U.S. stocks have nearly recovered all the losses suffered during 2022’s bear market.
The market’s recovery so far is due in large part to a rally in technology-oriented stocks.
Despite the market rebound, investors should prepare for more uneven performance through the end of the year.
Since reaching its low in October 2022, the S&P 500 has recovered nearly all the ground lost during last year’s bear market (defined as a drop of at least 20% from peak value). At the end of July 2023, the S&P 500 was down just 4.4% from its January 2022 peak, compared to its low point in October 2022 when the S&P 500 was down 25%.
After trading in a narrow range for the first few months of 2023, the S&P 500 finally broke through in late May and mustered a significant rally through July. Yet questions remain concerning the market’s current trajectory. “We’re out of the bear market environment, it appears,” says Rob Haworth, senior investment strategy director at U.S. Bank Wealth Management. “But it isn’t clear yet that a new bull market has emerged.”
The Federal Reserve continues to maintain elevated interest rates to combat inflation. While the inflation rate declined considerably since peaking in mid-2022, it remains higher than the Fed’s target 2%. The U.S. economy continues a steady but slow pace of growth. Favorable economic developments, like a strong job market and resilient consumer spending, have helped keep the economy on a modestly positive track. Corporate earnings slowed in the first and second quarters, but not as dramatically as anticipated by many market observers.
How will these and other factors determine the direction of the stock market in the second half of 2023?
Clawing back from a challenging year
In 2022, the U.S. stock market suffered its second bear market in three years. At the same time, the bond market struggled in the face of dramatic changes in the interest rate environment. “The market’s downturn in 2022 can be attributed to a rising level of uncertainty for investors,” says Haworth. Three key events contributed to this uncertainty, including persistently high inflation, a significant change of monetary policy by the Federal Reserve and the economic fallout from Russia’s invasion of Ukraine.
On the road to recovery, the S&P 500 topped out in early February 2023 at 4,179, then traded below that level until finally surpassing it in late May. At the end of July, the S&P 500 Index was up 20.7% for the year. More impressively, the technology-heavy NASDAQ Composite Index gained 37% through the end of July. “However, there’s been a wide dispersion in performance,” notes Haworth. “Technology stocks performed very well while other parts of the S&P 500 have been lagging. Large cap stocks have significantly outperformed small cap stocks.”
Tracking previous bear markets
Four bear markets have occurred in the U.S. stock market in the 21st century. You’ll note that the level of decline in the most recent bear market cycle is not as dramatic as the previous three.
Source: S&P 500 daily close. 2022 bear market represents the Index’s peak-to-trough through December 2022.
The bear market of 2000 to 2002 was attributed primarily to the bursting of a stock market “bubble” in prices for technology stocks, particularly some early-stage dot-com companies. The 2007 to 2009 bear market was driven in large part by a collapse in home prices. In February and March 2020, the shutdowns to combat the COVID-19 pandemic resulted in a short-lived downturn and economic recession.
“In 2022, we saw a massive change in sentiment,” says Haworth. The persistent nature of elevated inflation appeared to cause investor anxiety. Higher inflation was a result of demand for goods and services outpacing supply. Haworth notes that despite policy moves by the Federal Reserve (Fed) to slow economic growth, inflation, though trending in the right direction, remains stubbornly high.
Stock markets continue to exhibit volatility. However, the S&P 500 showed more consistency lately, generating gains in five consecutive months and six of the first seven months of 2023.
Source: S&P Dow Jones Indices. Figures shown represent monthly total returns for the Standard & Poor’s 500 Index, an unmanaged index of stocks. It is not possible to invest directly in the index. Past performance is no guarantee of future results. Monthly total return as of July 31, 2023.
Key factors to watch
What factors could lead to a more definitive, sustained bull market recovery? Haworth says three key considerations deserve the most attention:
- Inflation trends and future Fed policy moves. After peaking at 9.1% for the 12-month period ending in June 2022, inflation (as measured by the Consumer Price Index) dropped to 3.0% for the 12-month period ending in June 2023.1 Haworth notes that the Fed’s primary focus is how wage gains might affect inflation. “Average hourly earnings growth, which rose significantly in 2022, have slowed but stabilized at more than 4%, higher than the Fed’s goal.” He notes that the unemployment rate remains historically low, with significant job openings still reported. If that changes and the labor market weakens, the Fed may feel its inflation goals are within reach. The Fed hiked the short-term federal funds rate, from near 0% in early 2022 to 5.25% by July 2023, a significant attempt to slow inflation. The Fed’s rate hikes resulted in higher yields across the bond spectrum and borrowers’ loan costs increased. This has, to an extent, slowed demand, which the Fed anticipates will help quell inflation. “If we look at the Fed’s definition of progress on inflation, they want to get it closer to their target of 2% per year,” says Eric Freedman, chief investment officer at U.S. Bank Wealth Management. “The question is how much further inflation must level out before the Fed is again willing to change course on interest rates.” the Fed left open the door for more interest rate hikes this year and indicated that they won’t be reversing course by cutting rates anytime soon.2
- Consumer spending. “Consumer’s willingness to maintain reasonable spending growth has been the linchpin for the economy,” says Haworth. Although savings accumulated during the COVID-19 pandemic have declined, consumers have shown resilience, likely due in part to the strength of the labor market and more significant wage growth. Consumers devoted more discretionary spending to travel, restaurants and services than toward goods over the past year. “Data on housing starts, housing demand and auto sales show us consumer demand remains solid,” says Haworth, meaning to this point, there is no sign of a major consumer pullback. “We’ll keep an eye on credit card delinquencies, which are up, and could be a sign of consumers being more restrained going forward.”
- Corporate earnings. “First and second quarter, 2023 earnings (company profits), while contracting from previous quarters, did not slow as much as many expected,” says Haworth. The level of consumer spending may dictate the direction of earnings for the rest of 2023. “If investors’ confidence in earnings improves, that could give the market a boost,” says Haworth. “A concern is that earnings have been particularly strong for a select group of stocks, and we need to see improvement among a broader group of companies to upgrade prospects for the stock market as a whole.”
Haworth believes the outcome of these three variables will likely play the biggest role in determining the stock market’s performance in 2023.
Other considerations for investors
While they may not represent decisive factors, policy issues and geopolitical matters could affect investor sentiment and be reflected in positive or negative movements in the markets. For example, after a long political standoff between Republicans and Democrats over terms of a debt ceiling extension, an agreement was finalized and signed into law in early June. Stock markets generally responded positively. However, a new issue that may gain more attention in the coming months is a possible standoff over the annual budget for the federal government. The risk of a government shutdown in the fall of 2023 is considered by some political pundits to be a distinct possibility.
The Russia-Ukraine war is another issue that raises investor concerns. Haworth notes that with the war now well into its second year, markets may have adjusted to the resulting economic stress points. “There is less of an immediate economic challenge,” says Haworth. “Over the next few months, we’ll be watching whether grain harvests from Russia and Ukraine can move smoothly through shipping channels. We’ll also keep an eye on western Europe’s ability to stockpile energy supplies to meet their needs next winter.” Haworth says the market could react to any major development that shifts the conflict’s current course.
Growing U.S.-China tensions are another risk, but Haworth says that’s been more in the background recently for the markets. Perhaps more critical is that China’s economic recovery has been surprising slow as it continues to emerge from the strict COVID-19 policies China’s government lifted in 2022. “The economic impact China has on the rest of the world may be a more significant consideration for investors,” says Haworth.
Keep a proper perspective
Market volatility and periods of market uncertainty are not unusual. “Keep in mind that we’re likely to periodically experience market ups and downs, and over time, as we’ve seen recently, markets have shown an ability to recover,” says Haworth. Market volatility can be expected to persist given the range of issues that contribute to the market’s near-term uncertainty. “While we may see a more favorable environment develop down the road, the market still faces many challenges given the current fundamental and policy underpinnings,” says Haworth.
Freedman says it’s important to maintain an appropriate perspective about the markets. He encourages investors to view markets with a long-term lens. “Timing the markets and trying to be precise on when to be in and when to be out is challenging,” says Freedman. “Markets will do things at the exact opposite time you expect them to.”
Freedman emphasizes that having a plan in place that helps inform your investment decision-making is critical, particularly in times like these. “That’s the foundation of investing,” he says.
Despite the stock market’s strong 2023 start, Haworth says investors shouldn’t expect the sudden appearance of an “all-clear” sign that market risks have subsided. “We can expect choppiness in the markets, and not necessarily a straight upward path for stocks over the remainder of 2023,” warns Haworth. “While we’ve witnessed wider participation beyond a narrow band of large, technology-oriented stocks, we’d like to see participation broaden further.” Price gains across a broader spectrum of stocks would be considered a more encouraging signal of a market positioned to resume a consistent, upward trend.
Yet Haworth says it’s important for investors to consider positioning their portfolios for the long run. “We’re encouraging investors who may have taken a more cautious approach before to adjust back to their long-term strategic target portfolio today.” Haworth says for those who still have a sense of caution about the equity market, “Consider putting a portion of your portfolio to work in equities in a systematic way, such as dollar-cost averaging available cash over a series of months.”
Check in with a wealth planning professional to make sure you’re comfortable with your current investments and that your portfolio is structured in a manner consistent with your long-term financial goals.
The S&P 500 Index consists of 500 widely traded stocks that are considered to represent the performance of the U.S. stock market in general. Diversification and asset allocation do not guarantee returns or protect against losses.