More exciting looking up from below

While we got plenty of calls wrong in 2023, our overall view that the economy by this time last year was already halfway through the post-Covid, asynchronous recession we called a “Rocky Landing” proved prescient. This more optimistic framework for thinking about the very unusual economic and stock environment following the 2020-21 lockdowns led to our early January 2023 decision to return to an overweight in stocks in our balanced portfolios. And as we moved further toward the end of the rocky landing, we ratcheted up that overweight through the year: in May, July and twice in the October sell-off. That last increase—on Oct. 25, highlighted in an earlier commentary, surprised even us by how tightly it called the October bottom. Indeed, by the end of 2023, the unexpected 16% rally—nearly back to the old market highs—blew through our “optimistic” 4,600 year-end target for 2023 and took us only 4% away from our then 5,000 year-end 2024 target. This week’s pullback gives us a little more upside this year, about 10% to our recently revised target of 5,200. Compared to the wild numbers of the last five years (31% in ’19, 18% in ’20, 29% in ’21, -18% in ’22, and 26% in ’23), our outlook for 2024 seems, well, boring.

Having managed through 40-plus years of up, down and all-around markets, I know one thing for sure: the markets are never boring. Even in those years when the macro settles down, there’s often more excitement beneath the surface. We alluded to this several times late last year, most strongly in my “Enter the stock picker” proclamation. The thesis underlying this call, which remains in place as our single biggest piece of advice for investors in 2024, is pretty straightforward: as the scheduled recession that was “postponed” several times last year by the bears never comes (or better, is discovered to have already occurred, but asynchronously), stocks in higher risk sectors—still way off their previous highs even as the Mag 7 dominated S&P 500 Index is not—will have their year in the sun. So, we remain overweight stocks, and, importantly, overweight those areas, sectors and stocks that have been held back by macro worries that should continue to fade in the months ahead: “Value” (dividend payers, financials, health care, utilities), small caps, international and emerging markets.

Let’s unpack all this, highlighting where the consensus has moved our way, and where we are still a bit out on a limb (where I generally prefer to be):

1. Inflation is down but not out. Any market view for 2024 must take a view first and foremost on inflation. Over the last 12 months, the consensus has moved all the way from “runaway inflation” to, now, “back to sub 2% forever.” Our view is more nuanced. We’ve certainly been pleased with the overall decline, and particularly the fall of core PCE, now running just under 3.5%. And the softening of the labor market, or better said, the weakening of its strength, has been welcome as a harbinger of better news. That said, today's jobs number, at 216,000, was in the upper end of the tight range it held within all of 2023. A similar story with this week’s JOLTS data: down from its Covid highs, but at 8.8 million, still way bigger than the continuing claims number of 1.9 million. The post-Covid economy, for a variety of reasons, seems to us to be one that is now structurally short labor. And that probably presages several years of strong labor markets and strong wage gains that, even after productivity improvements, are unlikely to bring inflation to 2%. We’ve got it in the high 2 to 3% this year and next. Probably a little more pessimistic than consensus.
2. The Fed has paused but no way are six cuts coming this year. No way, no how. Given the amplitude of the bond market rally in the fourth quarter, with 10-year yields dropping from near 5% to below 4%, market participants have now run off and assumed nearly six interest rate cuts by the Fed in 2024, from 5.5% to 4.0%. This strikes us as aggressive and out of sync with the Fed’s framework, adopted late in 2021 (we felt then and now, about a year too late), that they have both a demand- and a supply-driven inflation problem: too much post-Covid stimulus running smack against too little post-Covid supply. The Fed confronted similar issues in the 1970s, and importantly, got it wrong, cutting rates too prematurely on three separate occasions, which allowed the inflation monster to re-emerge. We feel certain the Fed is determined not to repeat this mistake, and therefore, especially when the recession the consensus is still in some ways expecting doesn’t happen, is likely to disappoint markets with fewer-than-anticipated rate cuts. And by the way, once it passes on cutting in May, the Fed calendar basically prevents six cuts from happening in 2024; the election cycle precludes a cut in their late July through November meetings (barring a crisis), so that leaves them just April, June, and December, at best. That’s three, probably four, cuts less than hoped for. Oops.
3. The Magnificent Seven may be terrific companies for the long haul, but are at best single-digit return stocks in 2024. The positive fundamentals on most of the Mag 7 are well flagged and, in our view, probably overly discounted into their stock prices at this point. While a few names are “only” sporting mid-20s multiples, others are way beyond that. Of course, high-priced growth stocks rarely decline on valuation; rather, on deteriorating earnings expectations. We don’t envision the latter, given the strength of the economy and of the AI boom. But we do think the Mag 7, on an equal-weighted basis, collectively up 107% last year and now, collectively, 9% above their 2021 market highs, are at best market performers this year. Not bad, not great. Although we do feel even here, stock picking will matter.
4. The recession is behind, not in front of us. I’ve written a lot about this over the last six months, so I’ll try to keep this short. Most of the bearish economic consensus, which still lingers beneath the surface of even recently updated outlooks, have been predicting a systemic pullback in the U.S. economy using econometric models that simply don’t accommodate the weird, dislocated starting place of the post-Covid economy. They also don’t integrate the actions of other players in this multi-dimensional economic chess game, who see the same data and similarly have moved their confident forecast for the “Recession Start” ever forward through last year: from April 17 at 3 p.m., to July 3 at 9:30 a.m., then Oct. 12 at 10:00 a.m., to now a fuzzier “risk” in 2024. (Pardon the sarcasm to make a point.) When all the players in an economy expect and set up for the same thing, guess what: it doesn’t happen. What you get instead is an asynchronous recession as players/sectors adjust and get back onsides. That’s what we’ve just come through. First it was tech in 2021, with many stocks down 40-to-50% as the chip inventory glut was absorbed and discount rates rose abruptly. Then it was housing as mortgage rates soared. Next it was regional banks as several banks went under due to mismatched asset-liability structures and a highly visible forthcoming reset in the commercial real estate market was reserved for. Then industrials, as inventories were brought back in line. Now, in 2024, the good news is most of those adjustments are behind us, and the economy can chug along at its “normal” 2% or so underlying growth rate. Not great news, but a lot better than the market’s pricing of recession sensitive and value stocks is forecasting.
5. Value stocks look very valuable to us. If we’re right about most of the above, the stocks that have been held back most of last year due to recession worries should finally show some life in 2024. This call is staring at us. For starters, the equal weighted S&P, for instance, is only trading at 16.5x 2024 earnings, far more reasonable than the S&P’s Mag 7-driven P/E of 19.5x. The Russell 1000 Value Index, composed of a combination of defensive dividend payors and large cap cyclical stocks, is trading at just 15x earnings and is still nearly 5% off its old 2021 highs; we expect some double-digit gains here in 2024 as earnings get revised higher. The developed markets international index, EAFE, is trading now at just 13.5x 2024 earnings and is almost 10% off its previous highs, with currencies anywhere from another 10 -20% below more “normal” levels. And emerging markets, which of course include Chinese/Hong Kong stocks that have been declared “un-investable” (a bell ringer if I’ve heard one), are trading collectively at under 12x with nearly 20% earnings growth forecasted this year and a full 30% below their 2021 highs.

This is not a broad recommendation to “buy everything.” In fact, what really excites us about the market opportunity in 2024 are the stocks beneath the surface of not just the S&P, but even the value and international indices just mentioned. In fact, it is precisely in those areas, starved of investor capital as everyone moved all their chips onto the Mag 7, that individual bargains are truly to be had: well-diversified, stable market-leading businesses in both the U.S. and abroad that have simply been ignored as the market tides went all in one direction. Whether it be in financials, health care, even tech, utilities, Japan, emerging markets, in meeting after meeting with my investment teams, I’ve rarely seen this many good ideas coming to the surface. We’ll see. I’ve been surprised before. But right now, I’m feeling pretty good about what’s in store for old-fashioned stock picking in 2024. Lots of excitement looking up from below.