Risk vs reward for equities in 2023 has improved, given the declines in 2022 but the bottom for the equity market may still be some distance away. Without calling a bottom for equity markets, J.P. Morgan Asset Management in its recent report – ‘Investment Outlook 2023, A bad year for the economy, a better year for markets’ – has a base case of positive returns for the developed equity market in 2023.
J.P. Morgan’s base case for equities rests largely on three factors – recession, valuation, and earnings. The way these factors play out in 2023, the reflection will be seen in the stock prices next year.
Recession priced into stocks
J.P. Morgan’s 2023 base case of positive returns for developed market equities rests on a view that a moderate recession has already largely been priced into many stocks.
By the end of September 2022, the S&P 500 had declined 25% from its peak. Historically, following this level of decline, the stock market has tended to be higher a year later. There have been two exceptions since 1950: the 2008 financial crisis and the bursting of the dot-com bubble in 2000.
S&P 500 Valuations
S&P 500 valuations started 2022 not far off those seen during the dot-com bubble. However, high valuations could largely be attributed to growth stocks. Despite underperforming in 2022, these stocks are still not particularly cheap by historical standards.
Value stocks, however, are now quite reasonably priced compared with history. J.P. Morgan has a stronger conviction that value stocks will be higher by the end of 2023 than they do for those growth stocks that still look expensive.
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S&P 500 Earnings Expectations
Another risk to equities is that consensus 12-month forward earnings expectations currently look too high, having only declined by about 5% from their recent peak. A recession is likely to lead to further reductions in earnings expectations.
While some might argue that when these earnings downgrades materialize, they will lead the stock market lower, J.P. Morgan believes that the market has already priced in some further downgrades to consensus forecasts. The market is already factoring in worse news than consensus earnings forecasts suggest.
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2023 Equity Market Outlook
It would be unusual for the stock market to have bottomed already as that does not tend to occur before the unemployment rate has started to rise and the Federal Reserve has started to cut interest rates.
However, the market has already declined much more than usual before jobs started to be lost. Given this is probably the best-predicted recession in the last 50 years, we believe there is a chance that equity markets could have priced it in sooner than they normally do.
With quite a lot of bad news already factored in, they think that the potential for further downside is more limited than at the start of 2022. Importantly, the probability that stocks will be higher by the end of next year has increased sufficiently to make it J.P. Morgan’s base case.