During my early days as a newspaper reporter, mentors were few and far between. Whenever I needed help, the attitude of my managers was: “Look, kid, just figure it out.” As a journalist, I was raised by wolves.

Which gives me insights into the wolves of Wall Street. Forget the homilies of avuncular gurus. The stock market rewards unsentimental ruthlessness.

Hopes of a Federal Reserve “dovish pivot” have been cruelly dashed all year. As the Fed’s December 14-15 meeting approaches, the optimists could be setting themselves up for further disappointment. That’s why you need to judge stocks on their intrinsic merits, without wishful thinking about macro policy.

The stock market boils down to one thing: a daily wager on the future profitability of corporations. As I explain below, corporate profitability remains on track but it’s decelerating. With 2022 winding to a close, I’ll shed light on the degree of bullishness that’s warranted now and how to position your portfolio for 2023.

The final stretch…

After a dismal September, we enjoyed back-to-back positive months in October and November, and December is looking auspicious. Historically, December has been one of the best months of the year for the S&P 500.

The Dow Jones Industrial Average is now up more than 20% from its October low and down only about 5% from its all-time high.

To be sure, equities as a whole remain in a bear market. The S&P 500 is down nearly 15% year to date, and it’s on pace for its worst annual return since 2008, the year of the global financial crisis. The tech-heavy NASDAQ has been struggling the worst (see chart).

The resurgence in U.S. equities is driven by the growing sense on Wall Street that inflation is cooling, and the Federal Reserve will soon adopt a more dovish tone.

The probable transition to a milder rate hike of 0.5% at the Fed’s next meeting this month already was foretold by the minutes of the central bank’s November meeting. The market is currently pricing in that outcome, and Fed Chair Jerome Powell last week didn’t say anything to dissuade those expectations.

Fed policy decisions tend to exert a lagging effect, which means this year’s cycle of tightening will probably show up in the economy starting next year, increasing odds of a recession.

However, robust U.S. jobs growth and resilient consumer spending aren’t indicative of recessionary conditions. There’s a good chance that we’ll dodge an outright recession and, in the recent words of Powell, witness a “soft or softish” economic landing. Consumers have been telling pollsters that they’re feeling pessimistic about the economy, and yet their healthy retail spending has belied those sentiments.

The Red Dragon’s woes…

Among the big variables to watch in 2023 will be events in the world’s second-largest economy, China. The autocratic nation has been roiled by domestic unrest, as citizens protest draconian lockdown measures. What’s more, younger, better educated Chinese have been taking to the streets, demanding a more liberal society.

The response of China’s President Xi Jinping has been to double-down on repression, while at the same time modestly lift some COVID restrictions. The unrest is likely to blow over; China is a rigidly controlled state. But such social developments tend to move in unpredictable ways. Investors will be keeping a close eye on China and whether Beijing manages to stabilize its economy and society.

In the long term, China’s growth will slow from the rates of past years, just as Japan’s did. But China reflects an economic state similar to Japan in 1960, not Japan of 1990. Although other Asian countries (e.g., Vietnam) are offering stiff competition, China has further to go before it approaches Western wage costs and its products become too expensive.

Despite its current debt problems and political turmoil, China and its market will remain a global economic and financial bellwether into the foreseeable future.

In fact, Chinese stocks have been leading international markets higher on expectations of economic reopening. Hong Kong’s main index jumped 27% in November, its biggest monthly gain since 1998.

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For Q3 2022, the blended earnings growth rate for the S&P 500 is 2.5%, according to research firm FactSet. If 2.5% is the actual growth rate for the quarter, it will mark the lowest earnings growth rate reported by the index since Q3 2020 (-5.7%). That level of earnings growth is lackluster, but it’s not disastrous, either.

Stay patient and stay diversified. The recovery of equities in October and November underscore the wisdom of patience. I’m confident that next year, macroeconomic trends will increasingly turn positive.

An under-reported story has been the stimulus for construction spending provided by President Biden’s infrastructure bills. As inflation recedes and the global economy gets back on its feet in 2023, cyclical stocks in the construction sector should outperform. And don’t forget, war-torn Ukraine will eventually need a massive re-building program.

Now’s a good time to increase your exposure to undervalued tech stocks that have taken a beating due to rising rates, but which remain positioned to dominate the tech megatrends of 2023 and beyond (e.g., the cloud, Internet of Things, and 5G).

The week ahead…

Keep an eye on the following economic reports scheduled for release in coming days: S&P U.S. Services PMI, ISM Services Index, factory orders (Monday); trade deficit (Tuesday); unit labor costs, consumer credit (Wednesday); initial jobless claims (Thursday); producer price index, consumer sentiment, and inflation expectations (Friday).

Successful investors stay focused on the hard data and the underlying conditions as they truly exist, not as they want them to be. The Fed may ease up on rates soon, but don’t count on it. Investors who get lulled into complacency by a soothing narrative are sheep. And sheep get slaughtered.

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John Persinos is the editorial director of Investing Daily. You can reach John at: mailbag@investingdaily.com

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