Where Market Indicators Stand as the Bear Market Turns One

The bear market marked its one-year anniversary on Tuesday afternoon.

S&P Dow Jones Indices defines a bear market as a 20% drop in the S&P 500 index from the last closing high. The current bear market will continue to exist until the large-cap index posts a close higher than 4,292.44. This level is 20% above the current bear market’s closing low of 3,577.03, which was set on October 12, 2022.

I’d love to tell you when the next bull market will start. Unfortunately, my—and everyone else’s—crystal ball remains cracked. (When we asked the the office Magic 8 Ball if the market will be up this year, its answer was “Better not tell you now”.) What I can do is give you some insights about where the markets are as of the start of 2023.

Before I do, there is one key indicator individual investors don’t have to focus on: quarterly and annual performance. Professional fund and money managers are measured based on how they perform on a shorter-term basis relative to benchmarks and their peers. Our success as individual investors is measured by our ability to meet our goals. It’s a different mindset that allows us to tailor our portfolios to our needs as opposed to someone else’s performance demands.

With that said, here are some current financial market indicators.

Valuations Are Mixed—The S&P 500 was trading at 17.3 times trailing earnings and 17.3 times projected earnings for the next four quarters as of December 30, according to Refinitiv. This is neither cheap nor expensive. The S&P MidCap 400 index and the S&P SmallCap 600 index are much more attractive valuation-wise. Their trailing price-earnings (P/E) ratios were both 12.5 at the end of last week. Their forward price-earnings ratios were 13.4 and 13.1, respectively.

Price-to-Book Ratios Show Small-Cap Stocks Remaining Relatively Cheap on a Historical Basis—For the past few years, we at AAII have pointed out how small-cap stocks have traded at larger-than-average discounts relative to large-cap stocks. Small-cap stocks continue to be on sale. The median price-to-book ratio for the S&P SmallCap 600 was 1.67 at the end of 2022. This is approximately half of the S&P 500’s median price-to-book-value (P/B) ratio of 3.25. The historical average discount for small-cap stocks since 1988 has been 67% of large-cap stocks’ price-to-book ratio.

The discount persists despite the outperformance of small-cap stocks. In 2022, the S&P 500 fell by 18.1% whereas the S&P SmallCap 600 declined by 16.1%.

Analysts Have Become Less Optimistic About 2023 Earnings—Analysts are currently forecasting earnings for the S&P 500 to grow 4.4% this year. This forecast is down from October’s forecast of 7.8% growth and July’s consensus call for 9.3% growth. There are two big things to keep in mind when looking at these numbers: Analysts routinely underestimate corporate earnings, and analysts’ forecasts become less accurate over longer time periods.

Bond Yields Are Really Inverted—The 4.76% yield on the six-month Treasury bill as of the end of 2022 was nearly a full percentage point higher than the yield on the 10-year note. It was also about 80 basis points (bps) higher than the yields on the five- and seven-year notes. This inversion can clearly be seen in the first chart.

One oft-cited recession indicator is when the two-year note’s yield is above the 10-year note’s yield. The two-year note’s yield has been higher, on average, for the past two calendar quarters, which is a recessionary signal. Plus, the Federal Reserve has a lousy record of achieving soft landings following rate-tightening cycles.

It’s worth noting that there have been predictions of a recession occurring for many months now. More than two-thirds of economists at the investment banks and trading firms that do business directly with the Fed (aka, primary dealers) expect the U.S. to fall into a recession this year, according to The Wall Street Journal. To the extent the financial markets are efficient at pricing in all known information, at least some of this risk should already be priced in.

(Notably, Campbell Harvey, who identified the link between inverted yield curves and recessions, thinks the yield curve could be giving a false signal. “Ideally, we avoid the hard-landing recession and realize slow growth or minor negative growth. If a recession arrives, it will be mild,” said Harvey on LinkedIn yesterday.)

Diversification Disappointed in 2022—You may have seen me make this point in the January 2023 AAII Journal. There weren’t many areas of the market to hide. Stocks, bonds, real estate investment trusts (REITs) and cryptocurrencies fell last year. Major commodities like oil and gold were roughly flat on a calendar-year basis. What was up were yields on certificates of deposit (CDs) and other short-term, safe assets. Diversification didn’t break, but it experienced a bad year.

Inflation May Have Peaked—I say this with fingers crossed, but inflation is showing signs of having reached a peak for the current cycle. The consumer price index (CPI) rose 7.1% in November, down from 9.1% in June. The bond market’s expectations for inflation over the next five and 10 years have also declined from their 2022 highs. While inflation remains nowhere near the Fed’s stated target, it has been heading in the right direction. This, in turn, suggests we could also be nearing the end of the Fed’s current tightening cycle. (Interest rates could stay at comparatively elevated levels for a while after the Fed pauses.)

Optimism About the Stock Market Is Low—Optimism in our weekly AAII Sentiment Survey was unusually low 38 times last year. The AAII bull-bear spread (bullish sentiment minus bearish sentiment) was also unusually low 38 times. Historically, unusually low levels for both have been followed by higher-than-average (and median) returns in the S&P 500.

Bank of America’s Bull & Bear Indicator was 2.0 in early December, equivalent to the high level of extreme bearishness. The Investors Intelligence survey found that 37.5% of newsletter writers were bullish and 33.3% were bearish as of December 20, 2022. Near the end of 2021, bulls were exceeding 50%.

What does all this mean for the average investor? There are reasons for pessimism (the inverted yield curve and falling earnings estimates) and reasons for optimism (inflation may have peaked, valuations on mid-cap and small-cap stocks are cheap and investor sentiment is poor). If we had absolute certainty about the future, returns would be lower.

It may not sway your opinion either way, but the calendar does offer a few reasons for optimism. It is rare to see either large-company or small-company stocks experience negative returns on back-to-back calendar years. The third year of presidential terms tends to be positive for stocks. (The market has also done well when a Democrat is president and control of U.S. Congress is split, though the sample size is small with just four such years since 1945.) Finally, the S&P rose during the Santa Claus rally period. Historically, when stocks rise during the final five sessions of a year and the first of the next year, it’s generally been a good sign.