Hindsight reviews tend to expose pivotal market moments, enabling us to learn more. Looking at 2023, the S&P 500* ended the last quarter (and the first half of the year) on a 14-month high as most major stock indices logged solid gains. The linchpins of the progress were a pause in the Federal Reserve’s interest rate hiking campaign, stronger than expected corporate earnings (especially in tech), and the relatively drama-free resolution of the debt ceiling situation.
The second quarter began with chaos and volatility following the regional bank crisis in March. Most of those concerns were overblown though. Other than a handful of issues, regional banks were generally stable.
This stability allowed investors to refocus on corporate earnings, and the results were much better than feared. For example, 78% of the S&P 500 companies reported better-than-expected earnings in the first quarter:
Additionally, 75% of reporting companies beats revenue estimates:
The S&P 500’s earnings and revenue outperformance beat long-term averages. Unsurprisingly, this was a welcome sight for investors. When coupled with the general macroeconomic calm, it allowed stocks to drift mostly higher in April.
The technology sector caught fire in May, lifting the S&P 500. The rise came on the back of investor and financial media enthusiasm around artificial intelligence (AI). However, the end of the month saw some rockiness due to the debt ceiling. But as in every other time in history, an agreement was miraculously struck just before a deadly default (please note the sarcasm).
The resolution of the debt ceiling and continued stability of regional banks provided support for the ongoing equities rally. Other positive developments helped too:
- Inflation declined to the lowest level in two years.
- Economic data remained resilient, reducing near-term recession fears.
- The Fed confirmed market expectations by pausing rate hikes.
The upswing was followed by an expected consolidation for much of the last half of June, though the final week saw gains as managers conducted their quarterly window dressing. This is essentially where we are now in terms of a 2023 timeline. So, where do we go from here?
Second Half of 2023
The outlook for stocks and bonds is arguably the most positive it's been since late 2021. Much of this is due to the items highlighted above (e.g., declining inflation, resilient economy, etc.). The improvement in the fundamental outlook has been reflected in most stock buying prices, so much so that even the financial media has begun to proclaim a new bull market.
The market has taken a decidedly positive view on the ultimate resolution of several macroeconomic unknowns. But we must acknowledge there still are potential risks worth monitoring, especially with little room for disappointment after the run up so far this year:
Fed’s Impact Unknown
The economy hasn’t yet fully felt the impact of the Fed’s historically aggressive interest rate hikes. History shows rate rises can take far longer than most expect to affect economic growth. Thus, an “all clear” is premature.
There's clearly been significant progress on inflation. But it remains far greater than the Fed’s “2% target,” so the central bank could easily decide, and is expected, to hike rates further. The Bank of Canada and the Reserve Bank of Australia did that following pauses of their own.
Markets took regional bank failures in stride. Still, lending is reduced. That could usher in additional strain on the commercial real estate market and small businesses more broadly.
The bulls are loud and everywhere right now it seems. This sudden burst of enthusiasm needs to be considered in the context of what may still be an uncertain macroeconomic environment, especially because markets no longer have the protection of low expectations to cushion declines.
Even with the risks we just outlined, based on the data we see, we believe the rising stock prices over the past nine months reflect the start of a new bull market, albeit one with volatility. It will be driven by AI advancements and continued success in curbing inflation.
In our (often stated) view, the stock market bottomed out on Oct. 12, 2022. This may seem counterintuitive since we haven’t had a “normal recession” or seen more Fed cut rates yet. But there’s been a huge decline in inflation and efforts to lower it further seem to be working.
Therefore, we are updating our year-end target for the S&P 500 to 4,825. Note that the prior all-time high for the index was 4,821, so we're expecting equity markets to exceed those highs.
Yes, this is an aggressive view. Here’s our Road Map on how we can get there:
- Headline inflation continues to decline towards 3%.
- The Fed can point to real progress and Wall Street consensus will keep shifting dovish.
- S&P 500 earnings-per-share (EPS) growth (ex-Energy) will be positive in the second quarter (i.e., we hit the earnings trough).
- Investors will begin to allocate back towards equities out of the current $5.5 trillion cash pile.
Additionally, we will want to see softer jobs reports as that will encourage the Fed not to overdue additional rate increases. Fortuitously, on Friday we had a June jobs report that painted a softer picture than the ADP report earlier in the week. The headline jobs figures of +209k is a miss vs consensus of +230k and a revised +306k last month. And private payrolls, ex-govt, was only +149k, a significant drop from +259k from last month.
Most importantly, looking at the report, the gains in wages came from manufacturing, while services industries saw slowing wage growth. This is a big deal. We think the average hourly earnings (AHE) growth is in fact, not wage inflationary from the Fed lens. The takeaway being that wage growth in services slowed sharply. The Fed has been focused on services inflation and the growth in wages in services. That is actually slowing.
On a high level, this is a reminder that the ADP employment report does not sync up with the BLS official jobs report. Thus, the volatile market reaction mid last week was not necessarily warranted as median wages are slowing, which was a significant driver of inflation and a key data point for the Fed.
All year the stock market has been a “game of inches,” with lots of blocking and tackling. We think that continues the rest of the year, so it’s wise to be prepared for more volatility. That said, the trend indicates pullbacks of 2% or more are now generally viable (as was on display last week). Additionally, normalized inflation (not high inflation), is generally good for equities due to growing EPS.
But most importantly, the ascendance of AI will continue to drive the equity story. In fact, the AI play may be undervalued still.
We’ve been researching AI more deeply and suspect AI-related equities could be at the start of a super cycle like the internet, cloud computing, and other technological advances over the last 30 years. The charts below from Coatue Capital provide some useful insights^:
The NVIDIA results arguably became the “Aha!” moment. Plus – and this isn’t mentioned enough – AI can (and most likely will) solve much of the inflation problem on its own. Should that occur, this will justify the technology’s surge in fame and reinforce that its emergence is not just a bubble.
A final piece of evidence for our year-end target is the forward price-to-earnings (P/E) ratio of the S&P 500 (ex-FAANG stocks), which stood at 15.7X at the start of the year. It’s a mere 16.4X as of this writing:
We believe this P/E will expand as companies are viewed as resilient and the market broadens out, supporting the idea that we’re at the start of a new EPS expansion cycle. But to be clear, the key for that to happen is a combination of continued easing inflation and an improving growth outlook.
As for consensus, let’s remember that at the start of the year, sentiment was outright bearish. So, we expect pushback from consensus on further market gains, which will lead to the short-term volatility and the “buy the dip” theory.
If financial conditions ease, our analysis would continue overweighing technology, industrials, and energy stocks, and de-emphasizing utilities, consumer staples, and real estate equities:
All in all, our readers know a long-term focus and diversified plan can help withstand virtually any market surprise and related volatility. Successful investors know the journey is a marathon, not a sprint, and that even intense volatility should not alter this diversified approach. It's important to remain invested, stay patient, and stick to the plan.
* The S&P 500 is an unmanaged index of 500 widely held stocks that is generally considered representative of the U.S. stock market.
^ Cornerstone Financial Services, LLC owns NVDA directly in managed client accounts; Daniel Milan personally owns NVDA.
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