Stock Market Outlook 2023: Reasons for Optimism

“Be wary of the human tendency to fight the last war,” the famed investor Barton Biggs once warned. Most investors today are fighting the last war—the bear market of 2022—and believe that corporate earnings will collapse in early 2023 and bring the stock market down with them. Pessimism is rampant, but I am more optimistic.

First, historical analysis points to a quirk of presidential cycles: During the 16 quarters of every presidential cycle since 1950, the S&P 500’s best quarter of all 16 is the first quarter of the third year^1—the quarter we’re in currently. In the 12 months following a midterm election year such as 2022, the S&P 500 has averaged a 33% gain, and the index has netted an increase every time. The current presidential cycle has been no exception to the pattern thus far, pointing to positive potential for this quarter.

S&P 500 returns have been materially weaker during midterm election years.

In addition, economic indicators such as GDP and employment are showing that the U.S. economy is proving too resilient to warrant a first-quarter collapse in earnings. The outperformance of financials, industrials and materials in recent months also suggests otherwise, as the prices of such cyclical stocks usually drop before the economy falters. With continuing improvements on inflation mixed in, a strong first quarter is possible.

Instead, earnings may drip down slowly throughout 2023, frustrating market bears. Interest rates on long-term bonds have fallen lower than those of short-term bonds, creating an inverted yield curve that usually portends an upcoming economic slowdown. Could a weaker second half of the year follow a surprisingly strong first half? It is possible. If there is a risk to the stock market, it could be in the second half of the year.

Overall, there are bright spots as well as sectors that may be overvalued.

In the fourth quarter of 2022, value stocks started to outperform the market and sectors such as energy, industrials, materials and financials led. We could be in the early stages of value outperforming, though many investors don’t seem to recognize it because the memory of “easy” money in uber-growth stocks is simply too tantalizing.

When the dotcom bubble burst in 2000, technology fell 60% in the first year, and investors tried to buy the dip. But in the second year, tech was down another 22% as measured by the Technology Select Sector Index. Meanwhile industrials, financials and materials were all positive, but investors missed it because they tried to buy what worked in the last bull market. This year, there is striking consistency with that behavior. Investors have chased back into the tech darlings, but seem less interested in the value stocks.

During the dotcom stock bubble of 2000, the market cap of the five largest tech stocks in the S&P 500 comprised just over 20% of the index at their peak, bottoming five years later to only 5% of the benchmark. In 2022, the five largest technology stocks in the S&P 500 at their peak comprised 25% of the index. Will they similarly head to 5%?

On one hand, the 30 times average valuations of the five largest tech stocks today will likely never reach the triple-digit valuations of 2000. But the U.S. government’s desire to keep mega-cap tech stocks from dominating their industries has historically stunted their growth—and we are now seeing that with increased regulatory scrutiny. With slowing growth rates combined with premium valuations, it may be wise to reduce exposure to mega-cap tech stocks.

The S&P 500 has a concentration problem, as it did in the year 2000.

Combined weights of top six stocks within S&P 500

Combined weights of top six stocks within S&P 500

We believe emerging markets are in the early stages of outperforming. After the U.S. dollar’s peak in September 2022, non-U.S. markets finally began outperforming the U.S., and Asia ex-Japan has led since the end of October compared to Europe and Japan, which have also outperformed the U.S.

Therefore, Asia ex-Japan presents an intriguing equity area for 2023—particularly China. The People’s Bank of China is the one major central bank not tightening rates, and the Communist party has pivoted from its previous zero-COVID policy, which should result in increased economic activity. Global growth is accelerating and now U.S. bond market yields are less attractive relative to rest of world. Many emerging markets investors have moved money back to China, though foreign retail investors have largely resisted, so far.

Because the ravages of the previous bear market hurt so many investors, and initial attempts to buy the dip failed, recency bias is yet again keeping investors skeptical. People haven’t invested yet, because they are still looking in the rear-view mirror remembering the pains of the previous bear market. We expect most investors may turn more optimistic, but only after prices rise further, and that could pan out as their missed opportunity.