The last of the "hot" Jan prints is behind us. Payback for Jan equity gains explains markets potential to over-react to "hot" data and that period expected to end early March.

In normal times, one of the adages regarding economic data is “good news is bad news” — meaning, stronger data means a tougher Fed. This is the regime that has been at play for much of the past 18 months.

Jan saw strong inflation and economic data. And the last of the “hot” January inflation data prints was this past Friday with PCE (personal consumption expenditures). Stocks took a gut punch Friday on the heels of the stronger Core PCE inflation +0.6% vs +0.4% expected. PCE is always the last monthly inflation report (sequence CPI, then PPI, then PCE), so PCE tends to be less informative, but matters as it is the Fed’s preferred inflation measure.

• The “hot” Jan inflation figures have caused markets to price in “higher for longer” by the Fed, but our view remains the Fed will hike +25bp in March. While the markets are “data reactive” the Fed is “data dependent,” and there are multiple reasons to contextualize the Jan data.
• The obvious question is whether US economic momentum and inflation accelerated in January, or are there other factors at work? As is widely discussed, a combination of above average warm weather, COLA (cost of living) for social security, flawed Jan seasonals (due to Dec) are probably making Jan data look stronger than it appears, both for inflation and economic momentum. This is why those sticking with +25bp for March are doing so.
• The weakness in equity markets is part “payback” anyways. That is, the surge in January, which is one of the 7 strongest ever (1st 5 days), historically leads to a consolidation starting 2/16 (or so) and ending early March. This 3 week consolidation is something we highlighted a few weeks ago.
• And this same “payback” is seen when we see momentum breakouts. Recall, a few weeks ago we talked about the three momentum breakouts taking place on 1/12/2023, something seen 7 times in the last 50 years (hmmm… another 7). As we highlight later, the “payback” for this breakout starts 20 trading days later, or 2/11/2023. And this is expected to last 2 weeks.
• For the “data reactive” markets, Fed funds have moved up 2 hikes, or +50bp, by July 2023 (see below) according to JPMorgan Fixed Income strategists. This is in line with markets being “data reactive” and we expect much of this to reverse when February inflation data starts to come in.
• For now, we remain constructive on 2023 and still see as our base case, a stock market that will surprise forcefully to the upside.
• Does this sell-off in February change anything?
• The seasonals (or payback) told us a consolidation was coming. So this is not entirely a surprise. This, by the way, turns positive after the first week of March. This is also when we get the February jobs report. And we expect Feb to be softer than consensus as the January seasonal distortion is corrected.
• At a minimum, this “payback” explains why markets can over-react to disappointing data as noted above.
• Similarly, we do not think inflation is rearing its head higher. In fact, the U Mich 1-yr inflation (Feb final) came in at 4.1% (better than 4.2% mid-month) and overall is showing that consumer expectations for inflation are falling. This is in contrast to Core PCE which shows inflation jumped to a 6.85% annualized rate (+0.6% MoM). Which figure do you believe?
• Investors are rattled by this overall January set of data on inflation and economy, and thus, markets repriced in that direction. But we expect February to show a reversal of many of these trends.

Bottom line. We believe markets are in a consolidation period, but this should end in the next week or so (payback ending) and this would coincide with incoming economic data. The upcoming calendar is shown below.

CALENDAR: Key incoming data starting March 10

There is lot of incoming economic data this week (durable goods, housing, unit labor costs and ISM) but for the key inflation-related data, there is a bit of a dead spot until early March. As shown below, this really starts March 10th:

• 3/10 8:30am ET Feb employment report
• 3/13 Feb NY Fed survey inflation exp.
• 3/14 6 AM ET NFIB Feb small biz survey

• 3/14 8:30am ET CPI Feb
• 3/15 8:30am ET PPI Feb
• 3/17 10am ET U. Mich. March prelim 1-yr inflation
• 3/22 2pm March FOMC rate decision
• 3/31 8:30am ET PCE Feb

INFLATION: U Mich 1-yr shows consumers expect less inflation even as Jan inflation surges

Take a look below at U Mich 1-yr inflation compared to Core PCE MoM (annualized).

• which one is showing a clearer trend?
• there is a lot of choppiness in the Core PCE data and this surge in January seems incongruent with recent trends
• Why could core PCE MoM be at the highest monthly gain since July 2022?
• Did inflation suddenly surge? Or is there issues with the seasonals?

This abstract from JPMorgan Economist, Michael Feroli, summarizes this well.

• “the Jan growth rates almost certainly don’t reflect a new underlying growth trend”
• as he noted, the truth to recent economic momentum is probably somewhere in the middle.

But as financial markets are “data reactive” there has been a +50bp or so rise in Fed funds expectations for the remainder of 2023. This is a “higher for longer” view.

PAYBACK: This also explains February weakness

But the strong Jan gains are also behind the weakness in Feb. This payback is something that is apparent looking at composites:

• Using “rule of 1st 5 days,” payback would start 2/16 and through 3/7, or 3 weeks
• Using “trifecta” of 3 breakaway momentum measures, payback would start 2/11 to 2/24, or two weeks
• You get the picture. There is a reason to expect markets to chop.

This first chart shows this “rule of 1st 5 days” composite. And we are in the midst of this now.

Similarly, we discussed how on 1/12/23 there was 3 important breakaway momentum signals generated. These are detailed below.

While markets are higher every single time over next 3M, 6M and 12M, there is a “payback” period as shown below:

• starting 2/11 to 2/24, or two weeks, from the date of the first signal 1/12/23.

And equity markets in 2023 are following this closely. So, again, seasonals/payback are explaining much of the choppiness:

• or even at a minimum, this “payback” explains why markets can over-react to disappointing data

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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