Settling into a world of single-digit returns

Since our last Market Memo, the market has been churning away through the late summer thunderclouds we anticipated in “Every cloud has a silver lining.” These included continued weak China news, hawkish jawboning by Fed Chair Powell at Jackson Hole, earnings from Magnificent Seven leader Nvidia that were great but already discounted, and rising concerns about potential consumer stress ahead due to student loan repayments, declining savings and the squeeze from still high inflation numbers. As we suggested then, the offsetting silver linings seem to have been just enough to keep the bulls on their feet and struggling forward: China keeps dribbling out moderately helpful doses of stimulus measures, a softening labor market and China deflation are keeping inflation expectations moderate, and back-to school-spending is coming in as modestly positive (even if below last year’s heady growth). Even Wednesday’s much-anticipated CPI print, while slightly worse than expected, confirmed that inflation remains below year-ago levels and seems to be stabilizing, albeit perhaps a bit higher than where the Fed ideally would like to be in the long term. Same for today’s PPI. Net, net, the S&P 500 is up 2% or so since the dog days of mid-August—nothing to necessarily cheer about but at least stable.

Our advice to investors: get used to it. Now that macro concerns about the Fed, inflation, recession and China are fading, and valuations have risen in advance of an expected better, more “normal” year in 2024, we’re going to have to make money the old-fashioned way: grinding it out in earnings, along with the buybacks and dividend payments that derive therefrom. In this more muted return world of mid to high single-digit returns ahead, we’d point to five investment themes currently driving our portfolios:

1. Remain tilted towards stocks and look for dips to add further. Our first, most important piece of advice is to stay long this market, especially into year-end. We are now in the final phases of a bear market that began at the very end of 2021. As bear markets go, it’s been relatively average, lasting nearly two years, dropping 22% at its worst and now still 6% off the old highs. We expect to finally break through to new highs sometime in the fourth quarter, with a year-end price target on the S&P of 5,000. Earnings, which bottomed last quarter, are now likely to inflect higher in the coming earnings season, largely because most companies have slimmed down in expectation of a recession that isn’t coming. With nominal revenues reaching new highs on the back of nominal GDP that is expected to finish this year 25% ahead of 2019’s nominal levels, earnings from here on out should be broadly positive for markets. Stay focused on this prize, even as day-to-day economic news will surely keep bouncing around.
2. Look for the market to broaden beyond the Magnificent Seven. Many more bearish market strategists like to point to the 20.6x cap-weighted P/E of the S&P as a sign of how overvalued stocks are. While we agree that the mega caps may have gotten a little ahead of themselves for sure (that is one area of the market we remain underweighted, by the way), the broader market in our view is not expensive at 15.3x on equal-weighted earnings, and even cheap against our $250 earnings projection for 2024. One reason for our relative optimism, for sure, is the sheer number of stocks across multiple sectors and industries whose fundamentals look solid to us and whose valuations seem quite manageable. As earnings and economic data roll in over the fourth quarter, and as the fears we’ve cited around inflation, the Fed and recession all abate, these smaller and mid-cap stocks should finally escape purgatory and start performing. We’re comforted that we’ve already begun to see this over the last several weeks.
3. Stocks priced for a recession that doesn’t come should play catch-up from here. Areas of the market that seem most poised for a catch-up trade into year-end are those held back by recession fears; that’s where unexpected earnings pops are most likely and where valuations are most discounted. These more cyclical names typically reside in the Value indexes and is a key reason we are overweight these areas. Think Energy, Financials and Industrials, in particular.
4. Self-help stories help, and dividends and buybacks are likely to provide a higher share of total returns ahead. Another theme we like, for a world of lower returns, are companies that can generate returns to shareholders through “self-help:” cost-cutting/restructuring programs, dividends and share buybacks. These types of stocks, again, tend to find themselves in the Value indexes and this is an area, we think, where stock picking can be particularly helpful. Overall, Value stocks have lagged growth stocks this year by 25%, and small caps have lagged by nearly as much. We think these areas of the market, assuming we’re right that the economy, inflation and the Fed are stabilizing, are where stock picking should add the most value.
5. True high-growth companies will be in short supply and therefore valued. Another reason for cautious optimism, I’d add, is that the “other side” of the market, the high-growth stocks, should themselves do pretty well in the months ahead. Small-cap growth stocks, for instance, where a lot of very attractive biotech names, SaaS companies and suppliers to the better-known mega-cap tech leaders, are still down 30% from their 2021 market peaks and have a lot of catching up still to do. The IPO market is reviving, as evidenced by three high-profile IPOs just this week. And with two years of high revenue growth behind them since 2021, valuations are a lot more interesting. Further, though we expect mega-cap growers to bide time in the months ahead as earnings catch up to valuations, the reality is that their fundamentals in general are strong and quite sustainable. So, while we don’t expect another 30% run in the stocks in the year ahead, they should at least keep up with or exceed a market sporting the kinds of high single-digit returns we envision.

Many investors, having survived the Rocky Landing of the last 21 months, can be forgiven for having a case of the jitters at this point. And for that matter, so also should strategists be forgiven who remain focused on the macro drivers that have until now called nearly every bump and bounce of the last two years. To both camps, we’d say, stay focused on the prize. The months ahead should see a broad normalization following the wild years of Covid lockdowns, post-Covid re-openings and post-reopening policy shifts. Equity returns are likely to be more normal, perhaps even boring. Time to roll up your shirt sleeves and pick stocks. They should grind higher from here.