Market Commentary: February 2024

Written as of March 13, 2024.

Highlights this Month

• How much further will stocks rise?
• Concerns around the S&P 500.
• Market vulnerabilities: stocks vs. bonds.
• Will the Fed's balancing act lead to a soft landing or a harsh fall?
• The Fed's interest rate puzzle and the debate over real rates.
• Weighing rally optimism against caution amid mixed signals.

Executive Summary

In February, global stock markets continued their upward trend, with both developed and emerging market stocks experiencing gains. The S&P 500 saw a notable increase of 5.3% in February, bringing the year-to-date gain to 7.1%. According to Strategas, this strong performance has historically been associated with positive prospects for the remainder of the year. Strategas highlights this as the 13th best start for U.S. stocks since 1950. A broader analysis by Carson Investment Research suggests that maintaining positive returns in the first two months of the year typically leads to further gains, with March seeing an average return of 1.4%, followed by gains for the rest of the year and over the next 12 months. However, both note historical exceptions, like the significant decline in 1987 despite a strong start. 

The current market is not only displaying strength but also momentum, as evidenced by the S&P 500's prolonged avoidance of significant daily drops and its longest bull streak since 1971. The market has already surpassed year-end targets set by strategists for 2024, leading to potential revisions of forecasts, with many expected to be upward adjustments. 

Despite the impressive performance, questions arise regarding how much further stocks can rise, particularly with the concentration of top companies in the S&P 500. Concerns about valuation persist, with mixed views on whether the current market constitutes a bubble. The performance of the top companies, labelled the Magnificent 7, is impressive, but sustainability remains uncertain. The concentration of these companies in the market raises concerns about underlying weakness and the potential for a broader market rally. 

The divergence between stock valuations and bond yields also warrants attention, with stocks appearing more vulnerable in the short term. Future adjustments will likely be influenced by the U.S. economy and the Fed's efforts to navigate a soft landing, balancing risks of economic slowdown and inflation resurgence. The Fed's consideration of inflation rates, particularly real rates, adds complexity to its decision-making process. 

Inflationary pressures, notably from a tight job market and robust wage growth, present significant risks. Structural factors contribute to the tight labour market, with potential implications for inflation and economic stability. 

While the market rally presents opportunities, investors should remain cautious, considering the challenges and uncertainties ahead. Despite short-term optimism, the long-term outlook depends on various factors, including economic trends and Fed policies. 

February in Review

Stock markets continued their upward trajectory last month, with both developed and emerging market stocks seeing gains. While only two months into the year, strong performance in January and February suggested positive prospects for the remainder of the year, historically speaking. February saw a notable increase of 5.3% (total return in U.S. dollars) in the S&P 500, bringing the year-to-date gain to 7.1%. According to Strategas, this marks the 13th best start for U.S. stocks since 1950, and the highest since 1986. They argue that such strength tends to lead to further gains, citing historical data that shows above-average returns following strong initial performance. 

Carson Investment Research corroborates this bullish view with a broader analysis of returns. Historically, if the S&P 500 maintains positive returns in the first two months of the year, March tends to see an average return of 1.4%, followed by gains of 12.2% for the rest of the year, and 14.8% over the next 12 months. However, it's worth noting that 1987 stands out as an exception in both Strategas and Carson's data. Despite a robust gain of 17.4% in January and February of that year, the S&P 500 experienced a significant decline of 13.1% over the following 10 months. 

Stocks are not only displaying strength but also momentum. As reported by the Daily Shot, the S&P 500 has managed to avoid a daily drop of more than 2% for 253 trading sessions as of February 26th. Bloomberg recently noted that the S&P 500 is currently experiencing its longest bull streak since 1971, having gained in 16 out of the last 18 months. According to Rosenberg Research, the S&P 500 has already surpassed the year-end targets set by strategists for 2024. Bloomberg's data indicates that the average year-end target was 4,915, but with the S&P 500 ending February at 5,096, U.S. stocks would need to fall by 4% to align with this average target. 

However, it's worth noting that strategists often miss their targets by significant margins, as highlighted by Bloomberg. Sensing another deviation from projections, many strategists are likely to revise their targets upwards, following the lead of Goldman Sachs's equity strategy team. In January, Goldman projected the S&P 500 to end 2024 at 5,100, but they raised this estimate to 5,200 in early March. It's expected that other strategists will follow suit in revising their forecasts higher. 

How much further will stocks rise?

With some stocks performing exceptionally well, questions have arisen regarding how much further they can rise, as noted by publications like The Economist magazine. The focus remains on the Magnificent 7, which collectively have nearly doubled the S&P 500's 7.1% gain year to date. Despite this remarkable performance, Bank of America suggests that labeling this tech rally as a bubble might be premature. Comparatively, the Magnificent 7’s increase from peak to trough stands at "only" 139% as of February 15, which is lower than the surges witnessed in Japanese stocks in the late 1980s, the Dotcom Bubble, and Fang Stocks from 2020-2021.  

From a valuation standpoint, the top 10 largest stocks in the S&P 500 appear pricey, whereas the overall market seems less so. Goldman Sachs reports that the top 10 S&P 500 stocks have a P/E multiple of 25X, lower than the 36x multiple observed during the pandemic and the peak of 43X experienced during the 1990s tech bubble. In contrast, the remaining 490 S&P 500 stocks trade at a more modest 19 times earnings. Despite this, Apollo suggests that based on median P/E ratios, the current AI bubble surpasses even the 1990 tech bubble. However, Bridgewater contends that today's overall market does not meet its criteria for identifying market bubbles. While acknowledging that the Magnificent 7 may be "frothy," it does not yet classify as a bubble.  

The Magnificent 7 rightfully earn their name due to their impressive earnings growth rates. Bloomberg reports that since early 2020, the S&P 500, excluding the Magnificent 7, has seen earnings grow by approximately 25%, while the Magnificent 7 themselves have experienced growth of about 300%. When considering the P/E to growth perspective (PEG ratio), the Magnificent 7 traded at a ratio of 1.11 in mid-February, compared to 2.42 for the S&P 500. This suggests that the Magnificent 7 may not be as expensive as they appear when adjusted for their growth rates.  

However, the crucial question remains: how long can they sustain such high growth rates? Bank of America predicts that the earnings growth rate for both the Magnificent 7 and the rest of the S&P 500 will equalize by the end of the year. According to JP Morgan, year-over-year earnings for the Magnificent 7 are expected to be 25% in 2024 and 15% in 2025, compared to 8% growth for the rest of the S&P 500 in 2024 and 13% in 2025. It's important to note that eventually, the law of large numbers begins to affect every growth stock, along with adjustments in valuation. 

Concerns around the S&P 500.

The current concentration of the S&P 500 is raising concerns, particularly for U.S. stocks. According to Deutsche Bank, the top five companies—Microsoft, Apple, Alphabet, Amazon, and Nvidia—made up roughly 25% of the S&P 500 in mid-February. This level of concentration hasn't been seen since the 1970s Nifty Fifty era and exceeds the levels observed during the Dot-Com bubble. Such a lack of diversity in the market can sometimes signal underlying weakness, potentially leading to the market leaders faltering and triggering a bear market. 

However, it's important to note that this is just one potential scenario. As recently highlighted by Morgan Stanley, much of the rally in the S&P 500 since October has been driven by higher valuations. While the top 5 companies, known as the Mag 7, have seen robust earnings growth, the broader market hasn't kept pace. According to FactSet, S&P 500 earnings only rose about 2% last year, but they are expected to grow by 11% in 2024 and 13% in 2025. 

If these projections materialize, it's more likely that the broader market will rally and catch up with the Mag 7, rather than the Mag 7 faltering and aligning with the broader market. Signs of this catching up are already emerging, as highlighted by a chart from Barron's in early March, showing a closing gap between the S&P 500 and the S&P 500 Equal Weight Index. This narrowing gap would make the S&P 500 index less top-heavy, although it's uncertain whether this is a critical indicator for investors to monitor. 

A recent Bloomberg chart revealed that among the world’s 12 largest equity markets, the U.S. is the second least concentrated market, with only Japan having less concentration, while Canada falls in the middle of the pack. 

Market vulnerabilities: stocks vs. bonds.

Stocks appear more vulnerable in the short term compared to government bonds, primarily due to their valuation. According to Morgan Stanley, while 10-year yields have roughly followed the anticipated declines in the Fed Funds rate for 2024, U.S. stock valuations have continued to rise. This growing gap between bond yields and stock valuations seems unsustainable. Either expectations for Fed rate cuts in 2024 need to increase, pushing 10-year U.S. Treasury yields lower, or S&P 500 P/E multiples must eventually decrease. 

As noted by Strategas in early March, it seems that the adjustment is happening more in the 10-year yield than in stock valuations, as 10-year yields have been gradually declining. However, at current valuations, bonds seem more attractive than stocks, as indicated by the S&P 500’s ERP ratio (Equity Risk Premium), which Bloomberg reports is considerably lower than the average since 1945. 

Moreover, corporate credit isn’t offering much relief either, with spreads for both investment grade and high yield bonds well below historical averages and continuing to decrease. 

Will the Fed's balancing act lead to a soft landing or a harsh fall?

Future adjustments are likely to be influenced by the U.S. economy and the Fed's efforts to navigate a soft landing. If the Fed maintains high interest rates for too long, there's a risk of triggering a hard economic landing, which could lead to lower corporate earnings and stock prices. On the other hand, if the Fed cuts rates prematurely or keeps financial conditions too loose for an extended period, it could spur a resurgence in growth and inflation, prompting more rate hikes, lower valuations, and eventually another hard landing. 

Up to now, the Fed has been fairly successful in balancing these risks, but recently, the scale seems to be tipping more towards a resurgence in growth and inflation. Apollo's Chief Economist, Torsten Slok, made headlines in late February when he predicted no Fed rate cuts in 2024, a notable shift from previous expectations. Initially, the futures market had priced in up to seven rate cuts for 2024, but this has since adjusted to anticipate between three and four cuts, with the first likely in June. In their most recent communication, the Fed's dot plot indicated a forecast of three rate cuts for 2024. 

According to Goldman Sachs, the market is now placing less emphasis on significant rate cuts, instead anticipating more conservative adjustments from the Fed. As inflation rates decline, maintaining stable nominal rates results in a rise in the real Fed Funds rate. If the Fed perceives that higher real rates could hinder a soft-landing economy, they may opt for smaller rate cuts to bring down real rates. However, Bloomberg's U.S. Financial Conditions index suggests that despite the increase in real rates, financial conditions have actually been loosening rather than tightening. 

This development bodes well for the markets, as noted by Capital Economics, which highlighted the historical performance of the S&P 500 during periods of Fed rate cuts that weren't immediately followed by a recession. According to Citigroup, historical data also indicates that the Fed isn't typically deterred by a strong market when deciding to implement rate cuts. In fact, most rate-cutting cycles have commenced with stocks trading above their 200-day moving average. While the Fed may opt for smaller cuts overall, a robust market at the outset doesn't prevent them from initiating rate adjustments. 

The Fed's interest rate puzzle and the debate over real rates.

The Fed considers inflation when deciding on interest rate cuts due to high real rates. Inflation can be measured in various ways, leading to different conclusions. Financial assets, like break-even rates on inflation-protected bonds, usually indicate lower inflation, making real rates seem higher. Conversely, Core CPI suggests higher inflation, resulting in lower real rates. 

Using the Fed's preferred inflation measure, Core PCE, the Fed Funds rate doesn't appear overly restrictive. According to TS Lombard, January's monthly Core PCE was nearly the same as the current Fed Funds rate, indicating near-zero real rates. 

The Fed also considers the long-term equilibrium rate where rates neither stimulate nor restrict the economy. This level, known as R*, is subject to debate. While the New York Fed estimates it at 0.7%, the Richmond Fed suggests 2.2%. Adding a 2-3% inflation rate to the Richmond Fed's estimate for R*, the current Fed Funds rate of 5.25 to 5.50% doesn't seem far off. 

In terms of inflation, January saw an increase in price indices, challenging the deflation outlook. Both the Producer Price Index (PPI) and Consumer Price Index (CPI) showed higher-than-expected price rises, along with the Personal Consumption Expenditure (PCE) Index and the Institute for Supply Management (ISM) Services Prices Paid Index. 

Of particular concern was the PCE Supercore Services, which excludes energy and housing. While the headline PCE rose 2.4% year-over-year and Core PCE increased by 2.8%, both in line with expectations and down from December, the Supercore saw a notable 0.6% monthly increase, its largest in a year, though its year-over-year increase was slightly up at +3.5%. The Trimmed Mean, which removes extreme components, also showed strength both monthly and year-over-year. 

Looking optimistically, Stifel noted a rebalancing in the U.S. labor market, with fewer workers quitting and the Job Openings to Unemployed People ratio moving towards a sustainable range for wage inflation. Additionally, deflationary pressures in China could lead to lower import prices, at least until potential tariffs are imposed by political figures like Donald Trump. 

A significant risk for inflation lies in a tight job market coupled with robust wage growth. According to a recent report by the Boston Consulting Group (BCG), the tightness in the labour market predates the pandemic, and historically, such periods have ended with either a financial crisis or a break in the inflation regime. While the St. Louis Fed notes that an increase in early retirement has contributed to the tightness, the surge in retirements occurred after the pandemic and much later than when BCG identifies the tight labour market era beginning. This indicates that early retirement alone cannot explain the current labour market tightness. BCG attributes this tightness to various structural factors, including aging demographics, reshoring, and the transition to green technologies. As highlighted in a recent Bloomberg article, the U.S. requires more immigration, yet political tensions around immigration, particularly in the lead-up to the 2024 Presidential election, make significant policy changes unlikely in the near term. 

The robustness of the U.S. job market is one of several conflicting signals within the U.S. economy. Raymond James suggests that the perceived strength of the job market depends largely on the survey used. The Establishment survey, which generates the non-farm payroll figure, indicates U.S. employment is growing at a 2% rate, with an acceleration observed in January. However, the Household survey, from which the unemployment rate is derived, shows sluggish employment growth since early 2022, with recent months even witnessing negative growth. Furthermore, Bloomberg notes a discrepancy where yearly job growth stands at a solid 2%, yet hours worked have consistently declined. Most of this growth has been concentrated in three sectors: government, healthcare, and hospitality. While the job market may appear robust from the surface, a closer examination reveals underlying complexities. 

Weighing rally optimism against caution amid mixed signals.

So, should investors feel upbeat or cautious about this market rally? It's a bit of a mixed bag. On one hand, strong returns are hard to dislike, but on the other, this market presents some challenges. It's heavily reliant on a handful of dominant AI-driven companies, fueled by hopes of lower interest rates, and it's not exactly cheap. Yet, despite these concerns, it continues to climb. It's impressive, yet unsettling at the same time. 

The S&P 500 surged with the expectation of multiple rate cuts in 2024, but that was tempered down to just a few based on stronger inflation data, and surprisingly, the bull market didn't flinch. True, U.S. stocks are pricey, largely due to these top-performing companies, but they're also incredibly profitable. While we're doubtful about the sustainability of their growth rates, maybe that's a problem for another day. Valuation is typically a reliable predictor of long-term performance, but it's often irrelevant in the short term. 

Sentiment appears stretched, but let's not forget it's an election year. As noted by Strategas, stocks tend to thrive during election years when an incumbent President is seeking reelection. Cynically speaking, there are usually measures in place to keep the economy stable leading up to election day. 

In the near term, there could still be room for this bull market to push forward. Sure, it's trading well above its long-term moving average, and a pullback is bound to happen eventually. But rather than the top companies being dragged down to join the pack, perhaps the rally will broaden, and the S&P 500's equal weight index will catch up. Financial conditions remain loose, and the Fed is likely to further ease them with some rate adjustments, possibly starting in June. While there are concerns about the economy and interest rates in the long term, for now, things are looking pretty good. There are some cracks and uncertainties, sure, and maybe it will all end poorly. But not this month, and perhaps not before President Biden secures re-election.