The year of 2022 has been exceedingly difficult for the investing universe. The ending of an easy money policy era has been painful, to say the least. All markets have been terrorized by the Fed for the most part of 2022.
According to Bespoke Investment, 2022 is the first year in the history of the AAII survey (since 1987) that bullish sentiment was below its historical average every week of the year.
source: Bespoke Investment
With this kind of extreme negative sentiment for the entire 2022, the S&P 500 finished 2022 down 19.4%. That is remarkable! The S&P 500 should have lost 50% if the market acted on the bearish sentiment. This just shows that the fundamentals are strong. The market participants talked themselves into a bottomless pit. According to a Wall Street survey, 65% of the survey participants are expecting a recession in 2023. This is very strange. Historically very few can predict a recession. Recessions always sneak up on the economy. The main reason for the recession prediction is due to the Fed’s aggressive rate hiking in the name of fighting inflation.
Why does the Fed have so much power? A few words from the Fed officials can move the markets instantaneously. The Fed has the authority to create elastic money! The Fed can create money when there is a shortage due to economic contractions (hoarding), and it can then reduce its balance sheet reducing the money supply. The Fed sets the price of money, i.e. interest rates. Every single asset class is valued on the cost of money. Some asset classes are more interest rate sensitive than the others. Housing is the most interest rates sensitive sector. The Fed single-handedly created a housing bear market in 2022 by raising mortgage rates very aggressively in a very short amount of time. The housing market was under built before the bear housing market. The artificial high mortgage rates stopped new buyers from entering the market, but didn’t cause a wave of foreclosure like what happened in the 2008 financial crisis. This is another example of how this time is different than the previous market selloffs. This time is entirely due to the Fed’s pivot from “transitory” inflation attitude to an aggressive inflation fighter.
Back in September 2021 Fed meeting, the Fed was infamously talking down the rampant inflation as “transitory” and didn’t even think of raising rates in 2022. What did the Fed do in 2022? The Fed raised Fed funds rates by 18 times in 2022. This really shows that the Fed doesn’t have any predictive power. They are just simply reactive to situations such as inflation and employment data. Right now the Fed is projecting the Fed funds rates to be at 5.1% in 2023 and stay there for some time. We are highly skeptical of the Fed’s ability to keep the Fed funds rates projections. But we don’t want to trade before the Fed decision either. The simplest thing is to wait for the Fed to pause. Once the Fed pauses, the market will get a relief rally, a true relief from the Fed’s terror. A Fed pause will bring about the stability of the interest rates.
If the mid October 2022 low is not violated in 1Q 2023 and the Fed pauses either in February or March 2023 meeting, we could expect the market to rally from 1Q 2023 to 3Q 2023 with the DOW leading the NASDAQ. Why will the DOW outperform the NASDAQ in 2023? 2023 will not be the new beginning of a bull cycle. The market will be highly defensive in 2023 because the interest rates are high. Investors tend to hide in dividend paying stocks during risk off period. We think the odds are greater than 51% for the Fed to pause in 1Q 2023 and we will have a true relief rally in 2023. This is a contrarian call as 65% investors are expecting a selloff in first half of 2023. We expect that the selloff will come in 3Q 2023 to force the Fed to pivot in 4Q 2023 or 1Q 2024.
Historically, the third year (2023) of the presidential cycle is the best for the stock market and the fourth year (2024) is the best for the economy. We have some degree of confidence that the Fed is in line with the White House’s ambition for re-election. So odds are in our favor to have a good 2023!
In the beginning of 2022, we recommended energy ETF XLE which turned out to be the only big winner in 2022. In 2023, we plan to use sector ETF more than individual stocks to generate trade signals. 2022 has proven that there is always a bull market somewhere. The energy ETF XLE has defended our portfolio while every other area has been slaughtered by the Fed.
Below is a weekly chart of the S&P 500 index.
It is 11 weeks into the current weekly cycle. It would be 16 weeks into the current weekly cycle by February 1 2023 when the Fed hold a meeting and 23 weeks by March 22 when the Fed hold the next meeting. The most important thing is to watch if the mid October 2022 low holds. If the mid October 2022 low is not violated in 1Q 2023, then there is no 1H 2023 selloff. The 4-year cycle is elongated into 2024!