Stock Market Prediction 2023: The ONLY Thing That Matters in 2023

Stock market prediction - Stock Market Prediction 2023: The ONLY Thing That Matters in 2023

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Beware the stock market prognosticator who says you only need to know one thing when looking for the direction of stocks. Most financial advisors suggest watching a variety of different macro and micro indicators, as well as company and sector fundamentals across domestic and international markets, to determine whether stocks are going up or down.

However, my investment framework revolves around a concept that you need to understand first to determine the course for stocks. You need to appreciate the behavior of the single largest economic actor in the world: the Federal Reserve. Determining whether or not the Fed is easing or tightening monetary policy will be your best guide to calling for a bull or bear market in 2023.

And for now, the Fed says “Buyer Beware.” Without looser monetary policy coming in 2023, the bear market for stocks is likely going to continue.

What Does the Federal Reserve Do?

The Federal Reserve is tasked with the mandate to conduct monetary policy “so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.” It does this by using a variety of tools to manage financial conditions that encourage progress toward this objective.

Its primary tool is the raising and lowering of the federal funds rate, which acts as the main driver of how interest rates are set across the entire economy. In recent years, the Fed has also engaged in the buying and selling of assets to help achieve its goals, a process known as quantitative easing or tightening.

Generally speaking, if inflation is too low and/or unemployment is too high in the economy, the Fed is normally cutting interest rates and adding liquidity in order to raise prices and the level of employment. If, however, as we have seen more recently, inflation is too high and employment is robust, the Fed is raising interest rates to slow down the economy to bring it back into balance.

Why the Fed Is so Important for the Stock Market

Central to my investment philosophy is the notion that the U.S. economy is unable to sustain high enough rates of growth on its own due to structurally limited population and productivity growth, which are the main drivers of gross domestic product (GDP). U.S. population growth in the decade 2010-2020 grew only 7.4% in total vs. the prior decade at 9.7% and the 1990s decade at 13.2%. U.S. productivity change from 2007-2019 averaged only 1.4% per year, down from 2.6% in 2000-2007 and 2.2% in 1990-2000.

Due to these trends of weaker population and productivity growth, U.S. GDP in the 2000-2019 period (pre-Covid-19) only averaged 2.09% per year. This was down from the period between 1980-1999, which saw growth of 3.18% per year.

In light of these sub-par growth rates for the economy, there is constant need for assistance from the Fed via lowering of interest rates to help stimulate demand. And as a result, the stock market, which acts as a leading indicator for the economy, becomes hyper-sensitive to whether the Fed is adding or extracting liquidity from the economy. Bull markets are generally associated with improvements in Fed liquidity via lowering interest rates while bear markets often see liquidity being taken away.

Considering this idea, if I can determine the timeline to when the Fed will be providing liquidity to the economy again, I can better assess when to get back into the market on a belief that the bull market has returned.

Where Has Fed Liquidity Been in 2022?

As things stand right now, the U.S. economy is seeing both extremely high inflation and a very tight labor market. This has prompted the Fed to engage in a significant tightening of monetary policy starting at the end of 2021. The U.S. has seen several significant interest rate increases that have taken the federal funds rate up from 0% to 3.75%-4% currently with another 0.5% rate hike expected to come in December. The Fed has also been reducing the size of its balance sheet to the tune of up to $95 billion per month now, a reduction of over $350 billion thus far this year. More than $1 trillion in reductions is coming over the next 12 months.

This monetary policy tightening has raised the cost of capital for companies and has slowed down earnings growth momentum for them as well, both headwinds for most stocks throughout 2022. This helps explain why the stock market has been such a challenge for investors this year.

Where Is Fed Liquidity Going in 2023?

As we look ahead into 2023, recent commentary from various Fed members has suggested that they would like to maintain a restrictive monetary policy stance throughout the entirety of 2023. While the Fed is expecting inflation to continue moderating and the labor market to begin softening, it wants to be sure that inflation is firmly heading down toward its 2% target before easing liquidity conditions.

However, as I think about my framework again, if the Fed is going to wait at least a year before it thinks about adding liquidity again, the economy is not going to be able to see a sustained expansion continue into 2023. The stock market, a leading indicator for the economy, is likely to struggle as a result. This is not a great setup for allocating too much money into stocks right now.

Simply put, the longer it takes for the Fed to cut interest rates and add liquidity, the worse it will ultimately be for economy and for stocks. The economy is already seeing some signs of a slowdown developing in various parts, particularly in housing, but since the Fed’s mandate focuses on achieving price stability and maximum employment, there is very little the Fed can do about this slowing growth momentum at this point.

Without the prospect of increasing liquidity in 2023, we are likely going to see stocks resume their downward trajectory until inflation has fallen enough, or the labor market has slowed enough for the Fed to think about changing its course. The Fed does not see this outcome in 2023.

With this bear market for stocks continuing as we turn into 2023, investors would be best served raising cash and waiting for better entries before allocating too much of their capital into the stock market.

On the date of publication, Craig Shapiro did not have (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the Publishing Guidelines.

Craig Shapiro is the Macro Advisor at LaDuc Trading, a trader education service for professional retail traders and institutional clients.

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