April 1st, 2024
As markets reach new highs, investors capitulate about their exit. Has another bubble emerged? Should we take our profit and run? Is inflation under control, and will we see the Fed’s promised three rate cuts in 2024?
Bubble, Bubble Toil and Trouble?
US Large Caps, particularly US Tech stocks, have continued to set new high after new high. There has been debate over whether the current valuations are justified. Whether the impressive earnings growth can persist. There have also been calls for a rotation into the more unloved segments of the market. That being small and mid-capitalization companies who have yet to see the run up that the ‘Magnificent Seven’ have enjoyed. The run up for names such as Nvidia (NVDA), Microsoft (MSFT), and Meta (META) – among others – has been truly impressive, but also justified by earnings results that have consistently blown away analysts’ estimates. While these big names have ballooned in market cap, they have left the smaller – and less profitable – companies in their wake.
For those concerned of a bubble in tech valuations, the earnings growth continues to defy those claims. Earnings-Per-Share (EPS) growth for large cap tech has exploded higher and shows no sign of slowing down. Currently, S&P forecasts the Tech sector to grow earnings at 29% in 2024, and another 17% in 2025. Based on these metrics, the Tech sector is trading at under 20x 2024 EPS and around 17x 2025 EPS, which would be far from ‘bubble’ territory.
Having said that, there appears to be a significant relative value investment play one could make in market laggards – small & mid-capitalization companies who are historically undervalued – that should present itself as soon as the Fed begins cutting interest rates. I have made my case about this in several past newsletters. The chart below shows how the equal weight S&P 500 (RSP) and Small-Caps (IWM) have almost kept pace with the traditional market-cap S&P index (SPY), although the “Magnificent Seven” (MAGS) continue to lead the pack.
So, in 2024, it does appear that the market is trying to get on board with broadening exposure to those other than the Magnificent Seven, but at the same time tech continues to attract the most attention and investor capital.
As tech earnings continue their jaw-dropping growth, the candidates for a rotation haven’t been able to keep pace on the EPS front. It is well noted that 40% of small-cap stocks in the Russell 2000 are unprofitable. This explains why everyone has piled into large-cap tech and investors largely remain unwilling to rotate out of tech until interest rate cuts become present. Still, valuations on the laggards have fallen so low that they remain an enticing value proposition for when rates begin to decline.
Ultimately, big tech will likely continue to grow. Everyone else will likely catch up once rate cuts emerge. A bubble does not appear to be upon us.
Inflation and Rate Cuts
Investors have been on edge in anticipation of the latest Federal Reserve “Dot Plot” summary of interest rate projections due to speculation that some FOMC members would revise their rate cut forecasts. While there was some movement in the dots, the median forecast remained unchanged, at 75 basis points (three cuts) for 2024. Investors were relieved at the Dot Plot news and encouraged by Chairman Powell’s relatively upbeat tone during his press conference. Powell was not fully dismissive of the recent hot inflation data but stressed that two bad data points do not indicate a deviation from the downward trend in inflation and that the Fed still anticipates cuts at some point in 2024.
In my opinion, we’ll have some rocky moments this year. But the narrative oscillating between booming tech profits and rate cuts will continue the bullish market regime at least up until the election.
And now, your Monthly Market & Economic Update by the numbers.
Warmly,
Mark S Sauer
Market Update
Global Equities: Stocks grew at an exciting pace during the final month of the quarter, with the S&P 500 up 4.06% and the Nasdaq up 2.21%. The Dow Jones Industrial Average finished the month up 2.1% and Small Caps moderately performed with the Russell 2000 up 2.82%. Developed International stocks gained 2.62% while Emerging markets gained 1.02%.
Economic Update
GDP Revised: The final revision of fourth quarter 2023 GDP showed US economic growth improved from 3.2% to 3.4%, surprising economists who expected no change. The US economic output has defied all expectations and looks set to continue outperforming with the Atlanta Fed’s GDPNow model projecting a 2.1% growth rate in the first quarter 2024.
Charts of the Month
Home Builders Vs. S&P 500
Our first chart shows the SPDR S&P Homebuilders ETF (XHB – blue line), an ETF comprised of homebuilders, building suppliers, and home improvement retailers; compared to the S&P 500 ETF (SPY – orange line). XHB has begun to outperform the broader market in advance of the eventual Fed rate cuts, despite expectations for the first cut being pushed back to June at the earliest. The supply-demand imbalance has kept home prices high and given pricing power to new home builders even as mortgage rates exceed 7%. Housing inflation is a problem for the Fed as it seems unable to influence home prices which are contributing to keeping overall inflation metrics elevated.
Rate Cuts – Fed’s Dot Plot
Our next chart shows the change in the Fed “Dot Plot” from December 2023 to March 2024. While some of the more dovish FOMC members have revised their forecasts to call for fewer rate cuts, the median forecast remained unchanged, much to the relief of investors. The expected timing of the initial rate cut has been pushed back several times, with June odds presently at around 75%.
Inverted Yield Curve
Our final chart shows the spread between the 10 and 2-Year Treasury Yields. The spread between the two remains inverted and has now broken the record of 420 days from 1978-80 for the longest inversion in history (red bands highlight prior record and current inversion). A 10-2 yield curve inversion is typically considered a precursor to recessions, as noted by the grey shaded bands that followed prior inversions. While the future is unclear, this inversion is a bit different as it resulted from the most aggressive Federal Reserve policy in history amidst a backdrop of record-setting corporate earnings and historically low unemployment. Still, there can be considerable lag between inversion and recession, so the jury remains out on the Powell regime’s stewardship of the economy.
