Q2 2024 Multi-Asset Strategies Outlook
Top-Five Reasons the S&P 500® Index May Have Gotten Ahead of Itself
The S&P 500® Stock Index is in the middle of a remarkable run since its October 2023 lows. Optimism around artificial intelligence (AI), progress on inflation, hopes for an economic soft landing and Fed rate cuts help explain the rally. But now stocks are priced such that they require near perfection on the economy and strong corporate earnings growth in the future to justify further gains.
We see five reasons that stocks may have gotten ahead of themselves.
1. Corporate Earnings Aren’t as Good as You Think.
Earnings for the companies in the S&P 500 were up 4% in the fourth quarter of 2023.1 But those earnings are heavily skewed by the results of the Magnificent Seven mega-cap stocks. For example, Nvidia reported earnings growth of 486%. Facebook’s parent company, Meta Platforms, reported a 200% increase in earnings.
According to an analysis by UBS, when you strip out the so-called “tech+” stocks from the S&P 500, earnings growth for 2023 was barely positive. Furthermore, FactSet data shows health care, energy and materials firms endured double-digit earnings declines. Consumer staples and financial companies showed earnings growth of only 2%-4% on average. So clearly, the market overall is not showing great earnings results.
Another challenge is that future earnings estimates are too high in our view. According to FactSet, analysts are projecting earnings growth of 11% for all of 2024, powered by 17% growth in the fourth quarter. It’s hard for us to see where that sort of earnings growth will come from. The economy is near full employment, most Americans have burned through excess pandemic-era savings, and the federal debt and deficit are stretched.
2. Valuations Aren’t Great Either.
With these generous earnings numbers, the forward price-to-earnings (P/E) ratio for the S&P 500 is calculated at 20.4 times the earnings expected in the next 12 months. By comparison, the five- and 10-year average P/Es are calculated at 19.0 times and 17.7 times, respectively. If you take these earnings numbers at face value, stocks are only modestly overvalued. But if you are skeptical that companies could earn at these forecasted rates, valuations begin to look stretched.
By other metrics, the case is worse. The cyclically adjusted price-to-earnings (CAPE) ratio has only been this high twice. The first was during the dot-com bubble, and the second was in 2021 before the big 2022 sell-off. Of course, the Magnificent Seven stocks also contribute to this valuation disparity as investors have paid up for the potential earnings growth these companies have provided.
3. The Market Needs a Proactive Fed.
Like most market strategists, we were wrong in forecasting a recession last year. And we could be wrong now because it’s possible that the Federal Reserve (Fed) is on the threshold of engineering a “Goldilocks” soft landing. However, one could argue that the best way to achieve a soft landing would be to start cutting rates now before the housing and job markets weaken further.
But we don’t think that’s what the Fed will do. The notes from the latest Fed meeting make clear that the policymakers see the inflation risk from easing too quickly as outweighing the downside economic risk of keeping rates high for too long. In other words, they aren’t going to cut rates until they are confident that inflation is dead and buried. That’s bad news for those hoping for rapid rate cuts to justify the market’s latest rally.
4. Inflation Isn’t Done and Dusted Quite Yet.
Markets cheered because data showed the Fed’s preferred measure of inflation, core personal consumption expenditures (PCE), rose just 2.8% for the trailing 12 months through January.2 That’s half of what it was at its peak in early 2022. Sounds great, right?
Unfortunately, the latest monthly run rate for core PCE was 0.4%. That was consistent with recent core Consumer Price Index (CPI) readings (excludes food and energy prices) and Core Producer Price Index (PPI) readings, whose monthly rates of increase were 0.4%.3 Annualized, that works out to inflation of roughly 5%. That’s more than two times the Fed’s inflation target of 2%. To be sure, we’re not predicting a sudden increase in prices. But we think inflation might face more fluctuations than the market anticipates. Of course, January could have been a passing blip or a statistical oddity caused by one-time seasonal adjustments to the data. But we don’t think investors can give inflation the last rites, either.
5. The Long-Term Stock/Bond Relationship Suggests a Limited Upside.
As measured by the S&P 500, stocks returned 12.0% on an annualized basis over the 10 years ended December 31, 2023. If you look at the prior 50 years, stocks returned 10.0% per year.
By comparison, as of the end of February, the S&P 500 was up 7.1%.4 Of course, past performance can’t dictate future returns. However, these historical averages can serve as helpful guidelines for contemplating potential outcomes for stocks from here.
Here's another way to look at it. In late 2023, when Wall Street brokerage firms were issuing their 2024 forecasts, 5,000 was thought to be an aggressive call for the year-end 2024 level on the S&P 500. As of the end of February 2024, the index stood at 5,085.5 Of course, many analysts have subsequently raised their year-end projections as the market rallied. But it’s worth keeping in mind just how much ground the market has already covered in defiance of expectations.
¹ FactSet. As of March 11, 2024.
² Bureau of Economic Analysis. As of February 29, 2024.
³ U.S. Bureau of Labor Statistics. As of March 12, 2024.
⁴ FactSet. As of February 29, 2024.
⁵ FactSet.
Asset Class
U.S. Equity vs. U.S. Fixed Income & Cash Equivalents
Our biggest call is to overweight cash versus stocks. As long as the Fed holds short rates around 5.5%, cash is preferable to longer-term bonds and to stocks, whose relative valuations are less compelling. Stock momentum is undeniably positive, but not strong enough to overcome the attractive risk/reward cash provides at present.
Equity Region
U.S. vs. Developed Markets
Our model is shifting toward a preference for U.S. over developed market equities, but so far at least that directional change isn’t enough to move us into a new overweight position. The U.S. benefits from better relative growth and stock momentum. We’ll be monitoring these conditions closely going forward to evaluate whether a U.S. overweight is warranted.
U.S. vs. Emerging Markets
It’s a similar story in our emerging market model, where the trend is clearly moving toward a U.S. overweight. But so far the readings haven’t tipped over into actionable territory just yet. China’s economic troubles are well documented; growth elsewhere is uneven. Of course, emerging market fundamentals and opportunities are incredibly diverse, so this is an area where active portfolio management of underlying positions is another crucial step alongside tactical allocation decisions.
U.S. Equity Size & Style
Large Cap vs. Small Cap
We’ve been in a remarkable period dominated by the results of a handful of the largest stocks. That narrow market concentration has been waning in recent months, and small-company stocks have begun to exhibit positive momentum. And it’s true that in a soft-landing scenario of broader growth, small could do well relative to large. But economic uncertainty is high and for now we remain neutral by size.
Growth vs. Value
Our growth/value model is highly bifurcated. One component strongly favors value and the other growth. As we discussed last quarter, the growth and value segments each face a unique set of considerations that complicate an over- or underweight decision. Higher interest rates and economic uncertainty weigh on many of the value segments, while growth performance and earnings have been skewed by a handful of the very largest stocks. Lacking clarity or resolution on these issues, we remain neutral for now.
Fixed Income
U.S. vs. Non-U.S.
The much-anticipated recession never arrived, but our fixed-income team continues to believe that growth will run at a pace below the long-term average. The implication in terms of credit quality is that we are tilted decisively toward investment-grade credit over high-yield bonds, where the risk/reward is less favorable. In country terms, the U.S. may well be the cleanest shirt in the economic dirty laundry. We are neutral in terms of U.S. versus non-U.S. exposure, preferring to allow our fixed-income managers to choose the individual issuers and positions they find most compelling, regardless of country.
Alternatives
REITs vs. Core Assets
We eliminated our long-running underweight to real estate investment trusts (REITs), which proved one of our most successful tactical positions. Now we’re neutral and REITs have recovered some lost ground. But we’re reluctant to overweight the asset class given the fact that cash yields remain so compelling. In addition, mortgage rates/financing costs represent a challenge for the sector. Of course, attractive relative values remain, but we prefer to allow our portfolio managers to identify those opportunities for us, rather than make a broad call on the asset class at this time.
References to specific securities are for illustrative purposes only, and are not intended as recommendations to purchase or sell securities. Opinions and estimates offered constitute our judgment and, along with other portfolio data, are subject to change without notice.
International investing involves special risks, such as political instability and currency fluctuations. Investing in emerging markets may accentuate these risks.
Investment return and principal value of security investments will fluctuate. The value at the time of redemption may be more or less than the original cost. Past performance is no guarantee of future results.
Historically, small- and/or mid-cap stocks have been more volatile than the stock of larger, more-established companies. Smaller companies may have limited resources, product lines and markets, and their securities may trade less frequently and in more limited volumes than the securities of larger companies.
Diversification does not assure a profit nor does it protect against loss of principal.
Generally, as interest rates rise, bond prices fall. The opposite is true when interest rates decline.
Past performance is no guarantee of future results. Investment returns will fluctuate and it is possible to lose money.
The opinions expressed are those of American Century Investments (or the portfolio manager) and are no guarantee of the future performance of any American Century Investments' portfolio. This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.