• First, in December we became concerned about the possibility of a near-term pullback in the US equity market given deterioration in our sentiment work, and that remains the case today.
nd recently revised up our YE:
• Third, we see a mix of tailwinds and headwinds for US equities in the year ahead. Tailwinds include valuations that can stay higher than many investors realize. Headwinds include highly bullish sentiment, expectations for a sluggish economy, and uncertainty around the 2024 Presidential election.
• Fourth, we continue to see a number of problems for the Large Cap Growth trade and we give an edge to Value and Small Caps in the year ahead. But for a rotation into Value and Small Caps to be sustainable, US economic expectations need to improve.
If you’ve got a minute to spare on each of the top 10 things we’re thinking about, here’s another 10 minutes in total. A little longer than usual for the podcast, but it took a break for the holidays and we think it’s worth the wait.
month view, with a revised YE:
• When we introduced our 5,000 target back in mid November, it represented a gain of roughly 10% from levels in place at that time. Today, our 5,150 price target represents a gain of 8% vs. the index’s December 2023 close, making it fair to say our enthusiasm has actually come down a bit.
• Our new 5,150 target (our base case) is the average of five different models based on sentiment, our valuation and earnings forecasts, the economy, politics, and the cross-asset dynamic between stocks and bonds. The output ranges from 4,800 (our bear case) to 5,400 (our bull case).
at the end of:
Moving on to #2: The sentiment set up for the stock market has deteriorated and we are concerned about a near-term pull-back.
• The weekly AAII investor sentiment survey has been one of the best stars in the sky to navigate the US equity market with over the past year and a half. It’s also been oscillating quickly.
r hitting GFC lows in October:
• At current levels, this model is telling us to look for a flat S&P 500 over the next three months, and a gain of 6.4% over the next 12 months. It is possible net bulls will creep higher to the two standard deviation mark, which has happened several times throughout history. But we think it’s more than fair to say that the odds of near-term pullback have grown.
Next, #3: Valuations can stay higher than many investors realize.
in:
• That model had been calling for a YE 2023 trailing P/E in the S&P 500 of around 21-22x throughout the 2nd half of 2023 and a YE price level for the S&P 500 of 4,700-4,800 when used in tandem with our 2023 S&P 500 EPS forecasts.
ling for a trailing P/E at YE:
Moving on to #4: Our earnings outlook is good enough to justify another year of gains, but also restrains our enthusiasm.
• We’ve refreshed our S&P 500 EPS model, which is based on an income statement for the S&P 500. We model revenue growth, operating margins, and interest expense, using consensus forecasts for key economic variables, and make assumptions on buybacks and tax.
for:
• We’re not too worked up about this regarding the 2024 outlook for stock market pricing however. Many investors we’ve spoken with recently are bracing for disappointments on margins in particular, our below consensus numbers still anticipate the end of the earnings recession in the S&P 500, stocks have been moving ahead of earnings trends – telling us that ultimately 2025 expectations will drive 2024 price action, and it’s not usual for consensus estimates to start out too high.
Next, #5: The greater appeal of bonds seems like a dampener of US equity returns, but not necessarily a derailer of them.
• A fair amount of time in our December meetings was spent discussing the signal from our earnings yield gap model, which compares the earnings yield of the S&P 500 (based on a bottom-up consensus forward P/E) to the 10-year Treasury yield. The two have been close to parity in recent months, a departure from conditions of the post Tech bubble era in which the earnings yield has been dramatically higher than the 10-year Treasury yield. This analysis suggests US equities have lost their appeal relative to bonds, a data point cited often and loudly by many bears.
nting out that throughout the:
: We see the:
• On average, the S&P 500 rises by about 7.5% in Presidential election years, below trend and less than what we typically see in the 3rd year of the Presidential cycle. This stat tells us that any given Presidential election year is a source of uncertainty for the US equity market. Given all of the unusual aspects of the 2024 contest, that seems like an appropriate way to think about the political backdrop for stocks in the year ahead.
• Beyond the tendency of the stock market to be weaker in Presidential election years, we’ve been emphasizing to investors that the stock market usually has a weak start in presidential election years, with a rally into the fall, choppiness as election day draws near, and a post election rally.
• The circumstances surrounding this election are highly unusual. Biden is hurting in the polls form an inflation spike that felt as bad as a recession and disapproval over his handling of geopolitical events. Yet, it remains unclear how the fight over reproductive rights and Trump’s legal battles will impact turnout. We think it will be particularly difficult for Wall Street to anticipate an outcome this year.
that many investors expect in:
• One model that we use to formulate our target is a simple one that looks at how the S&P 500 tends to perform in different real GDP ranges. Current consensus projections as tracked by Bloomberg call for 2023 GDP to come in at 2.4%, but for growth to slow to 1.3% in 2024 and to stay below trend in 2025 at 1.7%.
• Historically, in the 0-2% range, the S&P 500 tends to be weak, with declines in the mid single digit range on an average basis and flat on a median basis.
n, and we’ve seen full year:
Moving on to #8: The new rules of thumb for the post COVID era are still emerging.
post COVID era of investing.:
• In this context, the fact that 2023-2025 GDP forecasts are still tracking at levels similar to the post GFC period, the worst decade in modern history for GDP growth, has made us, as well as many clients we’ve spoken with, wonder if economists are too pessimistic on the economic growth outlook.
Next, #9: Growth still looks ripe for (further) tactical correction, but economic forecasts need to improve for a lasting shift into Value.
ioning has stalled around pre-:
• We also think the Growth trade benefited in the fall from renewed fears of Fed hikes and rising 10 year yields, since the biggest names in the US equity market, which are mostly Growth stocks, have much cleaner balance sheets than the rest of the S&P 500. Those fears are no longer in place, allowing some initial rotation away from mega cap Growth stocks to occur.
• What’s next? We think economic expectations need to improve to sustain a leadership shift away from mega cap Growth stocks. Growth typically outperform Value when real GDP is trending below 2.6%, it’s long-term average. Value tends to work when real GDP is trending above that level.
Wrapping up with #10: We continue to see opportunity in Small Caps.
C positioning data on Russell:
• Most of those observations remain true today. One exception is that Small Caps no longer look oversold. On CFTC’s data, buyside positioning rose sharply in the final months of 2023 and has returned to its late 2020-2021 highs, though it remains well below its 2016-early 2020 highs.
•
ption is that the P/E of the R:
• That being said, we confess we’re worried about how much investors wanted to talk about Small Caps over the past month or so. In December it felt like everyone we met with (including the many varieties of investors who are not focused on Small Cap investing) wanted to talk about Small Caps and was constructive on them. We suspect Small Caps have become a much bigger consensus call than the positioning data reveals.
That’s all for now. Thanks for listening. And be sure to reach out to your RBC representative with any questions.
