Timmer: Expecting more market chop in 2023

We may see a sideways, volatile market in the coming year.


  • Markets may continue to face choppiness in 2023 as investors navigate potentially declining earnings and rates that stay high for longer than expected
  • However, Jurrien Timmer believes it's most likely that the market won't experience a significant downtrend (or uptrend) for the year, and may instead follow a sideways path
  • With interest rates higher than they were a year ago, bonds may provide better support to investors' portfolios in 2023 than they did in the past year

Even in relatively calm years, the market still experiences some ups and downs. For 2023, hopefully the market's inevitable waves will prove to be manageable. But I believe we need to brace for the possibility that they will be more treacherous.

My sense is that 2023 could be a sideways choppy market. I believe that choppiness could include one or more declines that take us back down to the low the market struck in mid-October (which was the low, so far, for this bear market) – but not necessarily much lower than that. I don’t, however, believe we are close to the start of a new bull market yet.

The way I see it, there are at least a few waves, or risks, on the horizon that could rock investors’ boats in the coming year.

The risks of falling earnings and recession

There is now broad consensus that earnings have peaked. Earnings estimates are coming down, and the percent of companies seeing earnings downgrades keeps rising.

Now, there have been many times when estimates were coming down as much as they are now, but it proved only to be a temporary slowdown within a broader earnings growth cycle. But there is at least one reason to believe that this earnings slowdown may amount to something more, and that is the yield curve.

In normal times of stable economic growth, the yield curve is generally upward sloping—with yields higher for longer-term bonds and lower for shorter-term bonds. Historically, this relationship has typically flipped in the lead-up to a recession, which is why an “inverted” yield curve (with short-term rates higher than long-term rates) is often seen as an omen of a coming recession.

The yield curve hasn’t been as inverted as it is today since the early 1980s. While it can be tempting to try to explain away the signal, it’s also notable that it’s now inverted pretty much no matter how you slice or define the yield curve—as the chart below shows.

No matter how you slice it, the yield curse is now inverted.
Title: No matter how you slice it, the yield curve is now inverted. Chart shows different measures of the steepness of various yield curves, expressed by subtracting a short-term yield from a long-term yield.  Chart shows that 4 major yield-curve measures have all turned negative, signaling inversion, in 2022.
A basis point is 0.01 percentage point. Risk-neutral yield refers to the nominal yield minus the term premium, which is considered to be the portion of interest rates that compensates investors for the additional risk of lending for longer periods of time. Source: FMRCo., Bloomberg.

A challenge is that historically, an inverted yield curve has “predicted” a downturn anywhere from a few months to a few years before a recession actually starts. But it’s a signal that should not be ignored. My guess is that a recession could be coming in the second half of 2023. If that proves to be the case, earnings could continue to be at risk into 2024.

What could this mean for the market’s trajectory? Stock prices have historically generally bottomed out well ahead of earnings – typically with a recovery that has started about 2 quarters before earnings start to recover. So, if an earnings contraction persists throughout 2023, it doesn’t necessarily mean that the bear market will also stretch through the end of 2023. But it could mean that the recent October low doesn’t end up holding as the low point for this bear market.

The risk that the Fed stays the course

Currently the market is expecting the Fed to raise the federal funds rate to about 5%, and then almost immediately to start cutting rates – bringing them to about 3% (a rate that would not be considered restrictive) in 2024. The market is pricing in this rapid rate-cutting even though Fed Chair Jerome Powell made clear in December’s Federal Open Market Committee (FOMC) meeting that the Fed may stay in the restrictive zone for some time.

The Fed even released a new “dot plot” (a chart that shows, with anonymous dots, each individual committee member’s personal assessment of appropriate monetary policy for coming years and the long run). The new dots showed that FOMC members generally felt the federal funds rate would need to remain above 4.5% in 2023 and above 4% in 2024. But the market is still betting on a fast reversion to lower rates.

There's a disconnect between market expectations and Fed expectations.
Title: There’s a disconnect between market expectations and Fed expectations. Chart shows dots from the Fed's most recent dot plot, overlaid against interest rate expectations implied in the Secured Overnight Financing Rate curve, showing a disconnect between how high rates are expected to be in 2023 and 2024.
The Secured Overnight Financing Rate (SOFR) curve shows implied estimates for future interest rates that are embedded into current yield curves. Each dot represents an FOMC participant’s assessment of appropriate monetary policy for a future period, based on the dot plot released December 14, 2022. Source: FMRCo., Bloomberg Finance LLP.

There’s an old saying in markets: “Don’t fight the Fed.” The risk here is that the Fed is correct and markets are wrong in projecting the path of policy in 2023, and that financial conditions will remain tighter for longer.

Why does this matter for stocks? Interest rates directly impact stock valuations via the discounted-cash-flow model (with higher rates implying lower fair values for stocks). The market’s rally off the mid-October low seems to have been premised on the expectation that the Fed would pivot, cutting rates before earnings deteriorate much further. In essence, the market rallied because investors were looking past the expected peak of this rate-hike cycle. But if rates stay higher for longer than investors have been expecting, the recent rally may not have been justified.

According to my analysis, a fair-value price-earnings (P/E) ratio for the S&P 500® is around 15, based on the discounted-cash-flow model and the Fed cycle. Applying that fair-value P/E to trailing S&P earnings of $217 per share would imply a fair-value level of about 3,255 for the index – about 600 points, or 16%, below the market’s close last week.

The virtues of patience and diversification

For 2023, patience is a life skill that will likely come in handy. Some good news is that the market’s 2022 decline has taken the air out of the asset-price inflation that was fuelled by the market’s pandemic-era surge and is now back into its long-term channel.

2023 could also be a year when diversification serves investors well. While large-cap U.S. growth was a winning segment for much of the past decade, a rotation seems to be underway. For the coming year, I think value could lead growth, small caps could lead large caps, and non-U.S. stocks could best U.S. stocks (at least on a relative basis). Small caps are currently pretty cheap, with an average P/E ratio of about 12.5.* And non-U.S. stocks – particularly emerging market stocks – could see continued relative earnings improvement if the U.S. dollar continues its recent softening.

And even if some of those aforementioned waves do rock the boats of stock investors in 2023, I think bonds could continue to provide some ballast in a diversified portfolio (as they have since October).

Bonds have started providing more support for portfolios again.
Title: Bonds have started providing more support for portfolios again. Chart shows year-to-date total return for S&P 500 and for Bloomberg US Aggregate bond index. After declining for much of the year bonds have started providing positive returns since October.
Past performance is no guarantee of future results. Year-to-date total return. Source: FactSet.

With the increases in yields and declines in inflation expectations we’ve seen over 2022, real yields are now clearly positive (meaning, yields after subtracting for inflation). In my opinion, this means that bonds are a viable asset class for 2023.

Risks to the downside – and upside

All in all, I expect 2023 to be a choppy year for stocks, with plenty of waves, but ultimately, I think it will be a year without a significant up or downtrend. And I think the bond side of investors’ portfolios may work even if the stock side doesn’t.

What could cause my cautious outlook to be wrong? The most likely risk to the downside would be that there's a major earnings storm (though again, because stock prices historically have bottomed before earnings do, this wouldn’t necessarily mean that stocks follow earnings all the way down).

My hunch is that if I am wrong with my choppy-sideways outlook, it's that the market has already bottomed, and we are in the early innings of a new bull market. Such an outcome would be anchored by an improving inflation narrative, and therefore a friendlier Fed.

For now, I continue to anticipate something in the middle between those extremes.


*Source: Bloomberg, FMRCo. Based on constituents of the Russell 2000 index of small-cap companies, including profitable companies only.

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