Back to the grind

As we grapple forward through the end of Q3 earnings season, we expect markets likely to grind higher into year-end and through 2024. We remain tilted towards value stocks and underweight growth stocks and have been using big pullbacks such as two weeks ago to add to equity exposure. We also shifted to neutral in cash during the October pullback, ending nearly two years of overweight exposure to an easy-to-deploy asset class that also offered value in this higher-rate, challenging environment. We think forward returns on the overall market likely will be in the single digits, making stock picking more critical to stock returns. Here are five reasons behind our thinking:

1. Q3 earnings season was mixed among stocks/names but overall earnings inflected higher this quarter for the first time in a year, as we expected. We anticipate quarterly numbers will continue to move higher, with an EPS estimate of $250 on the S&P 500 for 2024. (Some of this is coming from inflation, not real growth, but that’s partly why we own stocks; other assets such as bonds or cash have fixed returns that don’t inflect higher with inflation.) The best results seem to be coming within sectors, rather than across, which is why we think stock picking is going to be increasingly important. Consumer-facing companies with pricing power are doing fine; others that are more reliant on lower-income consumers who are badly stretched are doing poorly. Larger banks are doing better than the regional banks, and within the larger banks, some are doing better than others. Ditto among the Magnificent Seven: Tesla and Apple are struggling to grow as fast as expected, while Microsoft and Google still look formidable. Biotech stocks may be nearing the end of their recession, but again only for the winners … and so it goes. It’s all about stock selection.
2. The economy continues to soften but is unlikely to break. October’s jobs numbers inflected lower, though we saw strength in government and services, and the UAW strike probably was a temporary negative. The manufacturing ISM is in recession territory and has been for almost a year. Despite all the union strike headlines, overall wage growth across what remains a predominately non-union economy has long since peaked and is heading lower. Jobs also are shifting more toward part-time, less full time. But several big sectors already had a kind of recession: the chip industry, most manufacturers, housing, regional banks, investment banking, and as mentioned, biotech. Inventories have corrected back to normal levels. With the banking industry on high alert for almost a year, reserves against unexpected losses are now substantial. So, in our view, a “big R” recessionary pullback is unlikely going forward. And that might be good enough for a little earnings growth.
3. The Fed is done but unlikely to cut. We’ve been saying this for a while but let me reiterate: the Fed is done. Most of the economic numbers cited above suggest the economy already is softening, and inflation is grinding slowly toward what we see as its unofficial target of 3%. Chair Powell et al won’t announce this, lest the bond market rally further and steal defeat from the jaws of victory. On the other hand, with the labor market structurally tight, ongoing wars in Europe and the Middle East, more Federal largesse still filtering into the bloated demand side of the economy, and the Fed worried that it might end up replaying the 1970s’ Fed mess, we disagree with consensus on any Fed cuts next year. Maybe a cut or two in late ’24 or early ’25, simply because inflation grinds below 3% eventually, but nothing more. The Fed is broadly neutral at this point for markets.
4. Valuations on stocks are mixed, but reasonable overall. Assuming we’re right about 2024 earnings, the S&P today is trading at an 18x multiple, broadly in line with inflationary environments in the 2% to 3% range where we believe we are heading. The equal-weighted S&P, which includes the bulk of stocks, is even cheaper at a 14x P/E. Within the value indexes where we have overweight exposure in our models, plenty of stocks are priced at very low double-digit or even single-digit multiples for the “Big R” recession that is unlikely to come. Ditto for small caps. We are also overweight small-cap growth stocks, where some of the most innovative American companies trade and where we think an index 35% off its highs is poised to finally recover from its triple bottom in the “less worse” world we envision ahead.
5. The 2024 election cycle might help. As we enter 2024, with President Biden down in the polls, the executive branch will be doing everything it can to stimulate the markets and economy (e.g., Secretary Yellen’s announcement last week on the Treasury refunding schedule). And as we approach the election, if the polls hold up, the market could begin to try to discount the impact of more supply-side driven reforms that would reignite growth, similar to the Trump presidency. A key economic drag that not enough people are talking about in my view has been the impact of new levels of regulatory strangulation across much of the economy, which mostly hurts small businesses. Overlay on this the potential sunset in 2025 of the Trump-era tax reforms, which stimulated the small business sector, and the 2024 election could be pretty important for markets. It’s still way too early to begin to discount but this could become a driver once the primary elections start.