Stocks: Sentiment, Valuations Stretched, But A Constructive Outlook Remains Warranted
April 2024
After a 10% gain in the 1st quarter and a jaw-dropping 26% return since the end of October, the S&P 500 was due for a pullback or period of sideways consolidation to curb the unbridled optimism that had pushed many stock charts from the lower left to upper right over the prior four months. A rapid rise in Treasury yields at the start of April appeared to be just what the doctor ordered on this front as investor unease became evident, but bears have, so far, only been able to muster a 1% pullback in the S&P 500 – hardly indicative of a shift in market character. Treasury yields have moved higher year-to-date due to a combination of stronger U.S. economic data and sticky inflation prints which, assuming this backdrop remains in place over coming months, will have implications for the path forward for monetary policy and, in turn, portfolio construction. However, at present, the necessary preconditions don’t appear to be in place to generate a deeper pullback as Treasury yields have been rising as the U.S. economy has proven resilient and expectations for cuts to the Fed funds rate have dimmed. This backdrop should lead to earnings growth over coming quarters, the most important underpinning of equity valuations/prices.
Unbridled optimism appeared to make an appearance in February and into March as some lower quality pockets, such as unprofitable information technology and biotechnology stocks, along with a few of the more recent highly acclaimed initial public offerings (IPOs) garnered investor capital. However, with the Goldman Sachs nonprofitable tech index down 13.1% and the iShares Biotech ETF (IBB) eking out just a 1.1% year-to-date gain through March, signs of speculative excess in these corners of the market appear to be isolated and aren’t sending worrisome signals just yet. While frothy sentiment is certainly one indication that the rally might be on borrowed time, it’s notable that bullish respondents in the American Association of Individual Investor (AAII) Bull-Bear in late March rose to 50%, above the historical average of 37.5%, but still below the 52.9% peak reached in December of 2023. In short, while elevated, a fear of missing out will at some point likely force sentiment to get frothier before the current run is over.
Stretched valuations for the ‘Magnificent 7’ have long been cited by bears as reason to remain skeptical of the rally. But those concerns have so far proven unfounded, and capital has rotated both within the ‘Mag 7’ as well as out of communication services and information technology and into cyclical sectors as relative value investors have reallocated to benefit from an improved economic growth outlook. This rotation is an indicator of healthy price action and a market functioning as desired with stock-specific factors considered. While the ‘Mag 7’ as an equally weighted basket trades at 26.3 times forward earnings, when one looks beyond the behemoths at the top of the S&P 500, stock valuations appear less demanding. The S&P 500, excluding the Magnificent 7, trades at a little less than 19 times forward earnings, which is above the 5-year average of 17.6 times, but is below the peak of 20.7 times seen in August of 2020. While we’re not arguing that the S&P 500 is cheap even when excluding the ‘Mag 7,’ the index has been more expensive than it is at present, and if the U.S. economy remains resilient, equity prices should grind higher alongside earnings growth. Stretched sentiment and valuations could present near-term hurdles and limit S&P 500 gains, but earnings growth should ultimately win-out and push stock prices higher.
Patience Required On Small Caps As Near-Term Headwinds Persist. Given the growing likelihood that the initial Fed funds rate will be pushed out beyond June, the interest rate environment is likely to favor domestic large-cap stocks relative to small and medium-sized companies. Ongoing labor market strength also points to persistent margin pressures for smaller firms as they are forced to pay up for workers. We entered ’24 constructive on small and mid-cap (SMid) stocks, and while the S&P Mid-Cap 400 index has fared well, rising 9.5% on year-to-date through March, small caps have done very little, with the S&P Small Cap 600 rising just 2% over the same time frame. Small caps could remain beholden to labor market data and Treasury yields over the near-term, but once the FOMC begins cutting rates investors could quickly shift their attention to the leverage small caps have to a strong U.S. economy and focus less on potential profit margin headwinds, leading the asset class to garner increased investor interest and capital.
Broader Participation An Underappreciated Story. Improved breadth has been cited by market prognosticators, us included, as one big reason why the rally can continue, but often that is specifically in reference to the S&P 500. While over 75% of the names in the S&P 500 were trading above their 200-day moving average in early April, a respectable figure, there are many country level benchmarks abroad that can make a similar claim. In early April, over two-thirds of the stocks traded on exchanges in Canada, France, Germany, Italy, Japan, Mexico, and Spain, among others, could say the same, which is an encouraging datapoint that shows it isn’t just U.S.-based technology stocks powering the sharp rally since the end of October.
Admittedly, many country indices saw price momentum wane as April began, evidenced by a smaller percentage of stocks trading above their 10- and 50-day moving averages. However, fewer stocks trading above their 200-day moving average would be more concerning, and by that metric global equities remain on solid footing. Stock prices often lead the economy, in both directions, and the improvement in equity markets in the U.K. and across Europe is pointing toward an improved outlook for the Eurozone economy and profits across the pond. Japanese stocks have outpaced other developed markets abroad by a wide margin over the past year but have faltered over the past month as the Japanese yen has weakened further, potentially forcing the Bank of Japan to tweak monetary policy further in the coming months. It is encouraging that Eurozone equities have picked up the slack and pulled the MSCI EAFE higher, leading to outperformance vs. the S&P 500 over that time frame. Abroad, developed market indices have much larger exposures to cyclical sectors and less exposure to the communication services and information technology sectors that have pulled the S&P 500 higher in recent years. A global economic upturn could provide an outsized boost to foreign developed market stocks over coming quarters and low relative valuations could begin to get the attention of investors that have been consistently under allocated to these markets over the prior decades.
