You know what they say about assumptions? That’s right, they can make a “you-know-what” out of “u” and “me.”
Unfortunately, when it comes to markets, the folly of assumptions can do just that to many a confident and otherwise sophisticated investor. For example, just think about where we were last year at this time. The S&P 500 had just logged its worst annual performance since the financial crisis, the Federal Reserve was in the midst of the most aggressive rate hike campaign in decades, inflation was above 6% and concerns about an imminent recession were pervasive across Wall Street.
That bearish cocktail conjured market assumptions of more doom and gloom for 2023, one where the bears would devastate the bulls for a second consecutive year. Of course, we all know what happened. The S&P 500 finished the year with a gain north of 24%, while the Nasdaq Composite soared nearly 44%.
Today, the market outlook couldn’t be much more positive than it was a year ago.
The Fed is done with rate hikes and rate cuts are on the way, likely in early 2024. Economic growth has proven more resilient than most could have expected, and fears of a recession are all but dead. Inflation dropped substantially in 2023 and is not far from the Fed’s target, and corporate earnings growth is expected to resume this year.
So, yes, we are definitely in a more positive environment for investors compared to the start of 2023. However, just like overly pessimistic assumptions for 2023 proved incorrect, as we look ahead to 2024, we must guard against overly optimistic assumptions, because at current levels, both stocks and bonds have priced in a lot of positives in the new year.
Consider first that the S&P 500 is starting 2024 trading at a very lofty 19.5X valuation. Now, I’m not saying that valuation is unjustified, but I will say that valuation makes several positive assumptions about critical market influences in the coming year. How reality matches up with those assumptions will determine whether stocks extend the rally (and the S&P 500 hits new highs and makes a run at 5,000) or gives back much of the Q4 Santa Claus rally.
In a recent issue of my daily market briefing, Eagle Eye Opener, we defined the five most important assumptions investors are making right now, because it’s how reality plays out versus these assumptions that will determine if stocks and other assets rise or fall in Q1 and 2024. Let’s take a look at each now.
Assumption 1: Fed cuts rate six times for 150 basis points of easing and a year-end Fed Funds rate below 4.0%. The main factor behind the S&P 500’s big Q4 rally was the assumption that the Fed was done with rate hikes and would be cutting rates early and aggressively in 2024. How do we know this is a market assumption? Fed fund futures. According to Fed fund futures, there’s a 70%-ish probability the Fed fund rates finishes 2024 between 3.50-4.00%.
Assumption 2: No Economic Slowdown. Markets haven’t just priced in a soft landing, they’ve priced in effectively no economic slowdown as investors expect growth to remain resilient and inflation to decline, the oft-mentioned “Immaculate Disinflation,” a concept that’s possible, but to my knowledge has never actually happened. How do we know this is a market assumption? The market multiple. The S&P 500 is trading at 19.5X the $245 expected S&P 500 earnings expectation. A 19.5X multiple is one that assumes zero economic slowdown (if markets were expecting a mild slowdown, a 17-18X multiple would be more appropriate).
Assumption 3: Solid earnings growth. Markets are expecting above average earnings growth for the S&P 500 to help power further gains in stocks. How do we know this is a market assumption? The consensus expectations for 2024 S&P 500 earnings per share are mostly between $245-250. That’s nearly 10% higher than the currently expected $225-per-share earnings for last year (2023), which points to very strong annual corporate earnings growth.
Assumption 4: No additional geopolitical turmoil. Despite the ongoing Russia/Ukraine war, Israel/Hamas conflict and escalating tensions between the U.S.- and Iranian-backed militias throughout the Middle East, the market’s assuming no material increase in geopolitical turmoil. How do we know this is a market assumption? Oil prices. If markets were nervous about geopolitics, Brent Crude prices would be solidly higher than the current $77/bbl. Oil prices in the high $80s to low $90s reflect elevated geopolitical concern while prices above $100/bbl reflect real worry.
Assumption 5: No domestic political chaos. This is an election year in the United States. Republican front-runner Donald Trump is facing a long list of various civil and criminal charges along with challenges to whether his name will be on the ballot in certain states. Meanwhile, there has been no long-term compromise on funding the government, so shutdown scares remain a real possibility. And that’s before we get into the heart of election season later this year. How do we know this is a market assumption? Treasury yields. A 3.80%-ish yield on the 10-year Treasury does not reflect much domestic political angst. If markets become nervous about the U.S. political situation and/or fiscal situation in the United States, the 10-year yield would be sharply higher than it is now (well above 4.00%, like we saw in the late summer/early fall).
Bottom line, these market assumptions aren’t necessarily wrong. Events could unfold the way the market currently expects. But these assumptions are aggressively optimistic, and it is how events unfold versus these expectations that will determine how stocks and bonds trade to start the year.
If you’d like analysis such as this in your inbox every trading day, and if you want to avoid the folly of market assumptions, then I invite you to check out the Eagle Eye Opener, right now. For the cost of a morning latte, you’ll be completely up to speed on all of the essentials you need to thoroughly understand this dynamic market, and to avoid falling victim to overly pessimistic and overly optimistic assumptions.
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The Virtue of Contempt
“Contempt is not a thing to be despised.”
–Edmund Burke
I generally try to avoid feelings of contempt, as they tend to cast a pall on one’s psyche. However, some things deserve contempt, and it’s not wrong to recognize that. For example, bad anti-life ideas that are anathema to human flourishing are deserving of contempt. Con men, fraudsters and prophets of doom are deserving of contempt, as are the many charlatans hawking the latest “life hack” guaranteed to make you whole if only you subscribe to their “members only” YouTube channel.
Of course, a general sense of contempt for the world is a bad thing. But having rational, well-placed contempt that’s earned by the facts of reality isn’t a thing to despise — it’s a virtue to cultivate. It’s only by cultivating a sense of contempt for bad ideas that we can promulgate really good ideas — and really good ideas are what we all need in order to maximize human flourishing.
Wisdom about money, investing and life can be found anywhere. If you have a good quote that you’d like me to share with your fellow readers, send it to me, along with any comments, questions and suggestions you have about my newsletters, seminars or anything else. Click here to ask Jim.
In the name of the best within us,
Jim Woods
