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Will stocks rebound this year after a disappointing 2022? Here’s what to look out for:

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Investors are looking for a reprieve after the stock market’s poor performance in 2022. The S&P 500 finished the year down 19%, while the Nasdaq fell 33%, with a number of tech stocks falling even further.

Though most economists predict a recession this year, stocks have begun 2023 on a high note, gaining after the December jobs report showed unemployment remaining low but wage growth slowing – exactly what the Fed appears to want – and a continuing decline in inflation in the December Consumer Price Index (CPI).

So, will there be a new bull market in 2023? It’s impossible to know for sure, but here’s what investors should keep an eye on.

  1. The rate of inflation

Last year, the Federal Reserve dominated the narrative as its aggressive rate hikes caused stocks to plummet, particularly unprofitable growth stocks with stretched valuations. The reason for the rate increases was unusually high inflation, which peaked in the CPI at 9.1% year on year in June last year.

Because the Federal Reserve’s goal is to bring inflation back down to 2%, the faster inflation falls, the more likely it is that the Fed will ease off on rate hikes. Fed Chair Jerome Powell has stated that rates will remain high until inflation reaches the 2% target.

While the CPI is the most commonly used inflation measure, the Fed prefers a different metric: personal consumption expenditure (PCE), which it considers more comprehensive than the CPI. According to the most recent PCE report, released in November, the index increased 5.5% year on year.

In its December projections, the Federal Reserve predicted that PCE inflation would fall to 3.1% by the end of 2023, close to its long-term target of 2%.

Keep a close eye on PCE. If it continues to fall below the Fed’s forecast of 3.1% by the end of the year, stocks will benefit.

  1. Rates of interest

Over the last year, all eyes have been on the federal funds rate, which is now at 4.25%-4.5%. However, that is not the only interest rate to consider. Treasury yields also have an impact on stocks, and they have an inverse relationship. Stocks tend to fall when bond yields rise, and stocks tend to rise when bond yields fall.

Despite the Federal Reserve’s forecast for another 75 basis point hike this year, the interest rate on the benchmark 10-year Treasury Note has fallen significantly from its peak in October at 4.33% to 3.45%. This indicates that investors believe the risk of interest rates remaining high for an extended period of time has decreased, and it may also indicate that stocks have become more appealing. Interest rates have fallen as inflation has moderated.

It’s also worth keeping an eye on the yield curve, particularly the spread between 2-year and 10-year Treasury yields. The 10-year bond typically has a higher yield than the 2-year bond, which is typical for longer-dated bonds. However, the yield curve has inverted, which means that the 2-year now pays more than the 10-year, as illustrated in the chart below.

Treasury Yield 10-2 Years YCharts data spread

When investors expect the federal funds rate to fall over time and see more risk in the short term than the long term, the yield curve tends to invert. An inverted yield curve has historically been a leading indicator of a recession, but it’s unclear whether that will hold true this time.

Nonetheless, investors would view a normalisation of the yield as a positive.

If the Fed stops raising the federal funds rate, interest rates could fall even further, which would be good for stocks.

  1. Profitability of corporations
    Corporate profits are the third factor that will determine whether a new bull market begins this year. In fact, because the stock market ultimately measures how investors value future corporate profits, this may be the most important factor in determining when the next bull market begins.

Earnings in the S&P 500 fell 10% and 3% in the second and third quarters of last year, respectively. Analysts predict another drop in Q4, with earnings per share expected to fall 6% year on year.

However, the analyst consensus currently predicts that earnings-per-share growth will resume in Q1 2023 with an 8% increase and will continue to rise from there. Analysts predict that the broad market index will have a record earnings year.

This forecast may put the stock market at risk of negative guidance revisions, but it also indicates that analysts expect corporate earnings to rebound after a poor performance last year.

No one knows for certain whether or not another bull market will begin in 2023, but if inflation continues to fall toward 2%, the Fed stops raising rates, and corporate profits continue to rise, it appears that a new bull market will begin.

Jeremy Bowman is not a shareholder in any of the stocks mentioned. The Motley Fool owns no shares of any of the companies mentioned. The Motley Fool has a policy on disclosure.

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