The coming year will find it hard to match the big AI-related market rally of 2023. In the closing weeks, the market broadened out to include even the lagging small caps and regional banks thanks to a Fed pivot made known by Fed Chair Jerome Powell at the Dec. 13 Federal Open Market Committee (FOMC) meeting that Fed officials released projections of at least three rate cuts next year.
This was a surprise declaration and a complete 180-degree flip on the higher-for-longer narrative that the Fed had embraced going into the meeting voiced by several Fed officials. The news triggered an amazing rally within the bond market that drove the yield on the benchmark 10-year Treasury bond to 3.8% from 5.0% within the past six weeks that provided the catalyst for stocks to power to record highs.
The 2023 fourth-quarter rally will be a hard act to follow, and based on the capital gains logged during this wave up for stocks, it is probable that the front end of January could see broad selling pressure as investors book those gains. This thought is based on the idea that the market has pulled forward and priced in future expectations. It could be one of the more pronounced “buy the rumor, sell the news” setups facing investors in the last week of 2023, which technically defines the Santa Claus rally.
Assuming there is material selling pressure early on in January, it will be constructive for the market landscape. Many of the market’s leading stocks and sectors are technically extended and due for some consolidation. Being that fourth-quarter earnings season comes into its fullness the third week of January, the quintessential set up is for the best-of-breed stocks and sectors to pull back the first two weeks of January. This back-and-filling process will position the market to constructively build on its heady Q4 gains.
Straight up moves for markets invite elevated levels of volatility and shakeouts. The ideal investing landscape is one of a stair-step pattern, a move higher, lateral consolidation, followed by a new move higher. This price action can only be supported by further confirmation of lower future inflation trends, rising corporate sales and earnings growth and a series of Fed rate cuts that the market has built its gains upon.
Presently, the forward 12-month price-to-earnings (P/E) ratio for the S&P 500 is 19.3. This P/E ratio is above the five-year average (18.8) and above the 10-year average (17.6). Being the market is priced at the upper end of the historic range, the valuation must be supported by accelerating growth. Based on FactSet forward guidance, this should be the case.
“Despite concerns about a possible recession next year, analysts expect the S&P 500 to report double-digit-percentage earnings growth in 2024. The estimated (year-over-year) earnings growth rate for 2024 is 11.8%, which is above the trailing 10-year average (annual) earnings growth rate of 8.4% (2013-2022). On a quarterly basis, analysts are expecting the highest earnings growth to occur in Q4 2024. For Q1 2024 through Q3 2024, analysts are projecting earnings growth of 6.8%, 10.8% and 9.0%, respectively. For Q4 2024, analysts are projecting earnings growth of 18.2%.”
“All 11 sectors are predicted to report year-over-year earnings growth in 2024. Five of these sectors are projected to report double-digit-percentage growth led by the Health Care, Communication Services and Information Technology sectors.”
Despite concerns about geopolitical turmoil and uncertainty surrounding the presidential elections, assuming this set of earnings growth predictions is even close, one can argue that the market will maintain its premium valuation and build on 2023 gains. In light of all the potential headline risk, what the market cares about most of all is sales growth and profits. This is the holy grail of bull markets. Everything else is secondary in priority.
With that said, there is one element of stability that the current bull market needs to stand on, and that is a stable bond market where interest rates don’t move higher again because inflation re-emerges along the way. To put it plainly, bonds don’t need stocks, but stocks need bonds. The year-end 2023 would not have materialized without having been ignited by the rally in bonds.
The one thing that sticks out from the recent events is the sudden change of heart and position on monetary policy by the Fed. To go from a higher-for-longer to a count on three rate cuts narrative stirs the thought of wondering what data they are seeing that evoked such a pivot on policy. More than likely, it is the health of the consumer, the depleted savings levels and the high level of household balance sheet leverage.
With the consumer outlays accounting for 70% of U.S. GDP, any dialing back of discretionary spending will highly likely impact investor sentiment. The rally in rates has dropped long-term rates by a little over 1%, but the Fed Funds rate remains at 5.25-5.50% and will be for at least for the next 90 days, according to bond futures forecasting. Monetary policy doesn’t change this abruptly without some key information that drives it to do so.
Six weeks ago, extreme levels of federal, household and student debt mattered to the market. Today, not a peep. The cost of paying interest on these three mountains of debt is tied to short-term rates, which are unchanged. The only thing that has really changed is that there is more of it being created every day. Just something to think about going into the New Year, and might be what’s on the mind of the Fed as well.
