For those who were forecasting a soft landing for the US economy at the depths of the bear market in the fall of 2022, as well as the beginning of a new bull market, I think surpassing 5,000 for the S&P 500 on Friday served as vindication at last! What was a very, very small minority view has grown to be the consensus 18 months later with nearly every bear on Wall Street capitulating. Everyone is on board, and valuations for the major market indexes are fully reflecting the good news. Ironically, that creates a whole new problem for the bulls, which is that everyone is finally on board. The easy money has been made in the indexes. Converting all those investors who were hanging on to the bearish narrative of an impending recession and return to the bear-market lows is how we realized an approximate 40% gain in the S&P 500 since October 2022. The indexes are arguably at fair value, which means that market fundamentals will have to do the heavy lifting from here on out. For now, that doesn’t look to be a problem.
The percentage of companies in the S&P 500 outperforming fourth-quarter estimates so far is now above its 10-year average. We are also on track to see earnings grow on an annual basis for the second quarter in a row with sequential improvement, which is a positive rate of change. Still, the index now trades at a forward price-to-earnings ratio of 20.3, which is up from its year end multiple of 19.5. Both are above their 5- and 10-year averages. The consensus expects earnings to grow 4% in the first quarter and 10.9% for the calendar year. We will need to realize those numbers to validate current levels.
Earnings growth is dependent on economic growth. On that front, the expansion looks to be on a solid ground. I shared the chart below with readers more than a year ago to make my case for a soft landing, and these statistics are even more important today. There have been countless calls for the death of the consumer over the past two years, burdened by higher borrowing costs and growing mountains of debt. To the contrary, the most important metric is not the amount of debt but the consumer’s ability to service it. The percentage of disposable income required to service outstanding household debt remains at multi-decade lows. Furthermore, the rise in mortgage delinquencies that we would expect to see as the expansion ages also remains near historically low levels. Combine these factors with full employment and real wage growth, and the expansion still looks promising for the year ahead.
My primary concern remains the Fed’s timing of normalizing policy to what it considers to be a neutral rate, which members have said is 3-3.5%, by relying on lagging indicators to decide when to make the first cut. The impact of its final rate increases in 2023 are still working their way through the economy, like brakes that are being tapped on a car, slowing the rate of growth as the expansion matures. Moving from a restrictive policy in advance of achieving its annualized 2% inflation goal is imperative if we want to achieve a soft landing in 2024. Last week’s annual revisions to inflation data showed no surprises, confirming that we are on track for the Fed’s target during the second half of the year.
While my call for new all-time highs for the market during the first half of this year looks prescient, the way I suggested we would get there has not. The improvement in breadth that typified the rally during November and December has given way over the past six weeks to a renewed narrowing in performance, whereby the largest technology-related names are fueling all the gains. The equally weighted S&P 500 and Russell 2000 small cap index are flat on the year, leaving well diversified stock portfolios with not much to celebrate yet. This is an atypical post-pandemic phenomenon.
It is being perpetuated and fueled by passive index investing, which invests more and more money in the largest companies as they continue to become larger and larger percentages of the index. The top ten names now account for 35% of the index.
Another example of how concentrated performance stands and how dominant a few names have become in the indexes is Nvidia. Granted, this chip company is one of the prime beneficiaries of the artificial intelligence boom, but its market cap is greater than that of the entire Chinese stock market. It is also larger than all the companies that comprise the energy sector of the S&P 500, despite having a fraction of the net income.
Typically, when a stock becomes one of the largest in the index, it is a function of its value fully reflecting the improvement in fundamentals from the year before. This is why, as GMO demonstrates in the chart below, buying the largest stocks has a horrible track record in the year that follows.
That has not been the case over the past year, much less the past four, defining the post-pandemic period, which has given birth to what is now called the Magnificent 7. This is why they are so magnificent today. I can’t argue with how magnificent the performance of these companies has been since 2020. Yet it gives me a scary déjà vu back to the late 1990s, as well as any other point since when a group or type of securities have been viewed as impenetrable. Certainly, passive investing is fueling this phenomenon to an unprecedented degree, largely because it never had the influence it has today.
The success of these companies is currently the greatest risk for index investors. So long as it perpetuates, everything is fine. When the cycle inevitably ends, because it always ends for some reason, the drawdown should be substantial. When that happens is anyone’s guess. It could be six months from now or six years from now. Until then, party on. I see more value and less risk when searching among the remaining 493 stocks that make up the index, as well as names in the Russell 2000. I still think we need to see breadth improve and the less magnificent play catch up in terms of performance to see the next leg up in this bull market. It may take the beginning of the rate-cut cycle to ignite it.
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