Is the market correction over?

Coming off a bear market low for stocks (defined as a drop of at least 20% from peak value) in October 2022, the S&P 500 has yet to win back all its losses given up to the correction, but progress has been made.

"Investors are looking for signs that the market is on course for a full recovery,” says Rob Haworth, senior investment strategy director at U.S. Bank Wealth Management. “Yet the reality is that we’re dealing with a muddled economy and a muddled market environment.”

The Federal Reserve continues to maintain elevated interest rates to combat inflation. While the inflation rate is well below peaks reached in mid-2022, it remains higher than what is considered an acceptable level. The U.S. economy has slowed considerably from the rapid pace of expansion generated prior to 2022. Yet favorable economic developments, like a strong job market and resilient consumer, have helped to keep the economy on a modestly positive track. Corporate earnings slowed in the first quarter, but not as dramatically as expected.

How will these and other factors determine the direction of the stock market in the second half of 2023?

Clawing back from a challenging year

2022 was a difficult year for investors, one where both stock and bond markets suffered setbacks. At its lowest point, when it dropped to an index value of 3,583 in October 2022, the benchmark Standard & Poor’s 500 stock index was down 25%, from its peak the previous January of 4,796. “The market’s downturn in 2022 can be attributed to the rising level of uncertainty for investors,” says Haworth. Three key events contributed to this uncertainty, including persistently high inflation, a significant change of monetary policy by the Federal Reserve and the economic fallout from Russia’s invasion of Ukraine.

On the road to recovery, the S&P 500 topped out in early February 2023 at 4,179, then traded below that level until finally surpassing It in early June. To this point the index has regained more than half of the bear market losses suffered in 2022. Near the end of June, the S&P 500 Index (an unmanaged index of large cap stocks) was up 14% for the year. More impressively, the technology-heavy NASDAQ Composite Index gained 30% approaching June’s end.

Tracking previous bear markets

Four bear markets have occurred in the U.S. stock market in the 21st century. You’ll note that the level of decline in the most recent bear market cycle is not as dramatic as the previous three.

Source: S&P 500 daily close. 2022 bear market represents the Index’s peak-to-trough through December 2022.

The bear market of 2000 to 2002 was attributed primarily to the bursting of a stock market “bubble” in prices for technology stocks, particularly some early-stage dot-com companies. The 2007 to 2009 bear market was driven in large part by a collapse in home prices. In February and March 2020, the shutdowns to combat the COVID-19 pandemic resulted in a short-lived downturn and economic recession.

“In 2022, we saw a massive change in sentiment,” says Haworth. The persistent nature of elevated inflation appeared to cause investor anxiety. Higher inflation was a result of demand for goods and services outpacing supply. Haworth notes that despite policy moves by the Federal Reserve (Fed) to slow economic growth, inflation, though trending in the right direction, remains stubbornly high.

Stock markets continue to exhibit volatility. However, the S&P 500 showed more consistency lately, generating gains in five of the first six months of 2023.

Source: S&P Dow Jones Indices. Figures shown represent monthly total returns for the Standard & Poor’s 500 Index, an unmanaged index of stocks. It is not possible to invest directly in the index. Past performance is no guarantee of future results. * Monthly total return as of June 22, 2023.

Key factors to watch

What factors could signal the end of the market’s current “pause,” and lead to more definitive and sustained stock price movement. Haworth says there are three key considerations that deserve the most attention:

• Inflation trends and future Fed policy moves. After peaking at 9.1% for the 12-month period ending in June 2022, inflation (as measured by the Consumer Price Index) dropped to 4.0% for the 12-month period ending in May 2023. Haworth notes that the Fed’s primary focus is how wage gains might affect inflation. “Indications are that average hourly earnings growth, which rose significantly in 2022, is slowing.” He notes that the unemployment rate remains historically low, with significant job openings still reported. If that changes and the labor market weakens, the Fed may feel its inflation goals are within reach. The Fed hiked the short-term federal funds rate, from near 0% in early 2022 to 5.00% by May 2023, a significant attempt to slow inflation. The Fed’s rate hikes resulted in higher yields across the bond spectrum and borrowers’ loan costs increased. This has, to an extent, slowed demand, which the Fed anticipates will help quell inflation. “If we look at the Fed’s definition of progress on inflation, they want to get it closer to their target of 2% per year,” says Eric Freedman, chief investment officer at U.S. Bank Wealth Management. “The question is how much further inflation must level out before the Fed is again willing to change course on interest rates.” The Fed chose not to hike rates further in June but indicated additional rate hikes could be forthcoming to reduce chances that the current favorable inflation trend would reverse course.
• Consumer spending. “Consumer’s willingness to maintain reasonable spending growth has been the linchpin for the economy,” says Haworth. Although the savings accumulated during the COVID-19 pandemic are dwindling, consumers have shown resilience, likely due in part to the strength of the labor market and more significant wage growth. Consumers devoted more discretionary spending to travel, restaurants and services than toward goods over the past year. “Data on housing starts, housing demand and auto sales show us consumer demand remains solid,” says Haworth, meaning to this point, there is no sign of a major consumer pullback.
• Corporate earnings. “First quarter, 2023 earnings (company profits), while contracting from previous quarters, did not slow as much as many expected,” says Haworth. “Projections are that earnings will contract further in the second quarter, but the corporate earnings picture may start to improve after that.” The level of consumer spending may dictate the direction of earnings over the course of 2023. “If investors’ confidence in earnings improves, that could give the market a boost,” says Haworth. “A concern is that earnings have been particularly strong for a select group of stocks, and we need to see improvement among a broader group of companies to upgrade prospects for the stock market as a whole.”

Haworth believes the outcome of these three variables will likely play the biggest role in determining the stock market’s performance in 2023.

Other considerations for investors

While they may not represent decisive factors, policy issues and geopolitical matters could affect investor sentiment and be reflected in positive or negative movements in the markets. For example, after a long political standoff between Republicans and Democrats over terms of a debt ceiling extension, an agreement was finalized and signed into law in early June. Stock markets generally responded positively, though this was viewed as a short-term issue.

The Russia-Ukraine war is another issue that raises investor concerns. Haworth notes that with the war entering its second year, markets may have adjusted to the stresses created by the war. “There is less of an immediate economic challenge,” says Haworth. “Over the next few months, we’ll be watching whether grain harvests from Russia and Ukraine can move smoothly through shipping channels. We’ll also keep an eye on western Europe’s ability to stockpile energy supplies to meet their needs next winter.” Haworth says the market could react to any major development that shifts the conflict’s current course.

Growing U.S.-China tensions are another risk, but Haworth says that’s been more in the background recently for the markets. Perhaps more critical is the direction of China’s economy as it continues to emerge from the strict COVID-19 policies China’s government lifted in 2022. “The economic impact China has on the rest of the world may be a more significant consideration for investors,” says Haworth.

Keep a proper perspective

Market volatility and periods of market uncertainty are not unusual. “Keep in mind that we’re likely to periodically experience market ups and downs, and over time, as we’re starting to see recently, markets have shown an ability to recover,” says Haworth. Market volatility can be expected to persist given the range of issues that contribute to the market’s near-term uncertainty. “While we may see a more favorable environment develop down the road, the market still faces many challenges given the current fundamental and policy underpinnings,” says Haworth.

Freedman says it’s important to maintain an appropriate perspective about the markets. He encourages investors to view markets with a long-term lens. “Timing the markets and trying to be precise on when to be in and when to be out is challenging,” says Freedman. “Markets will do things at the exact opposite time you expect them to.”

Freedman emphasizes that having a plan in place that helps inform your investment decision-making is critical, particularly in times like these. “That’s the foundation of investing,” he says.

Despite recent positive stock market performance, Haworth says investors shouldn’t expect the sudden appearance of an “all-clear” sign that market risks have subsided. “The market correction may not be behind us yet,” warns Haworth. “We need to see participation by more than just the narrow band of large, technology-oriented stocks that have driven market performance so far in 2023.” Positive movement across a broader spectrum of stocks would be considered a more encouraging signal of a market positioned to resume a consistent, upward trend.

Yet Haworth says it’s important for investors to consider positioning their portfolios for the long run. “We’re encouraging investors who may have taken a more cautious approach before to adjust back to their long-term strategic target portfolio today.” Haworth says for those who still have a sense of caution about the equity market, “consider putting a portion of your portfolio to work in the equities in a systematic way, such as dollar-cost averaging available cash over a series of months.”

Check in with a wealth planning professional to make sure you’re comfortable with your current investments and that your portfolio is structured in a manner consistent with your long-term financial goals.

The S&P 500 Index consists of 500 widely traded stocks that are considered to represent the performance of the U.S. stock market in general. Diversification and asset allocation do not guarantee returns or protect against losses.