Get ready for a market launch in 2023

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Our domestic problems are important, of course, but their impact on investor sentiment is likely to be disproportionate to their impact on global markets. And for anyone with a well diversified portfolio, the international picture matters most.

Therefore, investors’ first resolution of the new year should be to look up at what is sure to be a bleak mix of headlines at home, particularly in the first half of this year. It will be a mixed bag outside the UK too, with China growing no faster than the global average for the first time in decades. But the US is likely to avoid the worst of the downturn. Even if America suffers a recession this year, it must be short and shallow.

The second important thing for investors to remember this year is that markets expect change in the real economy. It set back in 2022 before the economic challenges we are beginning to feel now and will turn the other way before the green shoots of recovery really emerge.

This is what will happen directly. However, the exact timing of a market pivot is difficult to predict. The starting point in ascertaining when that will be is to look at what history tells us.

The longest running data on stock market cycles goes back 150 years in the United States and shows nearly 30 bear markets and serious corrections over that time. So, on average, investors suffer a major setback every five years or so.

The third key point to keep in mind as we head into 2023 is that the current downturn is really par for the course and market volatility is the price we have to pay for the extraordinary wealth generation that the stock market has given us over the years.

On average, bear markets since the late Victorian period have temporarily recovered 33% of their value, which is slightly more than that when the decline coincided with a recession, and slightly less when it did not. The average duration of those bear markets is 19 months, with recessions lasting longer (22 months) than non-recessionary bear markets (4 months).

When markets trend in the opposite direction, they usually, but not always, reflect lower profits. The average decline in a company’s earnings during a bear market is 8% but there is a wide range with an average decline of 18% during recessions and gains of 7% otherwise.

Consistently, the market’s decline also reflects the weakness of the lower valuation as investors become more risk averse. In fact, there is not much difference whether the economy is in recession or not. Valuations tend to drop by about a third in a bear market, either in anticipation of lower earnings or to correct excessive optimism.

So how does the current situation measure up against this long-term picture? The duration of the current bear market is short if, as is likely, we suffer a recession this year. This certainly argues against the October low being the current cycle low.

Likewise, the resilience so far in corporate earnings seems implausible in a recessionary environment. Expectations, which are already declining, probably need more going forward. Looking back at the two big bear markets of the past 20 years, earnings fell by a quarter in the dot.com crash of 2000 and by half during the financial crisis in 2008.

The good news is that the deteriorating sentiment has already been reflected in lower ratings. This part of the reset has already happened. The 32% decline in the market’s price-to-earnings multiple is consistent with the long-run average.

So, putting it all together, I think patience will be a necessary virtue this year. The bear market so far feels very short, so I expect a retest of the October low, perhaps more than once this year. The main driver for that will be lower earnings rather than further declines in valuation.

One thing that didn’t surprise me this week was the disconnect between the rotten hand on the economy and market vitality. It is not uncommon for the market to go down in consecutive years, but it is quite unusual. And the final positive from the past 150 market data is that the average gain from one market decline to the next peak is about 90% over three and a half years. So, really, in spite of everything, Happy New Year.

Tom Stephenson is the Chief Investment Officer at Fidelity International. Opinions are his own.

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