Telemus Weekly Market Review December 18th - December 22nd, 2023
After a dismal 2022, stocks had a robust year in 2023. Gains were fueled by the largest seven stocks (Apple, Microsoft, Amazon.com, Alphabet, NVIDIA, Meta and Tesla), which ended up being coined the Magnificent Seven. Effectively these stocks had gains of anywhere from 50-200% on the year. Since these stocks collectively make up 28% of the S&P 500, these outsized gains had a dominant impact on the overall return for the S&P 500. When you look at the S&P 500 equal weighted index, which doesn’t account for the size of the company, that index had a return that was less than half that of the S&P 500.
What gets overlooked is that gains in the market during 2023 were fueled by rising valuations, not an improvement in corporate earnings. For the S&P 500 index, in aggregate, earnings per share were effectively flat on a year over year basisi. A common metric of valuation is the ratio of a stock’s price to its earnings per share (a.k.a. its price-to-earnings ratio). That means the entirety of the over 20% return in 2023 for the S&P 500 was due to rising valuation multiples. More specifically the price-to-earnings ratio for the S&P 500 concluded the year at 21x expected 2023 earnings. This compares to a 17x price-to-earnings multiple at the end of 2022. Over the trailing 25-years, the S&P 500 has averaged a price-to-earnings multiple of just under 17x. Therefore, one could interpret 2023’s market as having gone from reasonably priced to over-valued.
That assessment, however, is not quite as straightforward. A significant event during the year was the launch and broad adoption of Chat GPT. The tool provided a demonstratable construct for the use of artificial intelligence (AI) and proved that the technology may have meaningful commercial applications sooner than many thought. As expectations for how AI might translate into future earnings and cash flows evolved, stock prices adjusted.
A secondary influence on the market’s strong return in 2023 was the economy. The broad consensus expectation coming into 2023 was that there would likely be a recession in the back half of the year. The exact opposite happened, with the U.S. economy growing 5%, based on its GDP, in the third quarter alone. Collectively the strong economy, and future financial benefits of AI, left investors more comfortable with the future earnings prospects of companies, and consequently provided some justification for higher share prices.
When we dissect what worked and didn’t work in 2023, it really comes down to those Magnificent 7 stocks, which accounted for a vast majority of the broad market’s return. Alternatively other parts of the equity market, ranging from small cap stocks to international, had low double-digit gains, much less than the S&P 500 index. We consider this a narrow market, as only a select group of stocks had outsized gains during the year.
We believe this backdrop is important to be cognizant of as we project some unwinding in the narrowness of the market in the year ahead. The dichotomy in valuation between assets such as small cap and large cap stocks is outsized. We expect the variance to narrow over time. However, that path may not be linear.
As we exit 2023 market sentiment is almost the mirror opposite from where it was a year ago. Exiting 2022 the market consensus was that the U.S. economy would experience a recession in the back half of the year. This resulted in overall positioning being more conservative, with the quick rally to start the year catching most off guard. Now as we enter 2024, market expectations are for a soft landing for the economy, with the market pricing in such a scenario across all markets. While this scenario is certainty probable, the broad consensus view may not property account for some underlying macro realities. First, much of the economic strength in 2023 has been due to consumers spending above their means. This trend has occurred in the past and it inevitably slows. Second, given unemployment levels have been sitting near 50-year lows, we expect the unemployment rate to eventually rise, which would not be a positive for economic activity. Lastly, barring an unexpected (negative) economic event, we don’t see rates dropping that quickly and therefore we expect there to be a gradual increase in the number of leveraged businesses (including real estate) becoming distressed. Collectively, while none of these concerns will by themselves derail the economy, we do believe they highlight that market sentiment may not be attentive enough to underlying risks. Therefore, stocks appear to be exiting 2023 with an overly bullish perspective, similar to how sentiment was overly bearish exiting 2022.
Outlook
We enter 2024 with a constructive view of the equity markets, although we are not expecting a sizable move up or down in the broader market. The reason being is that market wide valuations are at the upper end of their typical trading range. Corporate earnings could benefit from an economy that is able to avert a recession, however, expectations already price in what we believe is a more than healthy 11% growth rate in earnings. Thus, barring an unexpected acceleration in the U.S. economy, we don’t see a catalyst for outsized gains for equities.
However, beneath the surface, the narrowness of the market in 2023 has created an unusually wider range of valuations across stocks. In such an environment we see an opportunity to add value through active stock selection decisions. In addition, we consider having more exposure to portions of the market, such as small cap stocks, that did not keep up in 2023 and offer more attractive relative valuations. While these approaches seem attractive going into the new year, we also recognize that risk factors such as geopolitical events or a slowdown in the pace of consumer spending could push investors toward thematic trades. This could even include a flight to safety trade that we’d expect the Magnificent 7 stocks to participate in. Ultimately, this perspective leaves us leaning toward asset selection opportunities, but doing so in a manner where one is not caught off guard should macro conditions unexpectedly change.
As monetary policy shifts from rising interest rates toward the onset of a rate cutting cycle by the federal reserve, we’d expect rate sensitive sectors and industries to benefit. These includes banks, utilities, and real estate investment trusts. The changing macro trends, alongside the dichotomy in valuations, is likely to lead to a change in sector leadership in 2023 away from technology and consumer discretionary sectors. This doesn’t mean that we expect technology stocks to necessarily be challenged, or even lag the market, however given the evolution in macroeconomic conditions and the market environment we expect their magnitude of differentiation to even out in the year ahead.
Since large cap U.S. stocks finished 2023 at valuations that are above-average, we expect returns in 2024 to be driven by earnings growth. Earnings growth projections are based on expectations for improving profit margins. Lower raw material prices and lower freight costs will help to support higher margins. However, for some companies rising wages and the elevation in interest rates will serve as a drag on margins. While we see the opportunity for skilled management teams to improve the profitability of their businesses, we do believe the current expectations around corporate margins might turn out to be too ambitious.
Overall, we expect more moderate returns for equities in 2024. Returns will be based on earnings growth and should be broader based than what was experienced in 2023. Asset selection will have a greater influence on an individual investor’s returns. We see opportunities in sectors and segments of the market that were left behind by the narrow market in 2023. We intend to be active in evaluating opportunities in the market and taking advantage of any emerging dislocations in asset prices.
iBased on forecasted earnings per share for 2023
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