Stock market ‘has been cracked this year’, strategist says, and there are 2 things to watch for next

Stock market ‘has been cracked this year’, strategist says, and there are 2 things to watch for next

As the economic slowdown weighs on profits, companies are reviving the “trust the process” slogan popularized by the Philadelphia 76ers in the post-Iverson era.

Markets, for their part, are already pricing in downside risks, with the S&P 500 and Nasdaq falling into bear markets this year — down 20% and 32% year-to-date, respectively — while the Dow has fallen more from 9%.

“The market is first, so the market is cracked this year,” Liz Young, chief investment strategist at SoFi, told Yahoo finance Live (video above). “The market showed us its pessimism. It showed us its reaction to the microenvironment.”

The market decline is largely dependent on the Federal Reserve aggressively raising interest rates and thereby slowing the economy due to decades of high inflation: Fed Chairman Powell recently acknowledged the risk of driving the economy into recession , but said a halt to rate hikes at this juncture would be “too premature.”

“Until we see consecutive months of inflation coming down in a meaningful way, I expect them to continue hiking and continue to taper,” Yang said. “I think they’re comfortable with maybe tightening a little too much and then trying to ask forgiveness from the markets later on with the tools they have to stimulate.”

Meanwhile, Young suggested investors watch for two other signs that the business cycle may be turning.

Shrinking profits

A sweeping contraction in earnings could be the next shoe to drop, according to Young. The market has not seen a wave of downward revisions to its earnings estimates since the start of the coronavirus pandemic.

“I think the part of it that hasn’t been priced in completely is that shrinking of earnings,” he said.

In a Nov. 4 note, Goldman Sachs cut its earnings target for the S&P 500 for the rest of the year as well as through 2024. The bank now sees 2022 earnings coming in at $224, from $226. Additionally, the company’s strategists revised their 2023 earnings expectations to $224 (previously $234) and to $237 in 2024 (from $243).

This image was created by Yahoo Finance using the Dall-E AI image generator.  (Open AI)

This image was created by Yahoo Finance using the Dall-E AI image generator. (Open AI)

Young added that if the U.S. were to fall into recession, she would expect her profits to shrink by 10% to 15%. At the same time, he noted, the decline in profits will vary across sectors due to inflation.

“Goods inflation is likely to come down much faster and to a more manageable level than services inflation, which tends to be stickier and includes things like rents, and businesses also face solid wage inflation,” Young said. “So sectors that are commodity-intensive and can benefit from commodity inflation and falling commodity prices are likely to do better and may not take as much of a hit to earnings.”

Financial upheaval

The U.S. unemployment rate is currently near 50-year lows, and the Fed generally sees an overheated labor market with demand for workers outstripping the supply of labor market participants.

But that could change as the Fed continues to raise interest rates.

“The last piece of the puzzle is that the economy is faltering, and you’re actually seeing data in the economy, the labor market, inflation coming down, that things are actually contracting,” Young said.

The bright spot for investors would be that by the time economic data stumbles, the stock market may already be in recovery mode, as stocks tend to fall well before a recession is over.

According to historical data from JPMorgan, on average, the S&P 500 bottoms three months after a recession begins and reaches a cyclical low 10 months before a recession ends.

“A recession is very likely at this point — it doesn’t mean it has to be bad, it doesn’t mean it has to be Armageddon,” Young said. “Recessions reset the business cycle and that can be a positive in this environment.”

Bradley Smith is a presenter at Yahoo Finance. Follow him on Twitter @thebradsmith.

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