Getting less lonely up here

Long-time readers of this space know that I’m a contrarian at heart and prefer adding to stocks on big pullbacks, rather than on upward price momentum. And I get nervous for sure when too many people agree with me. So when we added to stocks in last summer’s swoon and again in the more recent October correction, I was comfortable. As I was later in Q4 when we initiated our 5,200 year-end S&P target for 2024 and when we introduced a 6,000 target for 2025, announcing our view that the secular bull market was back in charge. 

Since then, the economic, earnings, inflation and Fed news have all played into our hand: the economic expansion out of the asynchronous recession/Rocky Landing of 2022-23 has forged ahead; earnings have bottomed and inverted higher; inflation has come off of last year’s high levels while remaining somewhat “stickily” above the Fed’s official target; and the Fed has continued to signal nonetheless that their next move will be to cut rates. All of this is pretty good news, maybe even “Goldilocks Plus” kind of news. On the face of it, many of the market skeptics have folded their tents and caved into the rally. Almost daily now another Wall Street house, formally bearish, has turned bullish on stocks. Cash on the sidelines has begun to come in. Momentum has picked up. The number of stocks making new highs is soaring. And as the quarter draws to a close, the S&P 500 is closing in on a 10% gain for the year—just breaching our formerly “bullish” year-end target of 5,200. Gulp.

What now?

After my return from London this weekend, our global macro team at Federated Hermes held an all-hands meeting to review our outlook and positioning. A healthy discussion that covered analysis on the gamut of possibilities led to the simplest of conclusions: we’re going to hold where we are and do nothing. We are sticking with our equity overweight call and zeroing in on stocks in the broader market outside the Magnificent Seven. Although aware that a correction could come from some unforeseen event, we’d rather add to equities again if a pullback comes than sell now and hope for one. In bull markets, you buy dips rather than sell rallies. So we’re holding tight.

Here's some more detail on what we’re thinking.

1. The fundamental backdrop looks very solid. Owners of stocks, over the long run, effectively own a share of the global economy, which in nominal terms expands over time, driven by population growth, productivity gains, capital investments, and trade. The U.S. economy, for all the worries, problems and misguided government policies it’s had to deal with, has now come through an 18-month asynchronous recession and is firing on multiple—if not all—cylinders. By the end of next year, in nominal terms, the U.S. economy is poised to reach a level almost 40% higher than it was in 2019 before it skidded into the temporary brick wall of Covid. Most of the data we’ve seen over the last few months suggest that recovery is solidly on course. Last week, the index of leading economic indicators, which had been running negative for 22 straight months during the Rocky Landing, finally turned upward, presaging better times ahead. The labor markets, absorbing rolling layoffs one sector at a time for nearly two years now, once again somehow punched up another strong result, with initial claims last week surprisingly low at 210,000. Regional manufacturing indices as well as the broader manufacturing PMI, are turning higher. Today’s durable goods number for February surprised to the upside. And while lower-end consumers are struggling with higher prices, consumption remains solid overall, driven by rising employment, wages and the wealth effect from the markets. Although we expect this quarter’s GDP growth to come off Q4’s blistering pace, it nevertheless looks likely to come in at about 5% in nominal terms. In short, a pretty solid backdrop for stocks.
2. Not surprisingly, earnings growth looks to accelerate and broaden out in the back half of 2024. The solid economic news, importantly, is translating into solid earnings news for stocks. The recently completed Q4 earnings season punched up solid year-over-year growth of 7.9 % for the S&P, well ahead of the consensus forecast of 1.6% and closer to our more optimistic outlook. Importantly, Street analysts coming out of earnings season have been upgrading their 2024 outlooks, which now stand at $243 for the S&P, a 6% gain (PS, we’re at $250). And while communication services and tech stocks have led the earnings charge higher until now, by the back half of this year sectors such as health care, financials, and materials (i.e., the Value trade), small caps, and international stocks look set to join the growth party. That bodes well for our equity overweights in those areas.
3. The Fed policy bias has shifted from “Avoid being Arthur Burns” to “Out-do Alan Greenspan.” I must admit that while watching Chair Powell’s presser last week from London even I was surprised by his relative dovishness, despite inflation coming in stickier than he’d previously predicted. While down from the market’s expectation of six cuts in January, the Fed still has three rate cuts on the table for this year. As we said then and say now, “No way, no how.” With the economic data so solid, labor so tight, and inflation so sticky, we’re still of the view that the Fed only cuts once or twice in 2024. But frankly, this could be enough for markets, given how strong the broader fundamentals are. My biggest takeaway from the Chair’s performance last week was that the framework for forecasting his next move, which till now has been “Don’t repeat the premature easing mistakes of Arthur Burns,” has shifted. He’s now trying to stick the landing and “Out-do Alan Greenspan.” If that’s right, it means he’s going to be pretty forgiving on near-term inflation data, as long as it remains on a long-term trend line towards the 2.5% to 3% range. If he can pull this off, he'll not only avoid being the goat, but perhaps become the G.O.A.T. We’ll see. In the meantime, Powell’s reluctance to squash the rally in stocks or in the economy puts us on a Goldilocks Plus direction of travel.
4. Politics is likely to grow more favorable as the year progresses. Many bears are hanging onto the hope that, somehow, the election season comes into play and gives them the market volatility they’ve been wrongly forecasting. My advice: don’t hold your breath. If polls continue in the current direction, and President Trump wins a second term, remember that in so doing the majority of the country, and presumably of investors, are going to convince themselves that he won’t be the coming of the apocalypse that some fear. Instead, markets will probably begin to focus on his likely supply-side policy framework: less growth-choking regulation, extension of the growth-oriented 2017 tax reforms, and more-controlled border policies. And if on the other hand the Democrats make a comeback either with President Biden or a substitute, stocks are likely to enjoy a honeymoon anyway on the grounds of “policy stability.” Either way, as we’ve said before, this election is extremely unusual: one incumbent battling another; not a lot of surprises; and whoever wins will by definition have a majority of investors on his side.
5. The broader market is still reasonably priced. Given this very positive outlook, it’s not surprising that stocks are no longer cheap. The S&P now stands at 21x our optimistic 2024 earnings number, not cheap given where rates are but perhaps fair given where they’re likely heading. More importantly, though, once you take out the effect of the high-growth Magnificent Seven stocks, the broader market is trading at a less-expensive 19x this year and 17x next year’s multiple. And some segments, ripe for stock picking, are even cheaper: the Russell 1000 Value, for instance, trades at just 16x 2024 earnings, and the international EAFE index of developed-market countries such as Japan, Germany and the UK, is trading at just 14x. 

So, as uncomfortable as we are when the consensus has moved our way, for now at least, we’re holding to our bullish overweight call on stocks. Both near- and longer-term fundamentals are solid, the Fed is supportive, and at the margin, even the political backdrop could improve from here. For all this, valuations, though no longer “cheap,” are still reasonable, and those on the alternative long-term asset, bonds, are less so.  Most importantly, outside the Magnificent Seven stocks that have led the charge higher, many pockets within the broader market remain attractively priced and are set to see improving earnings growth in the back half of 2024 and into 2025. It is precisely those pockets—value, cyclicals, small caps, emerging markets and EAFE—where we are overweight and where our teams of stock pickers are most active. Finally, even as the consensus has begun to break in our direction, there remains a mountain of cash on the sidelines, held by investors too skittish at the lows and now left watching, almost frozen, at the new highs. It’s getting less lonely up here, for sure. But as the secular bull roars on, the market is still far from over-crowded.