Is another market correction coming?

The U.S. stock market moved through various mini-cycles throughout 2023. From January through July, the benchmark S&P 500 index was up 20.65% on a total return basis. By the end of October, the index surrendered nearly half of those gains and briefly dipped into market correction territory, reflecting a 10% downturn from July’s highs. Stocks then rebounded in November with a rally that nearly topped the S&P 500’s July peak.¹

“For most of 2023, the S&P 500 traded in a range of 4200 to 4600,” says Rob Haworth, senior investment strategist at U.S. Bank Wealth Management. “November’s rally is a sign that investors may be at a transition point.” Haworth says markets are weighing potential future actions by the Federal Reserve (Fed), which raised the federal funds target rate it controls 11 times between March 2022 and July 2023. Investors are also closely watching the rate of consumer spending, which to this point has been critical for ongoing economic growth in the face of rising interest rates, which often result in a slower economy.

Fed officials appear willing to maintain elevated interest rates to combat inflation.² While inflation has been trending lower , it remains above the Fed’s 2% target. The U.S. economy continues to show surprising resiliency, growing at an annualized rate of 2% in the first and second quarters of 2023, jumping up to a 4.9% annualized growth rate in the third quarter.³ Favorable economic developments, like a strong job market and resilient consumer spending, helped keep the economy on a positive trajectory. Corporate earnings showed some progress in the third quarter, considered an encouraging sign. “Projections are for earnings to tilt in a slightly positive direction going forward,” says Haworth.

How will these and other factors determine the stock market’s direction in the closing months of 2023 and the start of 2024?

Clawing back from a challenging year

2022 marked the second bear market for U.S. equities in three years, though it was less severe than three previous bear markets.

Source: U.S. Bank Asset Management Group, based on S&P 500 daily close.

The combination of persistent inflation and the Fed’s rapid change in monetary policy direction (raising interest rates, reducing its bond investments) drove markets in 2022. Investors appeared to make some adjustments, but today the stock market continues to exhibit volatility. After five consecutive months of positive performance (March through July 2023), stocks lost ground for three consecutive months beginning in August before recovering in November.

Source: U.S. Bank Asset Management Group.

Key stock market drivers

What are the keys to a sustained bull market recovery? Haworth says two key considerations 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) has recently hovered in the 3% to 4% range.⁴ Haworth notes that the Fed is still trying to temper wage gains. “Average hourly earnings growth remains above 4%, still higher than the Fed’s goal.” The Fed hiked the short-term federal funds rate, from near 0% in early 2022 to 5.25% by July 2023, a move to slow the economy and, as a result, 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.”
• Consumer spending. “Consumers’ willingness to maintain reasonable spending growth has been the linchpin for the economy,” says Haworth. This is likely due in part to the strength of the labor market and more significant wage growth. Haworth says to this point, there is no sign of a major consumer pullback, but adds that “investors will be watching consumer spending trends to look for signs of a significant economic slowdown.”

External risks for the market

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. The growing conflict involving Israel and the Palestinian militant group Hamas that led to an Israeli invasion of Gaza, raises fears of an expanded Middle East conflict. The ongoing Russia-Ukraine war and simmering economic tensions between the U.S. and China along with China’s own economic challenges could evolve into bigger issues that impact the U.S. stock market. Domestically, lawmakers in Washington agreed to another budget extension to avoid a government shutdown, but further action will be required by January 19, 2024.

The market’s narrow leadership

While broad stock market performance remains positive, only a narrow group of stocks prospered this year. “Communication services, information technology and consumer discretionary stocks have carried the market in 2023,” says Haworth. “Performance lagged in all other sectors, including negative returns year-to-date (through October) for utilities, real estate, health care and consumer staples stocks.” Haworth says sustaining a more favorable market environment is likely to require broader participation across more parts of the market. “November’s rally saw interest rate sensitive stocks like utilities and real estate bounce back, but it’s too early to say if that’s sustainable,” says Haworth.

Source: S&P Dow Jones Indices, LLC.

Keeping a proper perspective

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.

In the near term, investors should prepare for the market’s recent volatility to persist. “Expect continued choppiness in the markets, and not necessarily a straight upward path for stocks in the coming months,” says Haworth. Yet he says investors may be better served by 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 stock market, “consider putting a portion of your portfolio to work in 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 time horizon, risk appetite and 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.