The Stock Market Is at a Crossroads

• Market Outlook

• Debt Limit Risks

• International Equity Opportunities

• Small-Cap Growth Opportunities

• China Reopening / Energy Markets

The resilient U.S. economy, a moderate European winter, a lower dollar, and China's reopening have given global investors and forecasters hope that a severe recession can be avoided. 2023 has started better than everyone expected.

The consensus is now a mild and manageable recessionary scenario driven by the strength in the labor markets. In the early weeks of 2023, investors began to hope that slowing inflation and strong employment figures could result in an economic soft landing.

You only get a secular bull market in stocks once the wind is at your back; by that, I mean a friendly Federal Reserve that's lowering or pausing rate hikes. The unemployment rate is usually the lowest before a recession as the yield curve is inverted, then everything changes.

In most cases, historically, markets tend to rally first before the recession when the yield curve begins reversing. But then, as the recession kicks in and the yield curve steepens dramatically, that's when typically, the actual market trouble begins.

Will the Fed over-tighten? History suggests that the Federal Reserve raises rates until they sink the economy into a recession. So now we are to believe the fastest rate hike cycle ever into the highest debt construct in history will not cause a severe recession.

Rate cuts will come; the question is when and will they come because something breaks in the economy. The longer the Federal Reserve waits to pause rate hikes, the deeper the eventual recession. Hence, the Federal Reserve will cut rates sooner than their current jaw-boning to the public currently suggests. We hear from the Federal Reserve on February 1st.

The technicals suggest we can still set up for a more significant tech-driven rally if earnings hold up going into the next Fed meeting in February and if inflation continues to fall. So we could see a rally throughout the first half of the year.

Suppose the current rally does continue, and the Fed makes a policy error and stays too high for too long in the face of the data, coupled with extended valuations. In that case, the June debt limit fiasco could trigger a more extensive market sell-off in the second half.

We are still determining what kind of soft or hard landing we will have. By the time the analysts have figured out the actual earnings situation, the market will have put in a bottom a long time before. It is our belief that the market bottomed last October. Any market sell-offs will be bought at higher levels than previous sell-offs. If this current rally continues, portfolio managers and institutions will begin to chase performance, and the market will grind its way even higher.

Historically, prices typically bottom around ten months ahead of a bottom in earnings. So if you wait for the trough in earnings, you will miss the significant market move off the bottom to start the next bull market. So the only question is now, when and how deep will the market sell-off be to get a great entry point for the next bull market rally?

Debt Limit

The U.S. economy risks defaulting on its debt this summer as politicians quarrel over increasing the country's debt limit. The current cap is at $31.4 trillion. The Treasury Secretary, Janet Yellen, says she will find ways to fund its debt obligations until at least early June.

A standoff in Congress is about to unfold over the coming months. Republicans and Democrats will engage in political brinkmanship over political goals while engaging in political theatre. The last time a potential default risk occurred was in 2011 when Congress narrowly averted disaster after markets shuddered. As a result, the U.S. had its credit rating downgraded.

The longer the debt limit fight takes to solve, the more significant the effect on the markets. The turmoil would be a drag on economic activity because of the uncertainty.

The newly elected Speaker of the House, Kevin McCarthy, is in a challenging situation. While conservative members of his party insist they do not want the U.S. to default on its debt, McCarthy is under pressure to demand deep spending cuts. McCarthy has suggested that he will only support raising the debt ceiling with a compromise on spending. If McCarthy concedes on too many points, he will likely be ousted as Speaker.

International Equity Opportunities

The outperformance in foreign markets has been noticed by U.S. investors, bruised by the 19.4% decline in the S&P 500 last year. Some of the shifts we see within the U.S. market, from tech leaders to leadership from industrials, basic materials, and energy, represent a higher share of markets like Europe and emerging markets. Even as emerging markets are considerably outperforming, some countries and regions are expected to perform better than others.

One of the primary drivers for emerging markets has been compelling valuations.

The increased interest in foreign markets has had multiple catalysts. For one, the U.S. dollar has been weakening, removing a headwind from many countries' corporate profits. Also, investors in foreign stocks will benefit if their local currencies gain against the dollar.

Another major catalyst was China's abrupt departure from its Zero Covid policy. That could ultimately help its economy and positively impact its Asian neighbors. China's reopening will give a boost to Europe's export economy. Europe is also expected to come through the winter without a significant economic hit from an energy shock, thanks to warmer weather, falling prices, and sufficient energy supplies.

Small-Cap Growth Opportunities

Growth stock valuations have fallen considerably over the past year, with small-cap growth stocks seeing significant multiple compression. So how do these valuations compare to history, and what may lie ahead?

The price-to-earnings (P/E) multiple of the S&P 600 Small-Cap Growth index was one of the lowest we observed at the end of December 2022.

There is a strong historical relationship between P/E and subsequent annualized returns. Historically, below-average P/E multiples in small-cap growth, which we observe currently, have led to above-average returns.

Small-cap growth appears attractive relative to the S&P 500, with more than an 18% discount based on price-to-next 12 months consensus EPS estimates. As a result, U.S. small-cap growth may be an attractive area for long-term investors. Also, to take advantage of two emerging trends, we recommend small-cap growth companies with strong balance sheets and resilient business models in European and emerging markets.

China’s Reopening Effect on the Energy Markets

China's economic reopening might boost global growth. Still, it will increase demand and put inflationary pressure on the global energy markets. If the Chinese economy's demand for other goods starts picking up, that will create considerable stress on commodity prices.

Europe competes in the same liquified natural gas market as China. The International Energy Agency (IEA) has issued a warning stating that European companies may face significantly higher costs when purchasing natural gas this year as there will be more competition for the commodity. As a result, inflation has been one of the biggest challenges for European citizens for the last year, driven mainly by higher energy bills.

The mismatch between demand and supply growth going forward means oil prices have to go sufficiently higher over the next two to three years to destroy discretionary demand. Oil demand will rapidly increase as China experiences a travel boom and an accelerated economic awakening.

China's opening is good news overall, but the potential inflationary impact could keep the world's energy markets stubbornly high. Some economists have warned that if commodity prices spike higher, the U.S. Federal Reserve might have to keep raising rates further.

Conclusion

You only get a secular bull market in stocks once the wind is at your back; by that, I mean a friendly Federal Reserve that's lowering or pausing rate hikes.

We are still determining what kind of soft or hard landing we will have. By the time the analysts have figured out the actual earnings situation, the market will have put in a bottom a long time before.

Historically, prices typically bottom around ten months ahead of a bottom in earnings. So if you wait for the trough in earnings, you will miss the significant market move off the bottom to start the next bull market.

The bear market we had last year was caused by the sharpest increase in real interest rates since Volcker put on the clamp in 1979, in a much more difficult situation than we are in now. Market analysts have predicted a tumultuous first half of the year in the markets, and then the market will recover and rally in the second half. History shows us that if everyone's on one side of the trade, they're usually wrong.

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Investment Disclosures

This material is not meant to provide investment advice and should not be considered a recommendation to purchase or sell securities.

The views expressed are the views of Infinitus Wealth Management, LLC. These views are subject to change at any time and may not represent the views of all portfolio management teams, Wealth Advisors, or other Investment Professionals. These views should not be interpreted as a guarantee of the future performance of the markets, any security, or any funds managed by Infinitus Wealth Management, LLC. These views are not meant to provide investment advice and should not be considered a recommendation to purchase or sell securities. Investment Advice will be given to individual clients based on risk tolerance, time horizon, investment objectives, and other considerations.

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