Stock-market investors expecting smoother sailing ahead after a volatile year have history on their side

With a slowdown in inflation buttressing speculation that the Federal Reserve is nearing the end of its interest-rate hikes, equity-derivative traders are expecting a break from the turmoil that kept racing through markets last year. That’s driven the so-called volatility curve — a plot that shows expectations for the severity of price swings in the months ahead — lower at every point than it was a year ago. 

Other historical data points also suggest that the optimism of the past two weeks isn’t misplaced. Among them: there have only been two back-to-back annual stock-market drops since 1950, during the recession of the early 1970s and after the bursting of the dot-com bubble at the start of this century, which lasted three years. Nothing along those lines is expected in 2023, at least among the base-case scenarios from most Wall Street strategists.

“With how bad last year was, there is so much bad news that’s likely already priced into markets,” said Ryan Detrick, chief market strategist at Carson Group. He thinks the US can avoid a recession, which would be a “major positive catalyst” for stocks. “We’re seeing steps in the right direction with inflation. That’s the key to the whole puzzle.”

Of course, investors shouldn’t expect completely smooth sailing from here. In fact, the January after a double-digit yearly slump historically has been a rough month for the S&P 500 Index. 

Still, the S&P 500 rose 2.7% last week and is up more than 4% for the year. On Thursday, the Labor Department reported that the consumer price index dropped in December from the month before and posted its smallest annual increase since October 2021. The data were widely seen as giving Fed officials room to further downshift the pace of rate hikes at the February meeting.

Those stock-market gains are welcome news for equity bulls after the S&P 500 posted a more than 19% loss in 2022, the worst hit since the 2008 financial crisis. The good news is such down years are usually followed by a rebound: The S&P 500 has rallied back from them by an average of 15% in the next 12 months, according to data since 1950 that was compiled by Carson Group.

“Markets may have good reasons to see the glass half full on inflation and dismiss hawkish” central bank rhetoric, said Emmanuel Cau, a strategist at Barclays Plc. 

Yet, there are still reasons for lingering anxiety among stock investors, who pulled $2.6 billion from US equity funds in the week through Jan. 11, according to a Citigroup Inc. note citing EPFR Global data. 

It’s possible the Fed could ultimately defy the market’s expectations. For instance, officials are indicating that traders are wrong to anticipate interest rate cuts later this year. And the latest round of corporate earnings reports are just starting to be released and carry their own risks. 

Those skeptical January’s gains will be sustained can also point to their own precedent. On the four occasions that markets have posted double-digit declines in a year since the turn of this century, stocks have fallen in the first month of the following year three times.

But for now, traders at the very least aren’t expecting any big shocks. The month’s two major economic reports — the employment figures and the consumer-price index — have already been released and showed that growth is continuing to hold up and inflation is easing. 

The Cboe VIX Index — a gauge of projected price swings in the S&P 500 that normally moves in the opposite direction of the index — finished last week at around 18, the lowest since last January.

Institutional investors have been covering their short equity bets in the past several weeks and earlier this month boosted their net-long position to the highest since May 2022, Ned Davis Research’s analysis of CFTC data show.

“If there is a recession where it lasts about two quarters, by the time we get to the second half of the year, markets should be pricing in a recovery,” said Ed Clissold, chief US strategist at Ned Davis Research. “If there continues to be favorable inflation data and if earnings come in pretty good, you could make the case that hedge funds will continue to cover their short positions, which would be pretty good fuel for the rally to continue.”