The economy grew faster than most expected in the fourth quarter. Unemployment continues to remain tame and corporate earnings, while not stellar, have been good enough to support financial markets this week.

 

Good news on the economy has been bad news for the stock market at least since the Fed has been tightening interest rates. The reasoning has been that stronger growth and employment would feed the inflation rate forcing even further tightening by the U.S. central bank and ultimately choking off the economy.

 

Now that inflation appears to be coming down, a bullish case is building that says we might get away with just a mild (as opposed to a full-fledged) recession. If so, corporate earnings would slow, but not fall off a cliff. Unemployment would rise, but not decidedly so, and a quarter or two of flat to slightly down GDP growth could suffice to continue pushing inflation lower. I call that the Goldilocks Scenario.

 

This week's macro data appeared to support that theory. U.S. fourth-quarter Gross Domestic Product for 2022 came in higher than expected at 2.9 percent versus an estimate of 2.6 percent. But that was down from the third quarter's 3.2 percent gain. Unemployment claims for the last week of 2022 fell by 19,000 to a seasonally adjusted 204,000. However, the number of temporary jobs, which usually leads to the overall unemployment rate is starting to decline.

 

The Fed's favorite inflation gauge, the Personal Consumption Expenditures Price Index, (PCE) came in a bit cooler in December. And corporate earnings, while not great, are still good enough for most stocks to maintain price support.

 

Most readers know that the quarterly earnings reports are a dance where the Street reduces earnings estimates low enough that most companies can "beat" estimates. Future guidance is therefore the focal point for investors. Coming into this week, traders were positioned for a "worst-case" scenario for most earnings announcements.

 

Microsoft is one of the most important stocks in the equity universe. It announced so-so earnings, but the stock leaped higher by 6 percent after the announcement because it could have been much worse. In the discussion after the announced results, however, management guided investors to expect fewer sales and profits in the quarters to come. The company's stock swooned in the after-hours. It dropped even further the next day and took the entire market down with it.

 

Traders decided at some point during the next day that the bad news was fully discounted and preceded to bid the stock back up to close even on the day. The same exercise occurred several times throughout the week on many stocks that announced earnings. On a macro level, the same thing happened on Thursday after the positive GDP quarterly data was announced. The markets spiked higher, but then gave it all back as the "good news is bad news" crowd reasserted themselves. In short, investors are grabbling to find a happy medium between the strength in the economy, the Fed's intentions toward future tightening, and the proper level for the markets given these unknowns.

 

It had been my view that the stock market could retest or even break last year's lows as early as February. I had predicted this unraveling as far back as early November of last year. It has now become the consensus view, which has made me increasingly uncomfortable.

 

If the bearish view were to come true, equities, as well as commodities and precious metals around the world would decline, interest rates would spike higher, and the U.S. dollar would skyrocket. I believe that would be a fantastic generational opportunity to buy the dip. Materials, gold, and silver as well as miners, would be high on my list of areas to accumulate. China and emerging markets would also be up there. 

 

If, on the other hand, my prediction fails to materialize, and the market continues to grind higher, we could ultimately see 4,370 on the S&P 500 Index, which is another 300 points higher from here, before all is said and done.

 

In the end, it all comes down to what the Fed will decide to do in its February FOMC meeting next week. The problem is that the higher the markets climb, the more dovish the Fed would have to be to support the market.

 

A continuation of their hawkish stance will disappoint the markets while sending the U.S. dollar and interest rates higher. If they moderate their message and hint at a possible pause to assess the results of past tightening, markets will continue higher. I wish I had a crystal ball, but I don't. However, either way, in the longer term, it seems that we end up in the same place, which is higher going into the second half of the year.

 

Bill Schmick is the founding partner of Onota Partners, Inc., in the Berkshires. His forecasts and opinions are purely his own and do not necessarily represent the views of Onota Partners Inc. (OPI). None of his commentary is or should be considered investment advice. Direct your inquiries to Bill at 1-413-347-2401 or email him at bill@schmicksretiredinvestor.com.