) than in January (4.0%), despite real GDP being negative for the first two quarters. Because of this, many market watchers dismissed the idea of a recession in the U.S.

In the third quarter, real GDP grew by an annualized 2.9%, and the Atlanta Fed GDP now model is estimating a growth of 2.8% in the fourth quarter.

It is expected that the road ahead will get bumpier as the lag effect of the Fed's rate hikes, as well as those of central banks in other developed markets, such as the eurozone, Australia, the UK, and Canada, kick in. Another aim of the Fed's rate hikes is to weaken demand, and a weakening of the labour market is seen as part of the solution for controlling inflation.

With its rate hikes this year, the Fed has been playing catch up all year, raising the target range for the fed funds rate by 75 basis points at four consecutive meetings. Therefore, the market welcomes the Fed's decision to raise the fed funds rate by "only" 50 basis points at its December 13-14 meeting.

The target range would then be 4.25-4.50%. This rate-hike cycle is nearly over if the Fed funds futures market has it right, and the terminal rate is in the neighbourhood of 5.00%. A rate cut by the Fed isn't likely to happen today.

Certainly, the Fed doesn't say that. According to the party line, the terminal rate will reach a higher level and then be held there for a while to ensure inflation is returning to 2.00%.

Reining in earnings estimates

The market has adjusted to the Fed's hawkish stance. That has hurt stocks (finally) and helped savers. While higher rates will remain a competitive headwind for stocks in 2023, they will also be a constant economic headwind.

Since inversions of the Treasury yield curve typically occur before recessions, many participants view them as ominous warnings of the economic environment.

Earnings growth is also adversely affected by recessions.

As Bloomberg notes, the average peak-to-trough earnings drop in a recession since 1960 has been 31%, based on Yale University professor Robert Shiller's data. S&P 500 earnings for calendar 2023 ($230.98) are expected to increase 5.7% over calendar 2022, according to FactSet.

As shown in the chart above, analysts have been reducing their 2023 earnings estimates since the middle of 2022. Despite that, there is still progress above 2022 expectations. Accordingly, the Treasury market is either overly pessimistic about the economy's future or equity analysts are overly optimistic.

As a result of this dichotomy, the market will move in fits and starts in 2023.

The Meaning of It All

With the Fed still intent on raising rates, and many companies yet to provide FY23 earnings guidance, a market trading at 17.5x calendar 2023 earnings seems out of place.

We expect to hear a lot of cautious-sounding guidance during the fourth quarter earnings reporting period due to the macroeconomic environment that forces lower estimates.

That's the $64,000 question. As the economy weakens, the answer will change. China's zero-COVID policy, Russia's war on Ukraine, and the Fed's monetary policy are some wild cards for growth. In either case, they can have a profound effect on the stock market.

The stock market has struggled in 2022 and it isn't over yet. The stock market typically do well in December, so perhaps a bad year for 2022 can end on a high note.

As deteriorating economic conditions collide with inflated earnings estimates, stocks will have their share of struggles in 2023, perhaps more so in the first half than the second. The economy will, however, struggle more than the stock market in 2023 for several reasons:

Stocks have already wrung out most of the excess from the pandemic stimulus bubble.

Higher-quality companies that are profitable, have solid free cash flow, and pay dividends are likely to exhibit relative strength in a tougher economy.

While deeper cuts to earnings estimates will hurt the stock market at first, they should ultimately result in better stock performance as the year goes on. In contrast to buying into value traps that exist before there is a deeper cut to earnings estimates, investors will be more confident that they are buying stocks at a true value in front of an inflection in earnings growth (and monetary policy) as opposed to buying into a value trap that exists before there is a deeper cut to earnings estimates.

Stocks are entering 2023 at a lower valuation than they were entering 2022, but they aren't cheap. Consequently, stock prices will decline as earnings estimates are cut further. Knowing that the darkest hour comes before dawn, those cuts will present an opportunity.

For investors, low valuations matter just as much as high valuations, except that low valuations produce better long-term returns.