Broker Check

Alpha Will Come from Many Places This Year

| January 22, 2024

The continuation of sloppy trading serves as a reminder that much of the easy money has been made in this run up. So, “buying the dip” may become the popular narrative once again.

As we've discussed before, the market is overbought. And while it can stay overbought for a while, we also need to recognize this isn’t a full risk-on market anymore (like it was to end 2023), even with the expectation of new highs by the end of this month.

Keep in mind, this is consistent with our overall 2024 outlook, especially considering it’s an election year and we expect most of 2024’s gain to occur in the second half of the year. In general, the start of an election year can be choppy because there are often unknowns that prove challenging for the market to grasp. Right now, they include:

  1. Continued fear around a “soft” or “hard” landing for inflation.
  2. Equity market anxiety around the timing of Federal Reserve interest rate cuts.
  3. Election risk mitigation by investors in the first half of the year.

Thus, we think the first half of 2024 will be more challenging for investors than the second half:

There will be opportunities for gains though. The overall macro environment is still favorable, especially with small-cap stocks, financials, health care, industrials, and technology.

Macro Data Reflects Broadening

Speaking of the macro-view, let’s expand on some of the positive macro drivers out there right now. Last year's tech-heavy rally was an either/or year because tech worked much better than anything else. This year, we see the pendulum swinging back, with greater participation across the board, signaling a broadening rally.

While stocks are off to a choppy start in 2024, it's important to remind everyone to ignore the noise and instead watch inflation. While prices won't necessarily fall in a straight line as the year-over-year comparisons get tougher, our readers know the inflation trend data is still clearly heading lower.

Markets look forward, and if the Fed’s next move is a rate cut, stocks will be fine. Timing isn't necessarily that important; it's the trend that counts. However, an easing setup will require investors to cast a wider net to outperform.

When big tech was driving most of the market’s gains, bears worried that narrow leadership meant any bull runs would be short in nature. But early last summer, we debunked that narrative. Fast forward a few months, and we witnessed the recent extreme risk-on environment as stocks ripped higher.

Perhaps the biggest macro data point causing a broadening market is that long-shunned value and small-cap stocks have outperformed growth stocks recently. Meanwhile, equal-weight strategies have begun to outpace market capitalization strategies (which are currently heavy on tech stocks).

It’s no coincidence stocks began rallying as Treasury yields fell and lower interest rates cut the cost of doing business. Looking forward from a profit perspective, the bottom-up sell-side analyst consensus now forecasts 10.7% year-over-year growth for S&P 500 earnings in 2024.

That sounds pretty good, right? Unfortunately, some skepticism still abounds, though we disagree with it.

Lower interest rates aren't the only reason to be optimistic about corporate profits. We're seeing additional macro signals that are bullish for earnings. For example, worker productivity has rebounded and unit labor cost growth has normalized, helping S&P 500 net margins expand to 12.8%:

We expect more good data on this as earnings season continues. This matters because stocks tend to do best when productivity accelerates sharply. Since 1950, when productivity is up significantly, the S&P 500 rises an average of 12.0% in the following 12 months:

This increased productivity should trickle down, supporting a broadening rally. What will benefit the most?

Laggards to Leaders

We still think technology will do just fine on the strength of superior earnings outlooks. But with a broadening rally, some of 2023’s biggest laggards are worth a look, specifically health care and financials.

The health care sector is forecasted to grow earnings per share by 17.5% – the highest of any S&P 500 sector. Additionally, its 12-month forward price-earnings ratio of just 18.5-to-1 is the lowest among the S&P 500's 11 sectors.

As for financials, we think the sector’s consensus forecast of 5.7% EPS growth is likely too low. One big reason is that when the Fed cuts rates, short-term bond yields will fall, steepening the yield curve. Since banks borrow short and lend long, a steeper curve makes loans more profitable and will boost net interest margins. The financials sector also has the second-cheapest forward price-earnings ratio in the S&P 500.

Now let’s look at how these sectors stack up from a “big money” perspective. As of this writing, health care owns the top spot in the MAPsignals sector rankings, while financials leapt to second (remember, these rankings reset every year):

An additional macro reason to appreciate the opportunity in 2023’s unloved sectors during this broadening is that health care and financials are the two best performing sectors in the 12 months following the last Fed rate hike since 1994:

The last rate increase by the Fed in this cycle was in July 2023. Over the past six months, financials are up 12.0% and health care gained 10.0%. So, there’s plenty of historical upside left.

This “laggard love” strategy is further supported by what “big money” professional investors have been buying so far this year. Health care and financials attracted the most inflows:

Taken together, these last two data points are powerful.

Understanding these macro drivers, we believe alpha will come from many places this year as the market broadens out. That said, the data supports being overweight the technology, financials, and health care sectors.

# The S&P 500 is an unmanaged index of 500 widely held stocks that is generally considered representative of the U.S. stock market.

Securities sold through CoreCap Investments, LLC.  Advisory services offered by CoreCap Advisors, LLC.  Cornerstone Financial and CoreCap are separate and unaffiliated entities.