A remarkable year for stocks
It looks like we are going to close out 2024 with another double-digit gain for stocks. This makes two consecutive years. Out of curiosity, I reviewed the early 2024 predictions of the 20 biggest research publishers on Wall Street. The results were surprising. This year’s 27% YTD gain for the S&P 500 is more than 10% greater than even the most bullish among them and more than 20% more than the average predicted gain.
What is most remarkable is that stocks performed so well when the Fed was forcefully committed to its restrictive policy actions which included raising interest rates and shrinking the size of its balance sheet. The Fed has now raised its policy Fed Funds Rate by more than 4% since its first hike in March 2022, including the most recent rate reductions. At the same time, the Fed’s balance sheet has been reduced by more than $2 trillion, or 23%, since peaking in April 2022. These policy actions would normally be viewed as headwinds for markets because they effectively remove excess liquidity from our financial system. Not this time!
There are several possible explanations for the surprising strength of stocks. First, investors are mostly focused on the long-term growth in corporate earnings, and trends in interest rates. Many expected a recession in 2024, but that never happened. Expected benefits from productivity-enhancing technologies like AI also played a role in investor optimism. Moreover, the inflation rate has come down considerably since the Fed started its rate-hiking campaign. Another reason for the strength in stocks is simply that there is a dearth of stock available relative to demand coming from the vast capital flows into U.S. equity markets.
Valuations are near historical peaks, but could go higher
As a result, the valuation of stocks has increased much faster than the pace of companies’ earnings growth. The forward multiple of earnings for the S&P 500 is now almost 23x. The last two times that stocks traded for more than 22x earnings were in 2021 and 2000. Both periods were followed by market corrections. In 2022, the market declined by more than 18%, and the 2000 episode was followed by a 49% decline which ended in 2002.
Apple provides a good example of how today’s valuations differ from earlier periods. In 2014, Apple stock traded for 17x earnings, but today the stock trades for 35x. The fact that the valuation multiple to earnings is higher doesn’t necessarily suggest that the stock is overvalued, but rather it illustrates the higher valuation that investors are willing to pay for high-quality companies today relative to other periods. This same dynamic is on display broadly across many sectors in today’s market.
It’s not just stocks that trade at premium valuations today. Bonds are also expensive relative to historical levels. Credit spreads (i.e., the difference in yields of corporate bonds as compared to U.S. Treasuries of similar maturity) are at record lows, which reflects a strong appetite from investors. Today’s investment grade corporate bond spread is 0.8% which is roughly 50% of the average credit spread during the last 30 years and the tightest since 1998. Why is this?
One answer may be that there is just too much capital in the hands of investors. Investors are sitting on nearly $4 trillion of money-market funds. Corporate profits and increased dividends need to be reinvested. Yet, there are not many new IPOs or new offerings sufficient to absorb all this capital. So, prices simply go higher. This may be too simplistic, but this is the reality of today’s markets. Putting money under the mattress is just not an option, especially when purchasing power is destroyed by inflation.
It’s different this time
We have all heard the phrase – it’s different this time. Now, it is AI and the coming period of increased productivity and monetization of investments being made in the ongoing digital transformation of our economy. There is no doubt that AI will impact our daily activities and the way companies operate, but we must also recognize that markets sometimes evolve into bubbles and then reset for the next cycle. No one rings a bell at the top or bottom.
Now the Fed is cutting rates. Since the Fed made its first cut in this cycle in September, the yield on the 10-year U.S. Treasury bond has increased by 1% to approximately 4.6%. The 10-year U.S. Treasury yield reflects investors’ expectations about inflation and earnings growth going forward. So far, the higher 10-year U.S. Treasury yields have not spooked investors enough to cause a major selloff, but it has impacted certain sectors of the economy, such as housing which depends on reasonable mortgage rates.
Looking ahead to 2025
Investors are reluctant to sell stocks with big gains before year-end for obvious tax reasons. As we enter 2025, investors will be focused on companies’ earnings guidance and impacts from the new administration’s trade and budget initiatives. In addition, the U.S. fiscal deficit, which is running at 6-7% of GDP, and the national debt, which is currently near $36 trillion, are a source of increasing concern. Interest payments are becoming a bigger component of the U.S. budget and could eventually require higher interest rates to fund future spending. Changes in long-term rates can occur quickly, giving investors little time to adjust before they impact market valuations of stocks and other assets.
Investors should proceed with caution and maintain a well-balanced investment portfolio given the two consecutive years of double-digit stock market gains, which have led to very high stock valuations. Rebalancing portfolios to match the appropriate risk tolerance may be a good New Year’s resolution.
Today, NBC journalist Savannah Guthrie is 53, Foreigner guitarist Mick Jones turns 80, and NFL quarterback Brock Purdy celebrates his 25th birthday.
Christopher Gildea
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