The LEI fell deeper into negative territory in December falling 1.0 percent and was weaker than more than 92% of all prior readings since 1960.

A cresting pattern in the LEI, followed by a downturn, has historically heralded recessions, which appear as grey shaded vertical bars on graph to the right.

The new year begins with a broad deterioration of economic conditions. The data has been weak in recent months and appears to be getting weaker. Monetary policy unquestionably works with a lag and the full impact of tighter financial conditions will take months to fully work its way through different sectors of the economy.

The consumer price index in the U.S. increased 6.5% in December marking the lowest inflation rate since October of 2021.

While there is strong data indicating that goods inflation has peaked, the rate remains well above the Fed’s target of 2.0%.

While we do expect circumstances will turn more favorable later in the year, the current trend is one of decelerating economic activity and fading, but still high, inflation. It is logical to assume the near-term environment may be volatile.

Corporate earnings are expected to have increased by only about 4% in 2022. This would be well below the 5-year average earnings growth rate of +14% and below the 10-year average earnings growth rate of nearly 9%. As the new year begins, estimates are falling, and analysts are projecting earnings growth of just about 3% in 2023.

Looking to 2023 and consensus estimates for S&P 500 earnings, the forward P/E is just under 17X. This valuation level is slightly below the 5-year average but above the 10-year average. Equities appear to be reasonably priced at current levels, meaning the market is neither “expensive” nor “cheap” relative to current earnings expectations.

_{With weakening economic activity and bearish investor sentiment, the equity markets begin 2023 in an uncertain position. Both corporate profitability and equity valuations will likely be under pressure for the next several quarters.}

A protracted recession is the key risk to equity markets in 2023. Any downturn running deeper or longer than the mild recession we foresee would likely take both earnings and valuations much lower.

Recessions are a natural and necessary means of clearing out imbalances in the economy and are simply part of the normal economic cycle. This said, they can create a lot of stress for investors. Over the past 70 years, recessions have produced an average drawdown of 30.7% for the S&P 500.

Bear market cycles, as painful as they may be, typically last about 11 months with an average cumulative loss of 31% and pale in comparison to the power of the average bull market cycle that follows. Bull market periods have typically lasted almost 4.4 years with an average cumulative total return of 155.7%.

We believe a mild recession will hit in 2023. With economic leading indicators now falling, the yield curve seeing its deepest inversion since 1981, and earnings estimates expected to come down in early 2023, a recession would appear to be inevitable.

The highest priority for Clearwater Capital Partners over the next 12 to 18 months will be to prepare our clients to understand this downturn and emerge stronger than ever. This will involve the discipline to avoid classic mistakes and being soundly positioned to prosper when good times return.

Following the most aggressive Fed hiking cycle in 40 years, the Fed remains firmly entrenched in a tighter monetary policy stance. We expect inflationary pressure will continue to moderate in 2023 giving the Fed the opportunity to pause with the fed funds rate just above 5%.

• Connected to the tighter financial conditions, our base case for 2023 sees the U.S. economy decelerating further with a mild recession beginning by mid-year. In turn, corporate profits can be expected to decline along with a slump in economic activity.

• We believe the October 2022 lows in equity prices will be retested in the first half of the year. If the October lows don’t hold in 2023, history would suggest some significant further downside is possible with the S&P 500 could trade as low as 3,300.

• The easy money policies and the fiscal stimulus following the COVID crisis provided a major tailwind for equities. Now, these factors have been unwinding in a significant way and tighter financial conditions represent considerable headwinds. The risk of a policy mistake wherein the Fed tightens too much will remain an important driver of the capital markets in the months ahead.
• While no one knows precisely when inflation will have receded enough for the Fed to conclude this historic tightening cycle, we believe the data will encourage the Fed to “pause” sometime in the first half of the year. In turn, markets will have the opportunity shift their focus to recovery and anticipate the growth we believe is likely in 2024.
• We believe a potentially difficult environment over the next several months will set up a period of stabilization followed by the potential birth of a new bull market. In this scenario, investors must remember that the point of maximum pessimism is also the point of maximum opportunity.

We believe a potentially difficult environment over the next several months will set up a period of stabilization followed by the potential birth of a new bull market. In this scenario, investors must remember that the point of maximum pessimism is also the point of maximum opportunity.

Most things that could have gone wrong for investors in 2022 did and as 2023 begins we find ourselves at a pivotal moment for our economy.

Clearly, our base case delivers a rather cautious outlook for the first half of 2023. This said, we must resist the trap of becoming too bearish as the markets find the bottom to this cycle. Eventually the tide will turn, and we must be positioned to participate in the early rallies of a new bull market.