What Did We See?
- U.S. Large Cap stocks, or the S&P 500 index, were up about 11.7% in Q3, about 26% for the year.
- The developed market of Japan was up about 2.0%.
- Europe and the U.K. were up about 6.7% and up about 3.2% respectively.
- Emerging Markets and Asia (Ex-Japan) were up about 7.9 and 6.5% respectively.
- Global fixed income returns ended the quarter from up about 8.6% (UK) to up about 1% (Japan)
Where Do We Stand?
- The very strong 2023 market rally regained steam in Q4.
- Valuations remain very elevated versus historic averages while earnings continue to be at risk.
- The markets will likely remain focused on the Federal Reserve as the economy continues to digest the recent massive interest rate increases.
- We remain in a position to weather any volatility with positions in Gold and Cash while taking advantage of opportunities when they present themselves.
The stock market finished 2023 with a very strong rally that surprised even the most bullish of investors. The Federal Reserve held their last meeting of 2023 during the quarter, holding rates at current levels for the third meeting in a row. The market viewed this as verification that the Fed is done raising rates and could even look to cut rates in 2024. Furthering this point, Chairman Powell sounded much more sanguine on fighting inflation and opened the prospect of a soft landing for the economy.
This fueled a double digit stock market rally that pushed the S&P 500 to a more than 25% return for the year. It would seem that the idea of rates staying “higher for longer” is a thing of the past as the market is now pricing in a full 6 (yes, six!) rate cuts in 2024. Almost every asset class participated driving markets to a level now considered as priced to perfection. If we don’t get the perfect soft landing the chances for a pullback or even worse are now high.
Leaps of Faith
The big rally to end 2023 was certainly a Leap of Fatih for most investors. Faith that the economy will hold up, faith that inflation will not rise again, faith that structural damage has not yet occurred in the housing markets, faith that there is no credit bubble about to burst. Sometimes all it takes is a little faith for markets to achieve their goals of ever-higher prices. Never forget, the stock market is a humanly-driven emotion meter. But that meter works both ways, positively and negatively.
The Good
The Federal Reserve may just yet achieve the ever elusive soft landing. That would mean that they were able to get inflation under control without pushing the economy into a recession. According to conventional wisdom, the Federal Reserve has only been able to pull off one soft landing out of 11 tries in the past 60 years (1994-1995). If you loosen the definition of a soft landing then maybe you can say they’ve done it more than once. However, the track record is not great.
Yet, for a moment, let’s assume they can do it this time. If they can, then the economy is not in a terrible place. Corporate balance sheets are stronger today than at any other time during a tightening cycle. Non-financial corporations have about $6.9 Trillion in liquid securities and cash. So if the economy does slow down without hitting recessionary levels, companies can survive (on average). At the same time, the US consumer remains relatively strong further bolstering the foundation for the next bull market.
The Bad
What if everyone is very wrong and the soft landing is in fact a hard landing? Under this scenario, the economy experiences a true credit event. Banks stop lending and the Federal Reserve cannot act fast enough to contain it. Economic weakness hits corporate balance sheets and earnings. Hence, valuations of companies will then be seen as way too high. Today the Forward P/E (Price to Earnings Ratio, a measure of valuation) on the S&P 500 sits above 19. The 30 year average for this measure is about 16.5. For reference, in 2008 during the Great Recession the forward P/E went below 10.
If the S&P 500 moves back to its long term average even without any loss in earnings, stocks will go down by 15%. If earnings are reduced by 10% and the P/E moves back to that long term average, stocks go down by more than 23%. You get the picture.
However, make no mistake, if the Fed is cutting rates because of slower growth, it’s not a good thing. If employment is in fact slowing one can expect slower economic growth that will eventually lead to lower rates. In conjunction with the extremely high earnings expectations cited above one would expect a repricing of risk assets (stocks, etc…) that fall better in line with a new (lower) valuation. There’s just not a lot of “wiggle room” if this scenario plays out.
The Human Factor
Simply the specter of lower rates does not drive economic growth. Nor do realized (actual) lower rates itself drive economic growth. In order for economic growth to come to fruition there needs to be a willingness to take risk. That willingness is certainly spurned on by lower rates.
For example, a corporation may be willing to borrow money for a new factory at 3% but they may think it not a good business decision to borrow at 9%. Since the new factory may have an inherent return on capital that is lower than 9%, it may not make sense to build the factory. However, if rates are lower than 9% they still may not want to take the risk of building that factory, if other factors are telling them not to. Other factors such as consumer spending trends, government deficits and the like. It takes a human to make that decision.
As evidenced by the amount of cash sitting on corporate balance sheets cited above, not a lot of humans have been making that decision to deploy capital. What do they see that we don’t see? What are they waiting for?
The Waiting is the Hardest Part
What these corporate managers are waiting for is the Fed to get out of the way. They are waiting to see if in fact the Fed can pull off the greatest magic trick in all of finance. Something that has been done less than 10% of the time in the last 60 years.
If they don’t have any faith that it can be done then why do we as investors? Good question. As always, the market is an anticipatory device. The market is always trying to figure out what comes next. Right now the market is telling us the soft landing happens, earnings continue to grow and the next bull market is here. Investors historically celebrate when they believe the Fed is done raising rates. What happens after that celebration is over is another story yet to be written. It is usually not very pretty.
History suggests that after the Fed pauses for a bit and then begins to cut rates is when the markets come back to reality. In the year after cuts began in 2001, the S&P was down almost 10%. In the year after cuts began in 2007, the S&P was down almost 18%.
It’s a buyer’s beware market for the next 18 months. It may be better to rent your stocks for the next few years.
If you have any questions or have experienced any changes in your financial situation please do not hesitate to Contact Me.
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