It goes without saying, 2023 was an interesting year. Whether it was the Magnificent Seven stocks propping up the stock market, the Fed’s relentless interest rate hikes, consumer debt hitting all-time highs, Middle East unrest, or the threat of a recession looming in the background – there was always something to watch. As 2023 came to a close the equity markets reached stretched valuations last seen right before the COVID crash, as measured by the Shiller P/E ratio for the S&P 500.
Now, I am not a perpetual naysayer nor am I someone who views a glass as half empty. In fact, I prefer to have an optimistic outlook. However, as the US equity markets continue their upward climb it feels like we are reaching nosebleed territory. For example, “analysts expect the S&P 500 to report double-digit earnings growth in CY 2024. The estimated (year-over-year) earnings growth rate for CY 2024 is 11.8%, which is above the trailing 10-year average (annual) earnings growth rate of 8.4% (2013 – 2022).” Yet when you compare projected earnings growth to the projected corresponding revenue growth of 5.5%, I am left to believe corporate earnings can only outpace revenue growth under two scenarios: Share Buybacks and Cost Cutting.
So what is a share buyback? Companies use cash they have on their balance sheet to purchase their stock on the open market, or they retire Treasury stock held on the balance sheets. As an example, General Motors announced a $10 billion share buyback at the end of November 2023; although they purchased shares and retired some outstanding shares to reach their $10 billion goal. For a company worth approximately $40 billion dollars prior to the announcement their buyback program was quite significant. I’d imagine the UAW was not happy about that!
On the other hand, with cost cutting a company can “cut the fat” by eliminating inefficiencies, but only up to a point. Once operational efficiencies are brought in line the next large line item companies tend to focus on is labor.
In my opinion, for analyst projections to be right labor expenses will need to decline which means the unemployment rate will inevitably increase. As noted in a previous market update email, based on 30 years of historical data, the Federal Reserve can afford to let the unemployment rate float up to 5.5% in order to help slow further growth in the US economy. The hiccup becomes the pace at which the unemployment rate increases will be dependent on how fast the economy deteriorates. If consumers continue to spend on credit, as they have done for the past few years, consumer spending could prop up corporate earnings – which in turn props up the US economy. However, considering the rate at which consumers are increasing their consumer debt, the interest they are paying on their consumer debt, and the fact that consumer loan delinquency (and charge-off) rates for banks outside the top 100 are reaching levels not seen since the COVID crash and the wake of the Great Financial Crisis – I am left to believe the US economy is on a knife’s edge.
If US corporate earnings grow 11.8% in 2024 then a fair S&P 500 valuation could range between 4,452 to 5,100 based on a 10 year average S&P 500 earnings multiple range of 17.7x to 20x; although this assumes 2024 skips the recession. However, as noted in the October market update, if a recession occurs the average drop in corporate earnings is around 16% which could put the S&P 500 valuation in a range of 2,268 to 3,345 based on an earnings multiple range of 12x to 17.7x (as measured by prior recessions).
To be clear, I do not know with certainty whether the US economy will head into a recession in 2024. I can only look at the macro and micro factors affecting the overall US economy to gauge the potential future of the US equity markets. Therefore, it remains my belief that when the US consumer is finally tapped out, or when the unemployment rate begins to rise at a steeper pace, the US equity markets will finally crack leading to a drop.
In my research the sequence of events that will lead to the US market correction will start with increased borrowing costs by small to medium businesses. This will lead to a re-prioritization of corporate expenses. The use of AI will help some small to mid-sized companies reduce costs but the real savings will come from labor cuts. As more people lose their jobs consumer debt delinquencies and charge-offs will increase putting more strain on the regional banks, corporate profits, and pressure on the Federal Reserve to cut interest rates.
In light of recent layoff announcements from companies like Hasbro, Nike, Fedex, Spotify, Citigroup, and Charles Schwab I believe Q1 earnings season, and potentially throughout all of Q1 2024, more companies across multiple industries will announce significant layoffs. These layoffs may have a one to two quarter lag effect on the economy but will eventually impact the broad economy. Since the stock market acts like a leading indicator of the overall US economy it is my assertion that as announcements come out, consumer spending drops, and delinquencies rise, the US equity markets should drop as well.
Unfortunately, at this time it is unclear whether we could experience a mild, or deep, recession in 2024. Although, if veteran investors like John Hussman (known for calling the top of the 2000 and 2008 markets) are correct then the US economy could be in for a very tough road ahead. If Hussman’s forecast of a 42% – 65% equity market correction comes true 2024 could be reminiscent of 2008.
It is therefore my belief the limited 6.7% upside in the S&P 500 as of January 1st (4,770 to 5,100), as compared to the potential for a market drop, is not worth the additional risk at this time.
Unlike previous detailed explanations where I provide charts, this explanation will pull from multiple resources and research. In math class we were always told to show our work, so this section will provide third-party details that support my investment thesis. While I understand analysts and portfolio managers can craft a narrative to support their view points it will be my goal to present a balanced narrative that will allow you to decide if you agree with my investment thesis.
Let’s begin with the Fear and Greed Index. This is a custom index that is made up of seven underlying variables. Each of the variables attempts to measure the current state of the overall US economy. The index ranges from Extreme Fear to Extreme Greed. Based on the daily readings of the underlying variables the overall index will adjust accordingly. As of January 1, 2024 the index is flashing Extreme Greed.
Knowing that let’s break the balanced view into the “Bull” versus “Bear” point of view.
The textbook definition of a “new bull market” involves two criteria. The first criteria is for a broad stock index to jump 20% from its bear market low. The second criteria is for the broad index to make a new all-time high. Therefore, based on this logic, for the equal weight S&P 500 to fit these parameters it would need to reach 6,200 (5,167 x 1.20) and also surpass the 6,664 high last reached on 01/04/2022. As of 12/28/2023 the index reached 6,427 before selling off. I should note, I elected to use this index as the Magnificent Seven stocks (which propped up the large cap US market in 2023) are less of a concentration in this index and therefore would not overly inflate the index, as compared with the market weighted S&P 500 and Nasdaq (neither of which have achieved both criteria).
Let’s continue on with the bull case; we are now in an election year. Historically speaking, “Morningstar and Ibbotson Associates analyzed S&P 500 returns during each U.S. presidential election year between 1928 and 2016. The S&P 500 rose in 19 of the 23 election years during the period — a batting average of nearly 0.83.” This would make one think this is going to be a year with strong gains heading into November.
Another historically relevant fact is “momentum”. This refers to the momentum an index experiences after a market drop. An example of this would have been seen between 2008 to 2010. In 2008 the market crashed 38% then rebounded 23% in 2009 and another 13% in 2010. Although, 2008 was an election year drawing into question the research Morningstar and Ibbotson performed. The same can be said about 2000…
To further understand the bull market case for 2024 let’s look at the collective analyst consensus for 2023 and 2024. Leaving 2022 and looking into 2023 many of Wall Street’s analysts forecasted a recession in 2023… a recession that never materialized. This outlook put many portfolio managers in a defensive stance to start 2023. In fact, this defensive positioning remained in tact until Q4 2023 where there was a chase for performance to close out the year. While technically analysts were correct (based on the underperformance of many individual sectors) the weighted/concentrated indices far outpaced performance expectations at the start of 2023. Knowing this “Wall Street’s outlook for 2024 is rosier. Analysts see lower borrowing costs, a soft landing (that is, an economic slowdown that avoids a recession) and a pretty good year for investors. But if 2023 taught the market pros anything, it’s that forecasts can look out of date pretty fast.”
So what’s the spark to push the US economy and corresponding markets higher? Well many analysts are calling for four to seven rate cuts in 2024. This would drop the Fed Funds rate from a range of 5.25% – 5.5% all the way down to a potential low of 3.5% – 3.75% by the end of 2024. When rates drop borrowing costs drop (yet still remain 3% higher than 2021). When borrowing costs drop corporate growth could jump as debt weighs less on future growth. Unfortunately this potential reaccelerating growth could refuel inflation concerns as equity market and real estate growth will put more money in the pockets of consumers… money that will most likely not go to paying off debt. If consumer demand continues to remain strong inflation could take longer to reach the Federal Reserve’s two percent target.
Let’s bring this home…
The main goal for the Federal Reserve over the prior three years has been to bring inflation down to two percent. Throughout 2023 headline inflation dropped from 6.4% down to 3.1% yet if we look at core Inflation (ex-food and energy) then inflation remains much higher at 4.01% as of November 2023. A leading reason for the discrepancy between headline and core inflation is related to shelter costs (or rental rate increases). Many analysts state shelter costs are lagging approximately six quarters which if that is true the assumption should be that rental costs should flatten and possibly drop by Q3 of 2024. Unfortunately, this thesis becomes more difficult to believe if interest rates drop rapidly due to their corresponding correlation to mortgage rates. The combination of declining mortgage rates and the lack of housing supply could lead to housing price, and rental rate, increases. When that happens shelter costs could increase leading core inflation to remain higher for longer… something the Federal Reserve does not want to happen.
It is my opinion that for the bull case to be reasonable the Federal Reserve needs to cut rates over 1%, consumer spending needs to remain strong, unemployment cannot increase above 4%, corporate profits/earnings need to reach an all-time record high, and investors need to believe it is better to move money out of a 5% money market, or short term bond, and back into the stock market.
The bear case is a little easier for me to explain as I feel like the last six market updates were quite supportive of additional pain ahead. However, let’s look at what other analysts and strategists have to say.
Let’s start with a few observations. For the last eight years the S&P 500 (market cap weighted) finished almost flat in 2015, negative in 2018, positive by year-end 2020 but sizably down with the COVID crash, and finally down significantly in 2022. Furthermore, the rally in Q4 2021 was up approximately 9.5% which is comparable to the Q4 2023 growth of approximately 11.21%. In fact, the S&P 500 (market cap weighted) returned approximately 28% in 2021 where the same index returned approximately 25% in 2023. Does this mean 2024 is poised for a pullback based on timing alone?
Looking past historic performance patterns, let’s turn our attention to the consumer. To know if consumers can continue supporting the economy we need to know how consumer income is broken down. “According to the U.S. Census Bureau, real median household income was $74,580 in 2022, a 2.3 percent decline from the 2021 estimate of $76,330.” Furthermore, in September 2023 “sixty-two percent of those making between $50,000 to $100,000 each year reported living paycheck to paycheck this month, and about 76 percent of those making less than $50,000 annually reported the same thing.” If consumers are feeling strain from paycheck to paycheck, it seems difficult to see how they will keep spending at the same rate they previously did. Although if stock prices continue soaring and real estate values keep climbing some consumers may find their balance sheets higher.
To know if current asset levels will support consumer spending let’s review wealth by age groups. According to the Census Bureau, based on 2021 research, households under age 35 had approximately $35k, households 35 – 44 had approximately $126k, and households 45 – 54 had approximately $186k. To be clear, this was at the peak of the market before the 2022 crash and the 2023 hyper concentrated rebound. Depending on the household group these numbers could be a lot less today depending on the breakdown between retirement accounts, home equity, and taxable brokerage/checking/savings accounts.
So what if the economy struggles in 2024, will the government step in to save the consumer like they did in 2008? This might be challenging with the US government reaching an all-time new high of $34 trillion of outstanding debt. It is important to note this amount is a combination of public debt and intra-governmental debt (e.g what the government owes the Social Security fund). If that isn’t scary, the government reached the last all-time high of $33 trillion in September 2023 (approximately three months ago). What is the likelihood the government makes a new all-time high in 2024? According to the Whitehouse “the deficit is projected to grow to $1,846 billion in 2024, and debt held by the public is projected to grow to $27,783 billion, or 102.0 percent of GDP.” This would mean the US government is expected to hit a record high at least once, if not twice, more in 2024. Not to mention the government debt will exceed US economic productivity (i.e. GDP). Furthermore, if the Middle East war worsens, if Russia decides to push harder into Ukraine, or if China invades Taiwan then our deficit, and debt, will only increase as it will become increasingly expensive to finance war.
But there is a silver lining… by the end of 2025 the deficit is expected to stabilize. How you ask? When the Tax Cut and Jobs Act was enacted in 2018 there were a number of provisions set to expire/sunset at the end of 2025. For example, individual tax brackets laid out in 2018 will revert back to 2017 levels. This means all of us could expect to see an increase in tax brackets from current levels at 10%, 12%, 22%, 24%, 32% 35% back to previously recorded rates in 2017 at 10%, 15%, 25%, 28%, 33%, 35%, 39.6%. So while the government could stabilize the deficit, and hopefully national debt, in the near future the American consumer’s paycheck is going to be further strained. What are the odds of a bipartisan deal in 2024 or 2025 to address this underlying US economic problem? To that end, even if they did agree on a bipartisan deal it is difficult to see how any outcome would help the consumer.
Let’s bring this home…
As I said in the summary section above, I am an optimistic person. I try to see the bright side in life. However, I am not completely sure if consumer spending will crack first or if layoffs will lead to consumer spending declines. In either case, the consumer is debt laden, paychecks are stretched significantly, and 90 day delinquency rates are at the highest rate since 2021. If the rate exceed 10% in Q4 2023 then the rate will be at the highest point since 2013. If layoffs increase then credit card defaults will increase, auto repossessions should increase, and home loan defaults could increase.
Considering the “bottom 80% of American households” have run out of their pandemic savings and their current jobs could be on the chopping block I remain concerned 2024 will be presented with my headwinds. These headwinds could lead to a big market drop… one that could wipe out all of the gains from 2023 and more – as stated above by John Hussman.
Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. You cannot invest directly in an index. Asset allocation is no guarantee of risk reduction. Past performance is no guarantee of future results.