“Rule of 1st 5 days” implies +26% gain 2023 (7 of 7 times). Dec CPI (1/12) could persuade markets it is less costly for Fed to change narrative than drive US into recession = financial conditions ease = upside stocks.

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With S&P 500 up already >2% in 2023, cash yielding 4% doesn’t seem such a good alternative

With the first 6 trading days of 2023 behind us, the S&P 500 is off to a solid start with >2% gains. We have a lot of clients telling us they are being “paid to wait” because they are earning 4% on their cash. This is true, but we think the mood of these investors will change when the S&P 500 gains 4% (this month?). Because, this will suddenly highlight the opportunity cost of owning cash (which takes 1 year to earn 4%) whereas S&P 500 could be on track to gain +25% or more.

• in simple terms, 2023 is shaping up to be the opposite of 2022
• at start of 2022, bonds warned inflation far bigger risk and Fed “behind the curve”
• at start of 2023, bonds warn inflation tracking far below Fed and consensus, and Fed “too hawkish”
• at start of 2022, investors were bullish at the start, and stocks fell 2% in the first 5 days
• at start of 2023, investors are outright bearish, and stocks surged >2% in the first 6 days
• Per the rule of “first 5 days,” since 1950, when prior year is “negative” and first 5 days >1.4% (n=7), equities average +26% gain and higher 7 of 7 times

In other words, the “base” case for 2023 is S&P 500 could gain >25%. Yes. And this is completely counter to consensus which sees equities falling to 3,000 ($SPY) in first half 2023, before recovering to be flat. In short, 2023 should see far stronger returns than many expect.

CATALYST: Dec CPI (on 1/12/23) likely drives “leg down” in consensus view on inflation

While many clients tell us a good Dec CPI print is priced in (meaning, the market expects a soft print or a below 0.25% Dec CPI), that is not the primary.

• In our view, we think the December CPI has potential to “leg down” how the Fed and consensus see inflation trajectory
• Street is looking for Dec Core CPI MoM% +0.25%, which is already a very good number as it annualized core inflation of 3%
• And third month consecutively of a downside read in inflation
• 3M annualized will thus fall to 2.8%, well within Fed target as well

But there is much more to why this matters.

Post-Dec CPI, Fed might be compelled to change its inflation narrative

Since the start of the Fed’s war against inflation at the start of 2022, the narrative has shifted several times (best summarized by Tim Duy of SGH Advisors):

• Fed narrative from “transitory” to “inflation is too high” to “core services ex-housing is too high”
• This latest story is premised on notion wage inflation driving this category (education, medical, cell phones, etc) and thus the unemployment rate needs to rise (destroy jobs).
• So with 3M annualized CPI <3%, Economists (Blinder) saying 3M SAAR shows inflation stopped in tracks and with wage growth slowing (Dec Jobs), we think the Fed might be compelled to change its inflation narrative

FED RISK/REWARD: Fed will likely realize it is less costly to change inflation narrative than reverse a recession

We think one of the changes in coming months is the Fed will soon realize it is cheaper to change the inflation narrative than reverse a recession leading to millions of lost jobs.

Fed officials all seem to be repeating the same message to market (see Bostic below), that rates will be 5% for a long time:

• yet, the 2Y is 4.27% and actually below the upper limit of current Fed funds
• the market simply doesn’t believe the Fed

We think it is because the bond market has already seen the inflation objectives are coming into place for inflation to fall towards 2% in 2023:

• core inflation is already tracking towards 2% (3M annualized post Dec)
• shelter inflation has peaked and Fed is acknowledging lag, so this is set to fall in 2023
• core inflation, ex-housing, is set to post a third negative MoM print (see below)

So, one would think the Fed should be willing to shift its inflation narrative away from “core services ex-housing” is rising. Using updated data from Dec jobs report:

• wage income, which is employment * avg hourly earnings, is now growing at a 3.7% annualized rate
• this is within range of 3.5% Fed views as consistent with 2% inflation (Phillips curve)
• thus, the “core services ex-housing” will soon be tracking to a 2% target

So does it make sense for the Fed to continue to stick with its current inflation narrative (“services ex-housing”) and thus need to drive a rise in unemployment rates?

• arguably, it is far cheaper for Fed to change its narrative
• than push the US into a recession (raise unemployment) to be sure inflation stays deader than dead
• at least, we think this will be the challenge facing markets
• markets will start to think about this dilemma
• and financial conditions will ease
• thus, stocks rise

STRATEGY: Financial conditions should ease in 2023, driving higher equity prices. Technology, Discretionary and Industrials levered to easing FCI

The “base” case for 2023 should be below. That stocks gained >1.4% in the first 5 trading days, and this portends strong gains for the full year:

• Post-neg year + up >1.4% on first 5 days
• Day 5 to first half median gain is 9.5%
• Full year median gain is 26%, implies >4,800 S&P 500
• 7 of 7 years saw gains.

Those 7 precedent years are shown below.

• the range of full year gains is +13% to +38%
• so, this is a VERY STRONG signal
• the two most recent are 2012 and 2019
• we think 2023 will track >20%

For those wondering what the rule of first few days is, it is a variation of the January effect. This looks at the first week of market performance and we first wrote about this 8 years ago. See the report below

The path to higher equity prices is discussed above:

• core inflation falling faster than Fed and consensus expects
• wage inflation is already approaching 3.5% target of Fed (aggregate payrolls)
• Fed could “dovishly” leg down its inflation view
• allowing financial conditions to ease
• bond market has already seen this and is well below Fed on terminal rate

Naturally, the question is what to own if FCIs are easing. As shown below, these are the sectors sensitive to FCI:

• most sensitive are Industrials, Discretionary and Technology.

And as shown below, these have been consistently sensitive to FCIs.

BASE CASE: The “maths” for what to expect in 2023, post a “negative return” year (2022)

Question: how common is a “flat” year? Our team calculated the data and it is shown below:

• since 1950, there are 19 instances of a negative S&P 500 return year. In the following year,
• stocks are “flat” (+/- 5%) only 11% of the time (n=2)
• stocks are up >20% 53% of the time (n=10)
• yup, stocks are 5X more likely to rise 20% than be flat
• and more than half of the instances are >20% gains

So, does a “flat year” still make sense?

As shown below, these probabilities are far higher than compared to typical years:

• since 1950, based upon all 73 years
• stocks are “flat” 16% of the time vs 11% post-negative years — BIG DIFFERENCE
• stocks are up >20% 27% of the time vs 53% post-negative years — BIG DIFFERENCE
• see the point? The odds of a >20% gain are double because of the decline in 2022

STRATEGY: VIX matters far more for 2023 returns than EPS growth

Our data science team compiled the impact on 2023 equity returns from variables:

• S&P 500 post-negative year (2022)
• the varying impacts of
• VIX or volatility
• USD change
• Interest rates
• EPS growth
• All of the 4 above, positive or negative YoY
• Data is based on rolling quarters and summarized below

The surprising math and conclusions are as follows:

• most impactful is VIX
• Post-negative year (rolling LTM)
• if VIX falls, equity gain is 22% (win ratio 83%, n=23)
• if VIX rises, equity lose -23% (win ratio 14%, n=7)
• I mean, this shows this all comes down to the VIX
• EPS growth has little impact
• If EPS growth is negative YoY (likely), median gain +14.8% (win-ratio 70% n=33)
• If EPS growth is positive YoY, median gain is 15.5% (win-ratio is 78%)
• Hardly a sizable bifurcation

As the scatter below highlights, we can see the sizable influence of the VIX. Even in all years, the VIX is a key factor:

• in our view, if inflation falls sharply
• and wage growth slows
• Fed doesn’t have to cut, but this is a dovish development
• we see VIX falling to sub-20
• hence, >20% upside for stocks

And as shown below, EPS growth has a somewhat important correlation, but hardly as strong as VIX changes.

• the difference in median gain is a mere 70bp (positive vs negative) post-negative year
• the importance of EPS growth is stronger in other years

37 GRANNY SHOTS: Updated list is below

The revised 37 Granny shots are shown below. The list is sorted by the most attractive (most frequently cited) to least. To be a “Granny shot” the stock needs to appear in at least two portfolios:

• $AAPL in 4 of 6 portfolios
• $GOOGL $MSFT in 3 of 6 portfolios
• $AMZN $META in at least 2
• This reinforces our favorable view of FANG in 2H2022

37 Granny Shot Ideas:

Communication Services: $GOOGL, $META

Consumer Discretionary: $AMZN, $AZO, $GPC, $GRMN, $ORLY, $TSLA

Consumer Staples: $BF/B, $MNST, $PG, $PM

Energy: $CVX, $DVN, $EOG, $PSX, $XOM

Financials: $ALL, $AXP

Health Care: $AMGN, $HUM, $UNH

Information Technology: $AAPL, $AMD, $AVGO, $CSCO, $KLAC, $MSFT, $NVDA, $PYPL, $QCOM

Materials: $CF, $FCX, $LIN

Real Estate: $AMT, $CCI, $EXR