History shows odds favor a 20% stock-market return in 2023 after a brutal 2022, Fundstrat says

Historical data shows there is a high chance that the U.S. stock market may record a return of 20% or more this year after the three major indexes closed 2022 with their worst annual losses since 2008, according to Fundstrat Global Advisors.

Fundstrat’s head of research Tom Lee said stock-market investors are more likely to see a year of positive returns than a flat year after stocks performed badly in the previous year. 

In the 19 instances of a negative S&P 500 index
SPX,
+2.28%

return year since 1950, over half of those years were followed by the large-cap index gaining more than 20%, according to Fundstrat’s data. Only two of those years were followed by a flat year with a return ranging from 5% to negative 5% . 

“Stocks are 5X more likely to rise 20% than be flat, and more than half of the instances are over 20% gains,” said Lee in a Friday note. 

Moreover, these probabilities are far higher than compared to typical years. In all 73 years since 1950, there is only a 27% chance for the S&P 500 to finish with an over 20% gain, compared to 53% odds in post-negative years. 

See: No one knows which stocks will fuel the next bull market, but they likely won’t be the bear market’s winners 

Here are three possible catalysts that would enable stocks to produce 20% gains in 2023:

Global ‘disinflation’ underway

Lee and his team think the U.S. inflation will undershoot the Federal Reserve and markets’ consensus by a wide margin in 2023. 

Economists polled by Dow Jones expect December’s inflation report, which is due out next Thursday morning, will show headline inflation remained unchanged from the previous month, or 6.5% year over year. The core price measure that strips out volatile food and fuel costs, is expected to rise 0.3% from November, or 5.7% year over year. 

However, Lee thinks the upcoming CPI report could see core CPI rise as low as 0.1% in December, which would represent a significant decline in the pace of inflation and put the three-month seasonally adjusted annualized rate (3M SAAR) at around 2%. “In our view, this would be a massive positive surprise,” said Lee. 

As a consequence, Lee and his team think it might set the stage for the Fed to lower the path of interest rate rises and even change the view that the benchmark rate will need to stay “higher for longer.” Fed funds futures traders now see a 74% likelihood of a 25 basis point hike at its next policy meeting, which concludes February 1, and a 66% chance of another in March, which would bring the terminal rate to 4.75-5% by mid-year, according to the CME FedWatch tool.

See: ‘Old habits die hard’: Traders take second look at 5%-plus U.S. interest rate by March

However, the central bank signaled its terminal rate could peak at 5.25% this year in its meeting last December, while expecting no interest rate cuts by the end of this year. 

Wage gains are set to slow

“Despite what look like ‘strong’ jobs markets, leading indicators already suggest wage gains are set to slow,” Lee said. 

The employment report on Friday showed wage growth was less than expected in December in a sign that inflation pressure could be easing. Average hourly earnings rose 0.3% for the month and increased 4.6% from a year ago, slightly less than expected and down from 0.4% a month earlier.

However, payroll growth, though it decelerated in December, was still better than expected, a sign that the labor market remains strong even as the economy faces rising headwinds from the Federal Reserve. The unemployment rate, meanwhile, slipped to 3.5% from 3.6%. 

See: Goldilocks scenario? Slower increases in worker wages could help U.S. economy avert a recession.

Equity (VIX) and bond volatility (MOVE) to fall sharply 

Equity and bond market volatility is likely to fall sharply in 2023, in response to a fall in inflation and a consequently less hawkish Fed, said Lee and his team. “Our analysis shows this drop in VIX is a huge influential factor in equity gains, which would further support over 20% gains in stocks.” 

The CBOE Volatility Index
VIX,
-5.92%

was off 6.4%, at 21.03 on Friday, while the ICE Bank of America Merrill Lynch MOVE Index, a gauge of implied bond-market volatility, was last at 119.53.

U.S. stocks rallied on Friday after the December employment report fueled hopes that the Fed’s monetary policy is finally starting to have some effect on the economy. The Dow Jones Industrial Average
DJIA,
+2.13%

ended about 700 points higher, or 2.1%, to 33,629. The S&P 500 advanced 2.3%, and the Nasdaq Composite
COMP,
+2.56%

gained 2.6%. 

See: Is a 2023 stock-market rebound in store after 2022 selloff? What history says about back-to-back losing years.