When the curtain officially closes on 2022 in two weeks, there's little doubt this year will go down as one of the most challenging on record for investors. The ageless Dow Jones Industrial Average (^DJI 0.35%), benchmark S&P 500 (^GSPC 0.16%), and growth-driven Nasdaq Composite (^IXIC -0.04%) have all tumbled into a bear market at some point this year, with the S&P 500 producing its worst first-half return since Richard Nixon was president.
But just because Wall Street had a down year, it doesn't mean an encore performance isn't in the cards. Although back-to-back years of underperformance have been rare for the broader market over the past quarter of a century, there is a confluence of headwinds that threaten to push the Dow, S&P 500, and Nasdaq Composite even lower.
In no particular order, here are the seven biggest threats to the stock market in 2023.
Image source: Getty Images.
1. Fed reactivity sinks Wall Street
Arguably the most front-and-center concern for Wall Street is the Federal Reserve's handling of historically high inflation. After more than a decade of building up its balance sheet into the trillions of dollars and printing money like it was going out of style, the nation's central bank has been left with no choice but to aggressively raise interest rates into a plunging stock market to tame inflation.
The well-known issue with the Fed is that it's a reactive, data-driven institution rather than one that proactively adjusts monetary policy. Since the data the Fed utilizes is backward-looking, there's a tendency to overshoot to the upside and downside when it comes to rate hikes and reductions. In other words, we'll probably be looking back in hindsight at some point in the not-too-distant future and realize the Fed was too aggressive with its rate hikes over too short a period.
If the nation's central bank holds true to its word of keeping rates elevated for much (if not all) of 2023, it wouldn't be a surprise to see corporate earnings take a sizable hit.
2. History rhymes, once again
Although history doesn't repeat on Wall Street, it does have a tendency to rhyme. Quite a few indicators would suggest that, while the Dow Jones, S&P 500, and Nasdaq all entered respective bear markets, the ultimate low has yet to be reached.
For instance, two valuation-based indicators portend additional downside in the S&P 500. The S&P Shiller price-to-earnings (P/E) ratio (also known as the cyclically adjusted price-to-earnings ratio, or CAPE ratio) has bottomed numerous times around a value of 22 during stock market corrections and bear markets over the past quarter of a century. The S&P Shiller P/E is currently at 29, and it didn't come anywhere close to 22 during the 2022 bear market.
Likewise, the forward P/E ratio of the S&P 500 is currently 17.3. There hasn't been a sizable correction, crash, or bear market since the beginning of 1999 that found its bottom at a forward P/E ratio of higher than 14. In short, valuation indicators would imply that equities are still pricey and have room to fall.
10-2 Year Treasury Yield Spread data by YCharts.
3. The dreaded "R" word
Another significant risk for the stock market in 2023 is the growing likelihood of a U.S. or global recession -- the dreaded 'R' word.
When the interest rate yield curve inverts and longer-dated maturing bonds have lower yields than short-term bonds, the U.S. is at a heightened probability of entering a recession over the next six to 18 months. Recently, the magnitude of inversion between the two-year Treasury bond yield and 10-year Treasury bond yield widened to its largest difference in 40 years. That's a telltale warning that a recession could be brewing. Just keep in mind that while a yield-curve inversion has preceded every U.S. recession since World War II, a recession hasn't followed every yield-curve inversion.
If a recession does materialize in the U.S. in 2023, you can be all but certain that corporate earnings are likely to fall. Wall Street analysts have yet to fully price in the impact of aggressive Fed rate hikes.
4. Home prices plummet
A fourth plain-as-day risk for the stock market in 2023 is the housing market. One of the biggest housing booms in history could give way to a truly epic bust in the new year.
Investors don't have to look far to see why all facets of the housing industry could struggle. After more than a decade of ultra-favorable mortgage rates, Fed policy helped 30-year mortgage rates skyrocket to a 16-year high of nearly 7% in October. To say that homebuyers have been spoiled with low borrowing rates would be an understatement. With 30-year rates hovering around 7% and the likelihood of a recession growing, homebuying activity should be minimal next year.
The bigger issue is that if home prices plunge 20%, 30%, or perhaps even 40% in a number of previously overheated markets, it might make financial sense for some buyers to simply walk away from their loan rather than pay a monthly mortgage on a property that's dramatically decreased in value. If that happens, a day of reckoning could be at hand for lenders.
Image source: Getty Images.
5. China
The world's No. 2 economy, China, also represents something of a no-win situation for investors in 2023.
On one hand, China's zero-COVID strategy looks as if it'll be very difficult to maintain over a long period. If COVID-19 infection were to spread throughout China, or if regulators dug in their heels and maintained the existing strategy for 2023, it would undoubtedly hurt the country's manufacturing capacity and growth. This would lead to persistent supply chain problems for many of America's biggest businesses.
On the other hand, if China relaxes its COVID-19 policies and largely returns to normal, we could see U.S.-China trade-war tensions reemerge. Let's not forget that, in early September, U.S. regulators banned U.S. semiconductor companies from shipping high-powered, artificial intelligence-driven chips and graphic processing units to China.
6. A commodity collapse
Energy stocks have represented one of the few safe-haven investments of 2022. A globally broken energy supply chain that's been aided by years of underinvestment (tied to the pandemic) and Russia's invasions of Ukraine has elevated crude oil and natural gas prices to well above their historical average.
However, commodities tend to perform very poorly during recessions and/or economic slowdowns. Even though increasing the oil and natural gas supply is incredibly difficult at the moment due to the factors listed above, West Texas Intermediate crude oil hit its lowest level in more than a year last week of $70 per barrel.
If a commodity collapse were to occur, similar to what was witnessed in 2008, oil, natural gas, and even the precious metals could tumble over a short period and take the broader market with them.
7. A crypto wash-out event
The seventh and final big threat to the stock market in 2023 is the potential for another cryptocurrency wash-out event.
Since hitting an all-time high aggregate valuation of $3 trillion in November 2021, the combined value of more than 22,000 listed cryptocurrencies on CoinMarketCap.com has plunged more than 70% to $866 billion as of Dec. 14, 2022. Though the Fed's monetary policy shift has played a role in the crypto bubble (once again) bursting, a clear loss of confidence in digital currencies following a multitude of crypto blowups hasn't helped.
Roughly six months ago, the coin once known as "Terra," which is now TerraClassic, imploded and evaporated nearly $60 billion in market value in a matter of days. More recently, the FTX cryptocurrency exchange scandal has come to light, with former CEO and founder Sam Bankman-Fried facing a litany of criminal charges from the U.S. federal government. The FTX Token has completely crumbled in the wake of FTX's collapse.
If another shoe drops in the crypto space in 2023, all trust could be lost -- and the ripples could easily carry over into the equity markets.
