When investors think about the stock market, they tend to characterize it in one of two ways: It’s either a bull market or a bear market, with a clear direction, up or down. But there’s a third option, and we’ve been living it the past year. Call it a trading-range or sideways market. If you had to pick an animal correlate, maybe it would be a crab.
For the past year, the S&P 500 index has fluctuated between roughly 3,500 and 4,300. But with a few exceptions, the broad-market barometer has stayed within 5% of the 4,000 level, notes Bob Doll, the chief investment officer at Crossmark Global Investments. That shows a fairly even match in the tug-of-war between the bulls and the bears, he says, and fits with one of his top predictions for 2023: “This will be a year when neither the bulls nor the bears will be satisfied as volatility continues in both directions.”
The stock market will, of course, break out of its range eventually, and it could do so before the end of the year. But in which direction?
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Wall Street is very much divided on this question, with strategists’ price targets ranging from as high as 4,600 to one strategist’s worst-case scenario of 3,500. A number of forecasts cluster around 4,300 at the high end (up 3% from the S&P 500’s level of 4,169 on April 30, the date for prices and other data in this story) and roughly 3,900 toward the low end (down 6%). Or consider a recent note from Goldman Sachs, in which the three-month, six-month and year-end S&P projections were all 4,000.
That doesn’t mean that investors should sit on their hands for the rest of the year. The market is never a monolith, and there will be plenty of individual winners and losers even if the broad-market index flatlines over the course of the second half. In other words, it would be a mistake to confuse a range-bound market with a calm one.
“We believe price choppiness and elevated volatility will be mainstays throughout the year as investors continue to face uncertainties related to inflation, the Federal Reserve and interest rates, earnings, and economic growth,” says Brian Belski, chief investment strategist at BMO Capital Markets.
Prudent investors will take advantage of the market’s fluctuations, says Doll. “Because I think the market is going to bounce around and go a whole lot of nowhere, I’d be a buyer on dips and a trimmer on rallies – and that applies to stocks, sectors, industries and the market as a whole. If there’s a stock I like, I’ll wait for my price and trim something else to buy it. It may sound like being a trader, but it’s not – it’s just doing your homework.”
The bear case for stocks
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The market pessimists – or as they prefer to be known, realists – see a number of insurmountable hurdles for the market ahead. Chief among them is a recession. Seven of the past nine Fed rate-tightening cycles have resulted in a recession, according to Crossmark Global.
Even economist and market strategist Ed Yardeni, of Yardeni Research, whose S&P target of 4,600 puts him at the forefront of the bulls, sees a 40% chance of the economy entering a recession in the second half of the year. At the very least, he acknowledges, tighter lending standards stemming from the recent regional banking crisis – perhaps as a number of small banks need to merge or be acquired – could restrict the flow of credit, putting a damper on growth. “It’s a legit point,” he says. “Maybe this is the thing that’s broken as a result of the Fed tightening.”
Goldman Sachs economists see only a 35% probability of recession over the next 12 months – but the consequences would be dire, says Goldman’s chief U.S. stock strategist David Kostin and his team: “If the U.S. enters a recession, we expect the S&P 500 would decline to 3,150.”
Kiplinger sees the odds of a recession at 50-50. If a contraction materializes, it could come as soon as the third quarter, but later if the labor market deteriorates slowly. For 2023 overall, the gross domestic product should increase by 1.4% if we avoid recession and by 1.1% if we don’t.
We may already be in an earnings recession. Whether or not the overall economy falls into recession, corporate profits – the engine that drives stock prices – are likely already in one, defined as at least two straight quarters of year-over-year declines.
The first happened in the fourth quarter of 2022, when earnings for S&P 500 companies fell 3% compared with the fourth quarter of 2021. When companies are done reporting for the first quarter, analysts expect earnings to be down nearly 2% from the year-ago quarter. The nadir now looks like it will come with second-quarter earnings reported later this summer, currently expected to be down more than 4%.
The main problem is the squeeze on profit margins, which peaked in early 2022 and have been contracting for four straight quarters. With inflation peaking, companies will have a harder time passing on price increases to their customers, says Saira Malik, chief investment officer at investment firm Nuveen. “The key holding up earnings has been pricing,” she says. “With sales volumes not great and profit margins compressing, earnings will get worse from here.”
Meanwhile, geopolitical tensions could escalate in a number of places across the globe, from Ukraine to China, to roil the market. “The geopolitical situation is as risky as it’s been maybe in our lifetimes,” says Doll. “The potential hot spots are legion.”
The bull case for stocks
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The optimists have lately had some momentum on their side. The S&P 500, essentially flat for the past 12 months, not including dividends, has gained 8.6% (price only) so far this year and is up more than 16% since the market’s low last October.
The current fixation on fretting about the next recession is counterproductive, says BMO’s Belski. “The market is so obsessed with making these recession calls that we’ve completely forgotten that the stock market discounted this by going down 25% last year,” he says.
Partly because an impending recession has been so well telegraphed, it might in fact never arrive, says Yardeni, who sees a 60% chance of a soft landing. From a contrarian perspective, all the fear mongering is a good thing, he says. “The market likes to climb a wall of worry – it’s great that so many people think a recession is coming.”
His theory is that we’ll be spared an economy-wide recession because a “rolling recession” is already coursing through a number of sectors and industries, starting with consumer goods last year and perhaps moving next to commercial real estate and possibly, to a lesser extent, autos.
But even if you believe that a recession in the traditional sense is inevitable, it may not come as soon or be as bad as you fear. Michael Arone, chief investment strategist at State Street Global Advisors, doesn’t see a recession until 2024, and based on the current outlook, thinks we’re headed for a “garden variety” recession that may only last a couple of quarters, with both businesses and consumers heading into the slowdown in good shape. “That’ll help soften the blow,” he says.
A Fed pause could refresh. The Fed’s battle against inflation has resulted in a five-point increase in its benchmark rate since March 2022. Although inflation remains above the Fed’s target rate of 2%, it’s well off its 9.1% peak in June 2022.
Kiplinger expects a rate of 3.6% on the consumer price index by year-end. It remains to be seen whether the Fed has won the war against inflation without making the economy a casualty. But the upside of any downdraft in economic growth is that it will keep the Fed from raising rates further and bring rate cuts that much closer.
Historically, the Fed’s Open Market Committee has started a new rate-easing cycle an average of nine months after the last rate hike, which was probably in May. But investors won’t have to wait for the cutting to start to see some nice stock gains, if history is a guide.
Since 1989, between the last rate hike and the first rate cut, the S&P 500 has gained an average of 13%, according to Sam Stovall, chief investment strategist at CFRA Research. Data going back to 1995 show shares of companies of all sizes, investing styles and sectors, including 99% of sub-industries in the larger S&P 1500, posted price increases. Financials were the biggest gainers, up an average of 22.5%, followed by real estate, up 20.1%, and consumer staples stocks, up 18.6%. The lone loser during the nine-month period: gold, down 7.1%, on average.
As for corporate profits, fears about an earnings recession are overblown, says BMO’s Belski, who notes that four of the past seven earnings recessions did not coincide with economic recessions. Moreover, stock market performance has historically held up well. During the 16 profit recessions since 1948, the S&P 500 rose an average of 5.9% in the six months following the second consecutive year-over-year quarterly earnings decline, with gains occurring 75% of the time.
The average return improves to 7.4% if you don’t count periods when an economic recession also occurred. The bulls are also chalking up better-than-expected (or at least not as bad as feared) first-quarter earnings as a win, especially with plenty of executives also providing reassuring guidance about coming quarters. As of the end of April, with more than half of S&P 500 companies having reported earnings, more than 78% had beaten analysts’ expectations. For comparison, just 66% beat expectations in a typical quarter (since 1994), according to earnings tracker Refinitiv I/B/E/S.
For the full year, analysts expect S&P 500 companies to notch profits of $220 per share, compared with $218 in 2022. “Corporate profits continue to defy the skeptics,” says Sheraz Mian, director of research for Zacks Investment Research.
“We are not suggesting earnings are great, but we continue to elude the earnings cliff that the market bears have been telling us about for a while,” he says.
Where to invest now
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In a range-bound market, investors have plenty of opportunities for decent returns. When BMO Capital looked at the 17 periods since 1990 when the S&P 500 was roughly flat for six months or more, it found that during those periods roughly 30% of S&P 500 companies still generated double-digit gains, with an average price return of nearly 28% and broad participation across all sectors. The outperformers shared certain traits relative to the broad market, such as slightly lower price-earnings ratios and higher earnings-growth estimates for the year ahead, to name two.
Indeed, although there is plenty of disagreement on Wall Street about the overall direction stocks are headed, there is remarkable accord on the best approach now: This is a time to insist on high-quality holdings, with characteristics such as consistent earnings growth, stable profit margins and solid balance sheets with little debt and strong cash flows. Snap up such stocks at reasonable valuations, when the market delivers them.
For BMO’s Belski, a stock exhibiting good value today is Bank of America (BAC, $29). Netflix (NFLX, $330), he says, delivers growth at a reasonable price; UnitedHealth Group (UNH, $492) is his pick for yield (currently 1.3%) at a reasonable price; and for high quality, he’d choose Apple (AAPL, $170). “All are names in our portfolios,” he says.
Stocks with consistently growing dividends not only provide income but also tend to capture most of the market’s up moves and protect your portfolio on the downswings, says Nuveen’s Malik. A stock she recommends is Linde (LIN, $369), an industrial gas company with top managers, a resilient business even in tough times, and increasing opportunities in clean energy. The shares yield 1.4%.
Fund investors looking for a basket of high-quality stocks should consider the iShares MSCI USA Quality Factor ETF (QUAL, $126), an exchange-traded fund with Home Depot (HD), Microsoft (MSFT) and Nvidia (NVDA) as top holdings. Dividend seekers can explore the Vanguard Dividend Appreciation (VIG, $158), a member of the Kiplinger ETF 20, the list of our favorite ETFs, or the T. Rowe Price Dividend Growth (PRDGX), one of the Kiplinger 25, our favorite actively managed no-load mutual funds.
In terms of broad sector weightings, Sameer Samana, senior global strategist at Wells Fargo Investment Institute, favors energy, where he sees a favorable supply-demand story; health care, which could see an uptick in spending following the pandemic; and technology, which “really powers everything,” he says. “You can’t talk about big-picture transformational trends without talking about technology – computing, artificial intelligence, the internet of things and so on.”
Tech is also a sector of interest for Malik. “Tech has worked very well year-to-date,” she says, and warns that it could take a breather. But she’s still bullish on software and semiconductor stocks. Software companies are seeing strong backlogs, and because of their subscription-based, recurring revenue streams, their business is economically resilient, says Malik.
Among her recommendations is ServiceNow (NOW, $459), whose applications help companies automate IT workflows. It’s also a “top pick” for BofA Securities, whose analysts see the shares trading at $600 over the next 12 months.
The semiconductor industry is notoriously cyclical and is near a trough in demand, although the stocks have rallied substantially higher in anticipation of the inflection point. Nonetheless, Malik sees more running room ahead as fundamentals improve. She likes NXP Semiconductors (NXPI, $164), which supplies chips to the automotive industry and
others.
A high-quality tech stock that Malik would buy if a choppy market delivers a dip in the price is Microsoft ($307). “It’s been a company we like for a long time,” she says. Positives include resilient business demand for the tech giant’s software, as well as strong growth prospects for its artificial intelligence and cloud computing offerings.
Fixed-income holdings were a disaster last year but can now provide both income and ballast for your portfolio. Gargi Chaudhuri, head of iShares investment strategy at investment firm BlackRock, recommends a “barbell” approach.
Investors can pick up attractive yields at the short end of the yield curve – think one- or two-year Treasuries or high-quality corporate bonds – while the longer-end should outperform when volatile markets push stock prices lower. For an all-in-one solution, consider the iShares Core U.S. Aggregate Bond (AGG, $100), an exchange-traded fund that provides broad exposure to U.S. investment-grade securities at a low expense ratio of 0.03%. It yields 3.8%. An actively managed fund we like is the Baird Aggregate Bond (BAGSX), another Kip 25 member.
Muni bonds are among the most vulnerable to interest rate volatility, so a Fed pause is welcome news. Limited supply and healthy state and local finances are more plusses, according to Nuveen. We like the Kip 25 fund Fidelity Intermediate Municipal Income (FLTMX). More-aggressive investors might take advantage of values in preferred stocks, skewed toward financial issuers and knocked down by banking-sector turmoil. The Fidelity Preferred Securities and Income ETF (FPFD, $20) yields 5.4%.
Maintaining a diversified portfolio is standard advice, says Crossmark’s Doll. “But it’s more appropriate when you’re getting this trendless market,” he says, particularly when it comes to exposure to international stocks. The dollar has already begun to soften as U.S. rates begin to stabilize and perhaps head lower. A lower dollar bolsters the value of foreign stocks as gains there translate into more greenbacks here.
“Dollar weakness is a tailwind, there are better fundamentals, and stocks are cheaper” overseas, says State Street’s Arone. He favors developed markets, including Europe and Japan. But bargain prices aren’t attraction enough, says Arone. “You need a catalyst. For us, what’s been interesting is that earnings-and-revenue growth outside the U.S. has been faster than it’s been for S&P 500 companies.”
The Fidelity International Growth (FIGFX), a Kip 25 fund, recently had nearly 48% of assets invested in Europe, including the fund’s top holding, semiconductor equipment maker ASML Holding (ASML). Japan accounted for just over 12% of assets.
Finally, as investors look ahead to an economic recovery and the market’s breakout from this trading range, it makes sense to think about positioning for the next leg up, says Arone. “I’d be thinking of things that benefit in the early stage” of recovery, he says. That includes cyclical stocks, or those most sensitive to economic swings, including industrials; value stocks, or those trading at discounts to earnings or other fundamental measures; and small-cap stocks, which tend to lead in the early days of an expansion. A shift to those groups could happen as the rest of the year progresses, he says, and investors look ahead to 2024. But, he concedes, “getting that timing precisely right is very difficult.”
Note: This item first appeared in Kiplinger’s Personal Finance Magazine, a monthly, trustworthy source of advice and guidance. Subscribe to help you make more money and keep more of the money you make here.
