Stocks offered cold comfort to investors last year, but equity markets have begun to thaw as inflation pressures slowly subside and the Fed inches closer to the end of its rate-hiking cycle.

The S&P 500 gained 7% in the first quarter and finished higher in March despite some panic about regional banks. That resilience was a positive sign for the overall health and direction of the market. Concern still outweighs confidence in the latest surveys of investor sentiment, and anyone looking for an excuse to sell certainly found one with the recent bank failures.

Nevertheless, stocks persisted. The Nasdaq especially has flipped the script year-to-date, increasing 16.8% through the first three months of 2023 (after losing 33% last year). The Russell 1000 Growth index gained 14% in Q1. The Russell 1000 Value, meanwhile, was flat. Some of the Growth-Value performance gap can be attributed to the most battered stocks bouncing higher off their lows, but it also suggests financial conditions will get better in the year ahead despite the strong likelihood that a recession is looming.

First-quarter earnings, which began last week, will offer a glimpse of whether such optimism is justified.

By one measurement, expectations seem modest. Consensus forecasts suggest S&P 500 earnings will decrease 7% from a year earlier. That would be the largest year-over-year decline since Q2 2020, in the immediate aftermath of a COVID-triggered economic shutdown.

But if earnings are declining while stock prices are going up, that means equities are trading at higher valuations. A glance at the Price-to-Earnings ratio confirms this. The forward 12-month P/E for the S&P 500 sits around 18. That’s nearly 20% higher than the P/E during the market lows last October (15.4).

Earnings in the financial sector will be highly scrutinized in the wake of high-profile bankruptcies, though it’s probably too early to quantify any longer-term fallout. The fact that 7 of 11 equity sectors finished positive in March suggests we avoided widespread contagion, but it’s too soon to declare an official “all clear.” There will be some aftershocks.

Something else to be mindful of is the market’s conviction that Fed policy will ease significantly in the next 18 months. Fed Funds futures suggests the benchmark interest rate is near its peak and that the Fed will cut rates by 100 basis points (think: 0.25% x 4) by April 2024 and 200 basis points by October 2024. Markets, in other words, are pricing in the effects of a much more friendly Fed. This could prove correct, but if the Fed only hits pause and ignores the rewind button, equity prices would need to recalibrate.

Seasonality, for what it’s worth, is favorable. Since 1950, April is the second-best performing month for US stocks (only November is better). In 17 of the last 18 pre-election years, equities have been positive in April (1987 being the only outlier).

Still, this is an uncertain economic environment that warrants a more cautious approach. Be mindful of your target allocation and rebalance if the year-to-date rally has left you overweight equities. Avoid chasing returns. Our hunch is that the gap between Growth and Value is likely to narrow.

Positive stock returns are something to be thankful for, but in this case, it also raises the bar. If economic data weakens and corporate earnings fall more than expected, stocks will likely give up some of their recent gains.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.