'Goldilocks' is a bit generous

Our call to get back to overweight stocks in early January certainly paid off quicker and bigger than we remotely imagined, but we’ll take it. Our concern is that from here the market is probably set up for some disappointments, particularly among the growth names that actually led the market last month even as earnings among these names had their second big leg down. Investors are hoping this is the last such earnings down leg; we doubt it. At the same time, they’re hoping the Fed will be cutting rates later this year; we doubt that too. And after last week’s jobs report, some are even thinking “Goldilocks,’’ with job growth soaring at its fastest rate since last summer even as wage growth moderated to its slowest pace since August 2021. That would be wonderful, for sure, though again, unlikely. As noted below, there are reasons to be cautious about the data and the message it sends to the Fed.

Indeed, even though we shifted early this year from “cautious” to “cautiously constructive,” adding back to stocks for the first time in 18 months, we continue to expect market volatility ahead as news flow on earnings, inflation, the economy and Fed bounces from bullish to bearish and back again. We are advising clients to buy dips, not sell rallies, with the S&P 500 likely to trade in a broad range between 3,600 on the downside and 4,400 on the upside. We expect better times in 2024, the key factor in our upside range, and in our model portfolios, we remain overweight defensive value names and international stocks and underweight growth stocks. We definitely are not buying the rally in tech.

Here are the factors driving our thinking:

• The good news is the economy is holding up, though slowing. While the manufacturing ISM is teetering on recession territory, the services ISM is still surprisingly strong. The latter could bounce further with China’s reopening. Despite all the layoff announcements, somehow the jobs numbers are holding up and wage growth remains solid if less inflationary, though I’d warn that January’s good readings need to be taken with a grain of salt given the notoriously high level of seasonal adjustments in them. Still, with wages rising 4%+ on average and unemployment at generational lows, the U.S. consumer remains buoyant. It’s hard to have a full-blown recession with the consumer spending money.
• The bad news is with labor supply still tight, core inflation is likely to remain above the Fed’s targets. The catch-22 here is that the core inflation problems the Fed is grappling with are supply side driven, and while China’s reopening is helping cure goods supply bottlenecks, labor supply remains tight and job openings are running nearly double the supply of people seeking work. If there is an offset, it’s that the bulk of openings tend to be in lower-wage service areas, though those also represent some areas where wages have been climbing the fastest. So, the underlying labor dynamic that has kept the Fed hawkish has not changed dramatically. This makes it unlikely that rate cuts are coming soon, even if the Fed pauses after two more hikes.
• We think markets are vulnerable near term to continued hawkish Fed speak, particularly if they remain too buoyant for the Fed’s comfort. The Fed is still playing from 1970s’ playbook when similar supply-side problems kept inflation too high. And with no help on supply-side solutions coming from the Biden administration, the Fed will have to keep monetary conditions tight, and not give in to the expectations of an early start to the rate-cutting cycle. Ironically, the more markets go up, fueling everyone’s animal spirits, the more hawkish the Fed is going to have be.
• In the meantime, earnings and valuations still have a ways to drop before they bottom. Earnings have been falling, not rising, and S&P earnings ex-energy this earnings season are so far down about 6%. Some of the weakness has come in consumer staples companies and retail, reflecting a near-term margin squeeze that will stabilize as inflation slows. Most of the weakness though is coming from the big tech and communication services names that are still learning just how much business they pulled forward from the future in the Covid boom. We think there’s lots more disappointment ahead here and that’s the key area that has kept our full-year 2023 forecast for EPS at $200, still way under the Street’s $230. We also think growth stock P/E valuations, now hovering in the mid-20s, are way too high for growth rates that are likely to be significantly lower than the hyper growth many of these stocks experienced in the run up to and through Covid.

All this leaves us continuing to favor defensive dividend-paying stocks and international stocks, within an overall balanced portfolio that is modestly overweight equities with room to get more aggressive if and when better buying opportunities materialize. The big dividend payers in telecommunications, consumer staples, health care and energy appear to be navigating the economy’s rocky landing, and their dividend streams look pretty safe. With overall market returns this year and next likely to be in the single digits, many of these stocks look like winners to us, especially given their relatively low valuations. We also have begun edging into international stocks, especially in Europe and Japan, where valuations are very cheap and economic/earnings growth is picking up. Emerging-market opportunities look better, too, lifted by China and a weaker dollar.

We like the “Goldilocks” story as much as the next person. But we know it’s hard to get things “just right” in the midst of a rocky landing.