To this point, declines in the stock market have been driven by higher interest rates. All else equal, higher interest rates bring down valuations for assets like stocks. Persistent inflation forced the Federal Reserve to ‘shock’ markets by raising rates much higher than was previously expected. November’s slower-than-expected CPI report was the clearest signal to date that inflation is slowing. The market’s hope for the ‘light at the end of tunnel’ for persistent inflation and rising interest rates has contributed to a strong stock market rally in the past 6 weeks.
However, our process does not suggest that this rally is sustainable. Interest rates work with a lag, and we have not seen the full effects on the economy. Our forward-looking indicators suggest an economic slowdown in 2023 which could pull down corporate earnings more than is currently reflected in stock prices. Furthermore, our objective technical indicators suggest that the recent rally is more likely to be a countertrend move in an ongoing downtrend rather than the birth of a new sustained uptrend. As such, we will look to take defensive measures in client portfolios where appropriate. We are already positioned fairly conservatively with cash in most portfolios, and we are less exposed to higher risk sectors and stocks than the overall market. We reiterate that while challenges lie ahead, it is not the time to get overly negative, but we are waiting until our process gives more of an ‘all clear’ before getting back to fully invested in stock allocations.
The increase in interest rates this year has made bonds more attractive than they have been in, at least, a decade. It is possible that market-based interest rates such as the 10-year US Treasury have already peaked. Even if rates continue higher in the coming months, the risk-reward for bonds today is extremely attractive. They currently offer appealing return opportunities for clients with excess cash without as much risk as the stock market.