In three decades of monitoring financial market this is the first time I have seen forecasters being overwhelmingly bearish on next year’s outlook. The average forecast calls for a decline in the stock market in 2023. Historically economists have been pervasively bullish, even in years before major bear markets like 2000-2001 and 2007.  Bank of America and Morgan Stanley are predicting stock markets could fall by more than -20%, extending this years’ decline.

This is in stark contrast to the universal bullish views for 2022 that were penned a year ago. The forecasters were wrong last year, and there’s a good chance of being wrong this year as well.  

The traditional 60/40 portfolio is having its fourth worst year ever.  Bonds proved to be no hedge to equities, with cash a refuge as interest rates rose to the 4-5% level. Other than a few niche strategies like trend following, this has been an extremely difficult year for most investors, especially the ones that took excessive risks: over-allocating to technology, speculative small caps, China/HK equities, or leveraged exposure especially on bonds. All of these caused losses in excess of broader markets.

Forecasters and investors are most at risk from the recency bias: assuming that the short term continues over the longer term. Staying bearish after a significant drop in markets while waiting for further drops before investing is the single biggest source of investor under performance.

In addition to the recession fears, some bearish commentators are worried about the opposite: inflation that keeps rising leading to stagflation. Central bank obsession of a 1970s wage price spiral that creates a sustained inflationary loop are misplaced.  The IMF published a new research last month on this topic, finding that higher wages rarely spiral out of control as they did five decades ago. Out of the periods where there was a short term wage spiral, in the vast majority of cases wage growth and inflation quickly cooled off. This was the case particularly where the surge in inflation was associated with falling unemployment and a decline in real wages, which is what we have now. 

The prevailing sentiment at the beginning of a new bull market is stubborn scepticism. We have this in spades now. 

Here is what’s happening under the market’s hood that points to a less negative outlook for next year:

1. Oil prices have completely reversed their surge from the Russia / Ukraine war. Earlier this year when oil was approaching its 2007 all-time high, we were swamped with predictions of $200+ oil. The opposite happened, with oil prices almost at half the peak hit this year.
2. The US dollar has started weakening from multi-year highs as the Fed pivots. A weak dollar is stimulative for the global economy.
3. Other than Hong Kong and China, US equities are the worst performers of all major markets when measured in local currencies. Europe, Australia, LatAm, Australia and Japan have all outperformed this year, suggesting that we’re at the start of a major turn away from the US’s 15 years of outperformance.  Further US dollar weakness will make the difference in performance even clearer next year.
4. Large speculators are short $238 billion of US Treasury bonds. The potential for a short squeeze here is enormous, so next year’s rally can extend beyond equities to bonds as well.
5. Copper, which is often referred to as the metal with a PhD in economics, bottomed in July and has gained 20% since. This is not the normal action of copper prior to a recession. Copper stopped falling in both 2002 and 2009 indicating a bottom in stocks and an end to the recession.
6. Investors think that the pace of interest rate hikes will cause debt defaults as the economy is unable to absorb loan rates of 5%+. In reality the aggregate corporate sector has reduced leverage. Household equity position in residential real estate hasn’t been this high since the early 1980s (which was another market bottom). Bank loan to deposit ratios are at multi-decade lows. Leverage is not as high as many think. 
7. The price of money isn’t expensive yet. Other than speculative crypto companies built on ‘assets’ created out of thin air, not much in the financial system is at risk of breaking. Like households, banks are not over-leveraged and have ample deposits to turn into new loans.
8. 2023 will be the third year of the US Presidential Cycle. Since 1930 the US economy has never entered a recession in the first half of a pre-election year. And the average gain has been +15%.

The underlying stock market action and the current rally is more consistent with a market in a bottoming process than one about to drop to new lows. However the tech sector may not be due for a big bounce. When the tech sector underperformed the broader market by a big margin in year one, it has always followed by another year of underperformance. 

Market commentators have repeatedly said that a recession is inevitable in 2023 with the majority expecting it in the first half, following the mantra that a central bank soft landing is next to impossible. While the risks of a recession are increasing as the economy slows and unemployment creeps up, indicators are instead suggesting a strong first half of 2023 for markets.  

The big surprise for 2023 may well be that a recession doesn’t in the first half, and markets rally into that realisation. This outcome would be a big surprise to markets if it comes true, but not to investors who are monitoring the underlying signals.