Market breadth surge in 2023 strengthens case stocks surprise to upside in 2023. Also strengthens case Oct 13th was low + Fed made unforced error in Dec.

Equities have been off to a solid start in 2023, gaining nearly 5% so far. As shown below, this strong start in 1st 5 days, particularly when the prior year was negative (ala 2022), bodes well for the remainder of 2023:

• 1st 5 day >1.4% + neg prior year = 7 instances = median gain 26% (100% win-ratio)
• If VIX falls on avg vs 2022 (avg 25), median gain is 22% (n=23)

Contrary to the consensus view that stocks will be “flat” in 2023, equity markets seem to be following more closely the historical context.

• as our clients know, we think the fundamental case for 2023 hinges upon a leg down in the trajectory of inflation that is underway
• but the Fed and consensus have yet to acknowledge/discount this
• bonds see a less aggressive Fed and economic data has been more supportive of a soft landing
• if market view of inflation does leg down, investors will arguably look past the earnings “valley” and focus on a more predictable/possibly easing Fed
• as such, we think 2023 is arguably more akin to 1982, when stocks went nearly vertical

In fact, the strength in 2023 also seems to be improving the technical picture. As noted by Mark Newton, Head of Technical Strategy, recently:

• S&P 500 and Nasdaq are showing long-term trend breakouts

Thus, we think investors will increasingly look at the market with the following context:

• S&P 500 is breaking out of long-term downtrends
• 10/13/2022 was the low and the sell-off in December was an “unforced error” by the Fed

MARKET BREADTH: Strengthens case for >20% gains in 2023

There are various ways to measure market breadth but many focus on the NYSE advancers and decliners.

• Whaley had a breadth thrust measure looking at 5D adv/total volume
• Walter Deemer has one that looks at Breakaway momentum measured by looking at 10D adv/dec
• and there are other combinations below
• and our team looked at instances where 2 of 3 were triggered as first discussed by @QuantifiablEdgs on twitter
• Interestingly, when 2 of 3 are triggered, equities show particular strength
• Since 1970, there are 7 instances of 2 of 3 and the median gain is 24%

These instances are shown below. And many occurred at key market bottoms:

• interestingly, the most recent was triggered 1/12/2023
• and this is the only instance that 3 of 3 were seen

The bottom line is the recovery in market breadth is a sign that demand for equities is recovering. We know investors are not “risk-on” coming in 2023. And if our view on the Fed trajectory change is correct, we will see financial conditions ease. This is all supportive of stocks strengthening in 2023.

STRATEGY: VIX matters far more for 2023 returns than EPS growth

Our data science team compiled the impact on 2023 equity returns from variables:

• S&P 500 post-negative year (2022)
• the varying impacts of
• VIX or volatility
• USD change
• Interest rates
• EPS growth
• All of the 4 above, positive or negative YoY
• Data is based on rolling quarters and summarized below

The surprising math and conclusions are as follows:

• most impactful is VIX
• Post-negative year (rolling LTM)
• if VIX falls, equity gain is 22% (win ratio 83%, n=23)
• if VIX rises, equity lose -23% (win ratio 14%, n=7)
• I mean, this shows this all comes down to the VIX
• EPS growth has little impact
• If EPS growth is negative YoY (likely), median gain +14.8% (win-ratio 70% n=33)
• If EPS growth is positive YoY, median gain is 15.5% (win-ratio is 78%)
• Hardly a sizable bifurcation

As the scatter below highlights, we can see the sizable influence of the VIX. Even in all years, the VIX is a key factor:

• in our view, if inflation falls sharply
• and wage growth slows
• Fed doesn’t have to cut, but this is a dovish development
• we see VIX falling to sub-20
• hence, >20% upside for stocks

And as shown below, EPS growth has a somewhat important correlation, but hardly as strong as VIX changes.

• the difference in median gain is a mere 70bp (positive vs negative) post-negative year
• the importance of EPS growth is stronger in other years

STRATEGY: Financial conditions should ease in 2023, driving higher equity prices. Technology, Discretionary and Industrials levered to easing FCI

The “base” case for 2023 should be below. That stocks gained >1.4% in the first 5 trading days, and this portends strong gains for the full year:

• Post-neg year + up >1.4% on first 5 days
• Day 5 to first half median gain is 9.5%
• Full year median gain is 26%, implies >4,800 S&P 500
• 7 of 7 years saw gains.

Those 7 precedent years are shown below.

• the range of full year gains is +13% to +38%
• so, this is a VERY STRONG signal
• the two most recent are 2012 and 2019
• we think 2023 will track >20%

The path to higher equity prices is discussed above:

• core inflation falling faster than Fed and consensus expects
• wage inflation is already approaching 3.5% target of Fed (aggregate payrolls)
• Fed could “dovishly” leg down its inflation view
• allowing financial conditions to ease
• bond market has already seen this and is well below Fed on terminal rate

BASE CASE: The “maths” for what to expect in 2023, post a “negative return” year (2022)

Question: how common is a “flat” year? Our team calculated the data and it is shown below:

• since 1950, there are 19 instances of a negative S&P 500 return year. In the following year,
• stocks are “flat” (+/- 5%) only 11% of the time (n=2)
• stocks are up >20% 53% of the time (n=10)
• yup, stocks are 5X more likely to rise 20% than be flat
• and more than half of the instances are >20% gains

So, does a “flat year” still make sense?

As shown below, these probabilities are far higher compared to typical years:

• since 1950, based upon all 73 years
• stocks are “flat” 16% of the time vs 11% post-negative years — BIG DIFFERENCE
• stocks are up >20% 27% of the time vs 53% post-negative years — BIG DIFFERENCE
• see the point? The odds of a >20% gain are double because of the decline in 2022

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