Let me start this morning by reviewing consensus expectations for 2024. Consensus is almost always wrong, but that is what is built into today’s prices for financial assets.
• The Fed will start cutting rates before mid-year. Fed officials lean toward June while markets are expecting March will be the beginning. Longer term, the Fed Funds rate should be headed toward 3%. It won’t get there in 2024 but the path toward 3% should be clearer by the end of 2024.
• Corporate earnings rose in the third quarter of 2023 and probably rose again in the fourth quarter. Earnings season is just starting. Going forward consensus is for an 8% increase in 2024. That presumes a soft landing.
• Indeed, markets expect a soft landing although there is a significant minority that predicts a recession.
• The market makes no prediction on events that could have some economic impact, including the outcomes of war in Ukraine and the Middle East, significant changes in the economic outlook for China, U.S. politics, or global warming.
• Immigration. About 3 million people tried to enter the U.S. via our southern border. About 600,000 were turned away. The rest got in somehow. Add that to legal immigration totals and that’s a lot of new mouths to feed, a lot of new workers who make and spend money. There is nothing wrong with being the best country in the world with the most opportunities. We are a nation built on immigrants. To be sure, the massive unchecked inflow creates problems, but economically it’s a positive.
With that said, one has to ask what are the upsides or downsides to that consensus? Let’s start with the upside.
• Inflation could fall quicker than expected allowing the Fed room to cut rates faster. That would bring down yields all along the curve and lead to higher P/E ratios.
• Corporate managements have proven surprisingly adept at maintaining or even increasing profit margins. Margins took a hit post-pandemic due to supply chain issues and difficulty keeping up with cost of goods inflation. In addition, inventories swelled and needed to be depleted. That process is probably over. Despite the pressure of lower top line growth, margins could hold up
• While the valuation of the Magnificent Seven is high by almost any standard (but maybe not absurd if growth matches expectations), the valuation of the other 493 stocks in the S&P 500 is no higher than normal. If earnings start to accelerate and interest rates come down, valuations will improve.
• Markets often stumble in front of the first rate cut, which often accompanies a weakening economy, but over the ensuing 12 months, stocks generally turn in above average performance.
• Adding these together, higher earnings, the possibility of lower-than-expected inflation and interest rates, and reasonable valuations excluding the very top of the S&P pyramid, leads to a possibility of another 10%+ year.
But all that has to work. The skies aren’t perfectly clear. Storm clouds exist. So, let’s look at the possible downside.
• Number one is the possibility of recession. Since the 1960’s, 9 of the previous 12 rate tightening cycles ended up in recession. The lead time between the start of the tightening cycle and the onset of recession was 21-24 months. We are in month 22. There is no statistical correlation between the pace of rate hikes and recession risk. There are signs that things have been slowing down post-Christmas. But there have been multiple signs of weakness over the past year in parts of the economy that did not lead to recession. Thus, it’s a risk, not a certainty.
• Should there be a recession, it will be hard to achieve the profit growth targets of analysts. Even if recession fails to evolve, and earnings grow at a high single digit pace or greater, the growth will be concentrated in a few industries, led of course by some of the magnificent 7.
• If there is a soft landing but inflation remains materially above the 2% target, the Fed will be in no hurry to lower rates significantly. Indeed, except for a few industries like housing, there are few signs to date that high rates are slowing demand in a material way. The Fed doesn’t want to cut and see inflation reappear. Better to keep rates higher for longer than risk a return of inflation.
• China is a mess. Population is falling and the decline is destined to accelerate. Deflation has taken hold. Central party actions to stem the tide have largely failed. The real estate sector is suffering from shrinking demand and swollen debt. China is over 20% of world GDP. When China sneezes, the world catches a cold. If growth falls from 6% to 3%, math suggests that will negatively impact world GDP growth by 0.6%. On the flip side, one way to stimulate production in China is to increase exports at low prices. China’s deflation becomes a negative force worldwide.
• Politics could interfere. Right now, Wall Street doesn’t care because (a) it doesn’t know who will be President and (b) it doesn’t know the makeup of the next Congress. But clearly Trump and a Republican Congress offers a far different economic picture than Biden and a Demographic Congress. Note that stock markets have done well under both their Presidencies. But for the most part, except for the Trump tax cuts in 2017, what little that has passed Congress has not made much economic difference.
• War. War itself is rarely bad for stocks. But oil embargos, supply chain disruptions and tariffs are. We need to watch and react.
• With all this said, the negative outlook suggests less earnings growth, higher interest rates and lower P/Es, and a sour consumer mood. Not the worst of all worlds.
The bottom line is that the optimistic outlook isn’t all that optimistic while the negative picture isn’t very calamitous either. That leads to a prediction of a market centered around current levels with more volatility than last year. Neutral for the overall averages but opportunities exist if one can isolate companies capable of growing at a rapid pace in an environment that offers only modest head or tail winds.
So, where does this lead me as an investor? If I find the right company, I don’t worry about whether the economy provides a modest headwind or tailwind. We have all kinds of revolutions happening. Artificial intelligence is number one. Not all the hype is noise. There was an Internet bubble in the late 90s but the Internet turned out to be very real. AI tools will be enhanced in the cloud. They will be enhanced on the desktop. Whether you are doing research, writing software code, fighting a legal battle, or simply trying to improve your customer’s experience, AI is the vehicle to make that happen. In the early 80s the PC revolutionized computing. In the 90s, the Internet did the same. The smartphone came along a decade later. Now it’s AI’s turn. Don’t underestimate it. But AI isn’t alone. Medicine is changing (with AI’s help). Revolutionary drugs to combat obesity not only make us thinner but healthier. Genetic engineering is saving millions of lives. Many were saved from Covid by mRNA. It has a bright future. There’s more to come.
Technology is also a powerful deflationary force. As machines get smarter, they can take over more and more human tasks, and they get more efficient. Intelligent farm equipment improves food yields. Someday (later than the hype suggests), driverless cars and trucks will be commonplace. This is an evolutionary process. Indeed, it has been for decades, and it is all deflationary. It will take time to completely heal supply chains but inflation of 2% or less is probably inevitable.
The question isn’t whether you want to own the companies leading all these transformations. Of course you do. The question is what is the right price to start buying? Big companies have huge advantages because they have the capital to invest in all this magnificent technology.
There will be market corrections; they always occur. Identify what you want to own. At least nibble when a correction happens. Don’t get too picky on price. Buy a little. If it goes down more, buy some more. That’s how you build positions. Somedays, markets give you a gift. Like 2009 or mid-2020 when all of us were in sequestered panic. But that doesn’t happen very often. More common are 10-20% corrections that offer relative bargains. Use them to establish beach heads. The long-term rewards will make the process worthwhile.
Today, Michelle Obama turns 60. James Earl Jones is 93. As a Philadelphian, I can’t ignore the birthday of Ben Franklin. Today, is the 318th anniversary of his birth.
James M. Meyer, CFA 610-260-2220