Key points
- The technology sector led the stock market to impressive gains in the first half of 2023.
- Analysts are optimistic about the outlook for stock prices.
- Tight credit markets, elevated inflation and interest rates remain risks.
The stock market is entering the second half of 2023 with positive momentum, which historically bodes well for returns for the rest of the year. The S&P 500 could be on track for its best annual performance since 2019.
Several key issues that weighed on investors’ appetites for stocks and other risk assets in 2022 have subsided in recent months.
Inflation has trended steadily lower, economic growth has been stronger than feared, U.S. banks have seemingly stabilized following a regional banking crisis and the Federal Reserve has made sufficient progress in stabilizing prices to pause its interest rate hikes in June.
Technology stocks and growth stocks have outperformed in 2023, and investors are increasingly optimistic the Fed can navigate a soft landing for the U.S. economy. But recession risk remains elevated, and some market experts urge investors to take a cautious approach to a red-hot market in the second half of the year.
Stock market performance
The S&P 500 gained 5% in the first quarter of 2023. But much of those gains were concentrated in the technology sector. Here are some highlights:
- The Technology Select Sector SPDR Fund (XLK) gained more than 21% in the first quarter and continued with another gain in the second quarter, for a total gain of 40% in the year’s first half.
- Large-cap tech stocks led the S&P 500 to a 14% gain in the first half of 2023. The tech-heavy Nasdaq left the S&P 500 in the dust, gaining more than 30% heading into the rest of the year.
- The blue-chip Dow Jones Industrial Average lagged significantly in the first half, gaining 3.8%. Investors shunned value stocks and rotated back into growth stocks, weighing on the Dow’s returns.
Artificial intelligence was a key investment theme that propelled tech stocks in the year’s first half. OpenAI’s ChatGPT AI chatbot took the world by storm, and Alphabet (GOOG, GOOGL) released Bard in response to ChatGPT.
The first-quarter tech stock rally broadened to other market sectors in the second quarter, driven by investor optimism surrounding a Fed pause and encouraging U.S. economic data.
It’s easy to see why investors will be optimistic about the next six months given the abundance of good news in the first half of the year, but there are still some potential roadblocks ahead that could trip up the 2023 stock market rally.
Stock market forecast for the next six months
Since 1950, when the S&P 500 finishes the year’s first half with positive returns, it has averaged a 6% gain in the year’s second half. If the index gains at least 10% during the year’s first half, second-half gains have averaged 7.7%.
Analysts are generally optimistic about the outlook for stocks in the second half of the year.
S&P 500 forecast
The S&P 500 officially entered bull market territory on June 8, having risen by at least 20% since its October 2022 lows.
That said, Wall Street analysts are projecting elevated interest rates will continue weighing on S&P 500 earnings in the year’s second half. They estimate S&P 500 earnings dropped 6.8% year over year in the second quarter and will grow 0.4% in the third quarter. The index’s forward price-to-earnings ratio of 18.9 is already above its 10-year average of 17.4, suggesting stock valuations are stretched.
Fortunately, analysts remain optimistic the S&P 500 will march higher next year.
The average analyst price target for the S&P 500 suggests 9.5% additional upside over the next 12 months.
The energy sector is expected to movie with 22% average upside over the next year. Meanwhile, the tech sector is taking a breather, with an estimated 4.8% upside for S&P 500 tech stocks.
Dow Jones forecast
If the appetite for growth stocks and tech stocks continues in the second half of 2023, the Dow Jones Industrial Average will likely lag. But if the U.S. economy dips into a recession, investors may seek safety in blue-chip stocks
The Dow gained 3.8% in the first half of 2023, but most of those gains came in the second quarter. The Dow is currently trading at around 34,000, around 8% below its all-time closing high of 36,799 in January 2022.
Nasdaq forecast
If the rally in tech stocks continues in the second half of 2023, it could be a historic year for the Nasdaq. The index has gained more than 50% in a single calendar year only three times in its 45-year history, and its more than 30% gain in the first half of the year puts it on track for its best annual performance since the dot-com bubble in the late 1990s.
But tech stocks will need to continue to demonstrate they can grow their businesses even in an extremely difficult environment of elevated interest rates and tight credit markets.
Inflation and the stock market
Inflation has been a primary concern for investors since early 2022. While the Federal Reserve has made significant progress on the inflation front, inflation remains well above historical norms.
The personal consumption expenditures (PCE) price index increased 3.8% year over year in May, down from 4.3% in April. Core PCE, which excludes volatile food and energy prices and is the Fed’s preferred inflation measure, was up 4.6% in May, surpassing the Fed’s target of 2%.
Fed Chair Jerome Powell has repeatedly pledged to keep interest rates elevated for as long as it takes to get inflation fully under control.
Elevated interest rates and tighter credit markets may affect economic growth in the second half of 2023, says John Lynch, chief investment officer for Comerica Wealth Management. “Falling corporate profits historically have led to reductions in employment and capital expenditures, and we see no reason why this experience should prove any different.”
That said, the S&P 500 could retest its October 2022 lows of around 3,500 before U.S. gross domestic product and corporate profits start to recover in 2024, Lynch adds. “After a bout of further volatility this summer, we look for the S&P 500 Index to be fairly valued near current levels (of around 4,200) by year-end.”
How to navigate the stock market in 2023
Republicans and Democrats reached a compromise on the debt ceiling in June to avoid a potentially disastrous U.S. default. Investors also received some reassurance about the stability of the U.S. banking sector when all 23 large U.S. banks passed the Federal Reserve’s annual stress test.
If the stock market rally continues in the second half of the year, the market may need to find some new leadership.
Adam Turnquist, chief technical strategist for LPL Financial, says the rally in growth stocks so far in 2023 may have been too strong.
“Since 1979, when growth outperformed value in the first half, it historically outperformed again in the second half. However, when the growth-value spread exceeded 5%, as it is now, value modestly outperformed growth in the second half,” Turnquist says.
The U.S. economy is also facing significant risks heading into the back half of the year. The New York Fed’s recession probability model estimates around a 70% chance of a U.S. recession within the next 12 months.
For that reason, investors should remain grounded after such a strong first-half stock market performance and proceed cautiously.
Given the diversion in potential outcomes, a portfolio balanced across the risk spectrum remains the best path forward for most investors, says Chris Fasciano, portfolio manager for Commonwealth Financial Network.
“It’s important to remain focused on the underlying data — not the headlines — and react accordingly to take advantage of potential opportunities that may arise from any increased volatility,” he adds.
Frequently asked questions (FAQs)
The consensus analyst 12-month price target for the S&P 500 is 4,813.70, suggesting roughly 9.5% upside for stocks by July 2024.
But it’s extremely difficult to predict where the stock market is headed in the short and medium term, so more upside for stock prices in the second half of 2023 is not a guarantee.
Based on current analyst price targets, the energy sector has the most potential upside over the next 12 months. Many energy stocks are attractively valued and extremely profitable in the current environment, making them a potentially appealing investment in a slowing economy.
The S&P 500 has delivered extremely consistent returns for long-term investors throughout its history, but the stock market is prone to unpredictable and severe periodic downturns. If your investment time horizon is more than a year or two, history suggests it’s always a good time to invest in a diversified portfolio of attractively valued, high-quality stocks.
