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Style investors recently witnessed a rare event when, on February 13^th, the P/E ratio of the S&P 500 Growth Index fell below that of the S&P 500 Value Index. At first glance, it is tempting to attribute this valuation flip-flop to the 2022 bear market, which saw Value outperform Growth by a whopping 24.2%. However, the bear-induced collapse of Growth stock prices in 2022 only served to return the P/E spread to a level just below its historical median of 5.1, meaning that the final move toward parity was caused by a force outside the market itself. That “something else” was the S&P 500 style reconstitution that occurs annually on the third Friday of December.

CPI readings for February were in-line with consensus estimates. Attention has been and will continue to be focused on banks and credit markets for investors and the Fed in the coming weeks. The Shelter Index made a fresh YOY high despite almost a year of declining YOY rent prices.

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Factor performance stabilized in February, recovering from a brutal start to the year. While those dynamics bled into the first two days of February, the trend quickly reversed as interest rates bounced off recent lows and stayed on an upward trajectory for the rest of the month.

While the valuation gap between Growth and Value sectors was compelling just a couple of years ago, it has closed drastically the last twelve months. Our analysis shows that Value sectors (Energy, Industrials) are still more favorable than Growth sectors (IT, Health Care).

Imagine telling a Small Cap investor in mid-2018 that: (1) the U.S. economy would spend all but two months of the next 4-1/2 years in expansionary mode; and (2) M2 money supply would increase by 50% in that time, and yet the Russell 2000 would gain a grand total of just 9% over the same span.

A large swath of the institutional asset-allocation world is engaged in the sometimes dangerous, binary game of “stocks versus bonds.” Although the 2022 bond debacle caused relatively mild damage to a massively overweight equity position, the bear markets of 2000-2002 and 2007-2009 produced losses for stocks versus bonds that exceeded 60%. 

Monetary conditions have worsened, recession evidence is piling up, and some of our Large Cap valuation measures have returned to their tenth historical deciles. However, with the economy near full employment we thought it worth revisiting the past to find examples where the market might have temporarily thrived under similar circumstances.

For those disappointed that February’s employment report won’t be released until March 10th, we have something to consider in the meantime.

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One of the societal benefits of recessions and bear markets is that they serve to correct the unhealthy excesses that build up in overheated economic booms and overly enthusiastic bull markets. As market historians, we believe it is instructive to look back at cycles of excesses and their corrections to learn how such patterns evolve and, quite often, repeat themselves.

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Both the headline and Core CPI were largely in line with expectations. The dollar’s recent weakness has served to support higher inflation as well as easier financial conditions. Our Scorecard suggests that the possibility of inflation staying persistently high is increasing.

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If the October S&P 500 low holds, the normalized P/E ratio of 22.7x on that date will signify the priciest bear market bottom in history; in fact, it is exactly the same level reached as at the August-1987 bull market high. Since October, the normalized P/E multiple has grown to 25.5x—higher than all but three previous bull market peaks.

The narrative for January’s strong stock market bounce is that not all key economic releases looked to be forecasting a recession. However, one must consider that this was only true for coincident and lagging data series.

The hostile monetary backdrop makes recent stock market exuberance even more irrational than in early 2021. Yet, this is the middle of a seasonal window that historically boasts an elevated level of craziness: It is the year preceding a presidential election—a time when monetary and fiscal stimulus are ramped up. 

The weight of evidence clearly leans more toward a recession, but the wild card is the recent dovish turn of global central banks, which can significantly boost confidence from investors, consumers, and businesses.

The fourth quarter of 2022 saw broadly positive equity-market performance with the S&P 500 returning +7.6%, the Russell 1000 Mid Cap Index at +7.2%, and the Russell 2000 Small Cap Index gaining 6.2%. Strong returns usually present a headwind for active managers, but the fourth quarter proved productive for actively managed funds.

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Deflating valuations in the Technology and Innovation space produced ghastly results for growth investors in 2022, with the S&P 500 Growth index experiencing an agonizing 29.4% loss. Meanwhile, last year’s bear market was no more than a mild irritation for value investors as the S&P 500 Value index lost just 5.2%. The collapse in exuberantly priced growth stocks produced a 24.2% return spread between the value and growth styles, which goes into the record books as the second biggest annual win for value since 1975.

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The defining characteristic of last year’s bear market was the collapsing valuations of speculative growth stocks. A mania for themes such as cloud computing and disruptive innovation during 2016-2021 drove those names to fantastical valuations and bestowed market capitalizations of tens- and even hundreds of billions of dollars on such companies, many of which had yet to turn a profit.

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This year is off to a much stronger start than suggested by the 3-4% gains in the blue-chip averages: Through January 12th, the Value Line Arithmetic Composite—an equally-weighted index of about 1,700 stocks, was up 7.0%.

Both the headline and Core CPI were in line with expectations.
Sticky ex-Shelter CPI has rolled over and EM inflation surprises are negative now.
Disinflation remains the dominant theme but some inflationary pressure can be quite sticky.

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A signal from the newest addition to our Technical category seems to have gone awry. On November 30th, the percentage of S&P 500 stocks trading above their 50-day moving average topped 90%, thereby issuing the second “breadth-thrust” signal in four months.

2022 was a nasty year for the stock market, but a wonderful one for market numerologists. This year is a different story. Two of the three calendar patterns are bullish, including the one in which we put the most stock (pun intended): The Presidential Election Cycle. 

Hopes that this decade might see a repeat of the “Roaring Twenties” took a hit last year. But there’s plenty of time to recover, and bulls will be encouraged to learn that cumulative stock market performance for this decade, thus far, is better than at the same point in the Roaring 1920s.  

Frequently, there’s money to be made in the stock market in the months following the initial curve inversion. After the inversions of August 2006 and June 2019, the S&P 500 rallied another 23% and 19%, respectively, into its final bull market high. If this cycle plays out in textbook fashion, the business-cycle peak would arrive in September.

Market veterans know there’s just one thing more probable than a recession after the yield curve inverts: Yield curve denial among a large group of sell-side economists and market strategists! Indeed, the earliest of those dismissals occurred last March—a month before the first of more than a dozen iterations of a yield curve inversion. 

Style rotation powered S&P 500 Value to a 24.2% advantage vs. Growth, while DM large-cap Value earned a 20% return spread against Growth. Small-cap spreads favoring Value were also in the double-digits, but narrower because small-cap Growth wasn’t exposed to the collapse of mega-cap Tech. 

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We’ve heard for eons that “Low bond yields justify high equity valuations.” Value-conscious investors might have described this conundrum another way: “Low future returns in one asset class justify low future returns in another.” (Mysteriously, only the first rendition became a CNBC catch-phrase.)

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The 2022 bear market will be remembered as a year when collapsing growth stock valuations and rising interest rates doomed almost every asset class to return purgatory. Hopes for avoiding a second down year rest with a potential top in interest rates and solid earnings underpinning the stock market. Wall Street strategists have a year-end 2023 price target of just over 4,000 for the S&P 500, a few percentage points of upside from today but hardly reason to toast a prosperous new year.

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Today, we are announcing that our Chief Investment Strategist, Jim Paulsen, will be retiring at the end of the year. Jim has been a popular counselor to our firm's institutional clients and a regular commentator in financial media. He will be stepping back from publishing and other day-to-day duties, but will remain a partner and senior advisor to our firm, which he joined over five years ago.

Jim is such an original thinker and provocative market forecaster, and we feel fortunate he chose to wrap up a long and distinguished career here at Leuthold. Our research clients and the millions of people who followed his work in hundreds of TV and print interviews were equally fortunate, having benefitted from his insights and, frankly, his knack for being right.

We’re going to miss Jim at a professional level — he has legions of fans on Wall Street and Main Street, but none bigger than the members of our own research and investment teams — and personally, as a friend and colleague. His family, the philanthropies he cares about and the Minnesota Timberwolves basketball team are all lucky to be getting more of his time and focus.

We wish him well with his new endeavors.

-John Mueller and Jeff Leadholm – Co-CEOs