The stock market just completed its best performance through July in 26 years. The S&P 500 finished last month up 21% since the start of the year. Gains in the US marketthis year have largely been driven by the so-called “Magnificent Seven,”a group of large technology companies comprising Nvidia, Apple, Amazon, Alphabet, Meta Platforms, Microsoft, and Tesla. The market’s rally has broadened in recent months, as Wall Street has become more optimistic that inflation is cooling, the economy could avoid a recession and the Federal Reserve is nearing the end of its rate-hiking cycle.
2023 has been almost a complete reversal of 2022. Inflation is falling rapidly. This is key, as it was higher than expected inflation that caused the Federal Reserve to increase interest rates more than expected. Economists assumed that the higher interest rates would most likely create a recession in 2023. The surprise is that the economy has managed to stay afloat despite the higher interest rates.
No one is exactly sure why this is the case, but my best guess is that the massive increase in savings that resulted from the efforts to prop up the economy during the COVID pandemic has left consumers flush with cash. Today’s consumer is less dependent on credit cards and higher cost financing than usual. The consumer is also benefiting from a very strong job market. Unemployment is at its lowest since 1973. According to the textbooks, wage inflation should be a problem when the labor market is this tight. So far, this hasn’t been the case. We are seeing some wage inflation in entry level jobs, but not as much in the high paying professions.
If higher interest rates did not lead to a recession, then it’s unlikely that a recession will emerge over the next year as interest rates gradually move lower. The Federal Reserve is signaling that it is done raising interest rates. The market projects that the Fed will cut interest rates by as much as 1% over the next year. Achieving a “soft landing” was considered to be a long shot. A soft landing occurs when the economy cools off enough to constrain inflation but does not decelerate enough to fall into recession. This is increasingly viewed as the most likely economic trajectory for the next twelve to eighteen months.
A soft landing changes the outlook for earnings in 2024. If the economy does not fall into recession, earnings will likely grow next year. This is the foundation for the current market rally. None of the major investment firms were forecasting continued economic expansion at the beginning of the year. This is reflected by the extremely pessimistic outlook that investment banks had for the S&P 500 at the beginning of the year. Large investment firms are rapidly revising their forecast for where the S&P 500 will end 2023.
Every other day, it seems a new institution is scrapping its recession forecast. JP Morgan’s change in outlook was described by Marketwatch on August 4th:
A top economist at JPMorgan Chase & Co. no longer expects a recession to arrive in the U.S. before the end of 2023. He doesn’t expect one in 2024 either but said the risk of a potential downturn remains elevated. Michael Feroli, chief U.S. economist at JP Morgan, on Friday officially abandoned the bank’s earlier recession forecast, putting the largest U.S. bank by assets more in line with others on Wall Street in thinking that a recession might be avoided even though the Federal Reserve has increased rates to a 22-year high.
“We have revised higher our outlook for growth in economic activity this year and next, and no longer expect the economy to fall into a mild recession,” Bank of America US Economist Michael Gapen wrote on Tuesday. Bank of America now sees the Fed’s interest rate hike ending in a “soft landing, where growth falls below trend in 2024, but remains positive.” The shift by Bank of America’s team of economists from a mild recession in 2024 to no recession at all comes amid growing optimism about the state of the US economy.
Jan Hatzius, the chief economist at Goldman Sachs, thinks the United States will pull off a soft landing — perhaps one so soft that the Fed might be able to lower inflation over time without unemployment having to rise.
So, it seems a recession is no longer imminent. If we assume that the economy will continue to grow through 2024, we can also assume the earnings will continue to grow. This is a huge support for continued gains over the next eighteen months.
I’m less interested in where 2023 earnings will end up. The market will trade based on its expectation for 2024 earnings. Currently, the consensus estimate is for $245 for the S&P 500 in 2024. Estimates will likely increase over the next few months so let’s say that the S&P 500 will earn $250 in 2024. If it trades at 20 times forward estimates, then the S&P 500 should be worth approximately 5,000 at the end of this year—potentially 10% higher than today. Early estimates for 2025, are coming in around $275 for the S&P 500, which implies a value of 5,500 at the end of 2024. The combination of falling interest rates, investor skepticism, and rising earnings creates a near optimal environment for stocks.
A common argument against the market continuing to rally is that it is too expensive. I mentioned earlier that the “Magnificent Seven” (Apple, Amazon, Alphabet, Microsoft, Nvidia, Tesla, Meta) are responsible for a large part of the gains in the S&P 500 this year. They’re also a big reason the multiple is so high. Take them out, and the multiple contracts to close to its historic norm.
More than half of the stocks in the S&P 500 are trading below their historic P/E average and below the S&P’s historic average. That implies that investors can still find value in the markets. Stocks should do well as long as we can continue to dodge a recession. We’ve endured a volatile two-year period. It seems likely that the next two years will be much steadier than the last two years.
