As B.B. King sang: “Nobody loves me but my mother. And she could be jivin’ too.”

Investors want to believe that the Federal Reserve will soon ease up on tightening, and they want to believe in Fed Chair Jerome Powell’s suggestions that a pivot could be around the corner, but the skepticism runs deep. The optimists have been burned once too often this year. Powell could be jivin’ us.

The rebound in U.S. stocks that kicked off in mid-October hit a brick wall last week, as investors again lost faith in more dovish monetary policy.

Paradoxically, last week’s swoon in stocks also was born of diminishing faith in the prospects for economic growth in 2023. This concern about future growth is occurring in the current context of wage gains, solid jobs growth, and healthy consumer spending. The economy’s strength suggests that the Fed still has more work to do in curbing inflation, which in turn points to economic damage down the road.

But let’s not be ungrateful for the rally so far. Equities have mounted a strong comeback over the past two months. Bonds also have shown renewed life, as rates have dipped from their October peak. Cautious optimism is still warranted.

The divergence between the Dow Jones Industrial Average and the technology-heavy NASDAQ is instructive. Rising rates are more deleterious toward growth stocks with higher valuations and longer investor horizons.

When interest rates are rising, growth sectors like tech must produce much higher growth rates to justify the risks shouldered by investors for a higher return. Rising rates also diminish the value of future cash flows, reducing the value of current share prices.

The NASDAQ’s lagging performance tells us that investors still aren’t convinced that the Fed will ease up on tightening over the short term.

It’s also revealing that large-cap stocks have outperformed the small-cap Russell 2000 during the rally, which tells us that doubts persist about economic growth. Small caps tend to outperform during economic expansions.

WATCH THIS VIDEO: Economic Crosscurrents, Explained

A hike of 0.50% (50 basis points, or bps) at the Fed’s meeting this week is the likely “pause” at which policymakers will step back and scrutinize economic conditions after a year of aggressive hawkishness. That would leave perhaps 50-75 bps of further hikes in early 2023 before the much-desired pivot.

In the meantime, the choppy bear market grinds on (see chart).

Recent inflation data have been encouraging indeed, with the November producer price index (PPI), released last week, showing clear signs of a peak in price increases.

Whether we get a “Santa Claus rally” this month or not, the roller-coaster ride is likely to continue. On Monday, the major U.S. stock market indices closed sharply higher, as follows:

• DJIA: +1.58%
• S&P 500: +1.43%
• NASDAQ: +1.26%
• Russell 2000: +1.22%

Investors harbor hopeful expectations about the latest consumer price index (CPI) data, scheduled for this week. These inflation numbers will set the table for 2023.

I expect a bull market with sustainable momentum to emerge next year, but only after the Fed substantially steps back on boosting rates.

The biggest cloud over investors is the Fed’s implacable determination to conquer inflation, because it spells unavoidable economic damage. This reality is reflected by the decline of the yield curve (10-year rates minus 2-year rates) into inverted territory, as short-term rates point to restrictive Fed monetary policy and longer-term rates indicate cooling inflation and declining odds for economic growth.

From a sector standpoint, defensive stocks have outpaced cyclicals during the recent rally, another signal of investor caution. Rising rates and still-elevated inflation underscore the appeal of companies that enjoy reliable revenue and pricing power. We’ll get evidence that a new bull market is in the wings, when cyclicals start to gain serious traction again.

These broad trends confirm the importance of patience, discipline, and proper diversification. As 2023 looms on the calendar, stay on your toes to execute opportunistic sector rotation.

Tactical sector rotation doesn’t involve market timing, per se. It’s temporarily changing your mix of investments predicated on trends that you expect to unfold over the next three months to a year. The goal is to seize on fast-moving trends or take advantage of any short-term view of the markets.

In the meantime, here are the salient economic reports scheduled for release in the week ahead: the November CPI (Tuesday); Powell’s post-meeting news conference (Wednesday); initial jobless claims and retail sales (Thursday); S&P U.S. manufacturing and services PMIs (Friday).

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