The Big Picture
Inflation is coming down, interest rates have come way down, forward 12-month earnings estimates continue to increase, the unemployment rate remains low at 4.2%, and the Federal Reserve is about to cut the target range for the fed funds rate for the first time since March 2020.
How can you not like the stock market with a fundamental backdrop like that?
To be sure, there has been a lot of love for the stock market this year. The market-cap weighted S&P 500, the equal-weighted S&P 500, and the Dow Jones Industrial Average are on the doorstep of prior record highs reached in August.
The Nasdaq Composite set a record high in July and is up 17.8% for the year as of this writing. The S&P Midcap 400 and Russell 2000 have trailed that performance, yet they are still up 8.9% and 7.2% year-to-date, respectively.
2024 has been a great year thus far for the stock market, which has also been energized by AI enthusiasm, mega-cap leadership, and visions of a successful soft landing for the U.S. economy.
The greatness can be seen in the performance of individual stocks, and it can also be seen in the full, if not rich, valuation for the S&P 500.
It's Getting Hot in Here
Getting right to it, the market-cap weighted S&P 500 trades at 21.1x next twelve-month earnings ("NTM") and 23.2x trailing twelve-month earnings ("TTM"). The former is a 32% premium to the 20-year average. The latter is also a 32% premium to the 20-year average. That is rich.
Of course, the run by the mega-cap stocks has had some outsized influence on the stretched valuations. Looking at things on an equal-weighted basis, the P/E multiples are less demanding.
The equal-weighted S&P 500 trades at 16.7x NTM earnings and 18.3x TTM earnings. Both are in-line with their 10-year average. That isn't rich, but it is full.
The S&P 500 Index, however, provides one pathway to investing in the stock market. There are multiple paths to doing that. One can focus on an individual stock, an industry group, a sector, and/or an index. You can invest in micro-cap stocks, small-cap stocks, mid-cap stocks, large-cap stocks, and mega-cap stocks In aggregate, though, the U.S. stock market isn't cheap.
One telltale indicator for such an assertion is the ratio of the Wilshire 5000 market capitalization to nominal GDP. This is the so-called "Buffett Indicator," popularized by none other than Warren Buffett who said the following in late-2001:
"If the percentage relationship falls to the 70% or 80% area, buying stocks is likely to work very well for you. If the ratio approaches 200% – as it did in 1999 and a part of 2000 – you are playing with fire."
We're well beyond the ratios seen even in 1999 and 2000. In fact, the ratio today (193.5%) is approaching the record high seen in August 2021 (201.1%).
In the realm of things that make you go "Hmmm," Berkshire Hathaway has been actively reducing its (large) stake in Bank of America (BAC) and now sits on $277 billion of cash and short-term investments as of its second quarter earnings report, up from $147 billion in the same period a year ago.
Money Park It Funds
Is the Wilshire 5000 to GDP ratio an outright sell signal? No. It is, however, a valuation beacon that suggests one needs to be more discerning about "chasing stocks," and the price of entry, as future returns will be less when starting from a high valuation point.
That is a prudent warning for a market that runs on momentum, awarding billions of dollars of market capitalization to companies X, Y, and Z just because company A had a good earnings report or has issued a press release with the right buzzwords.
This is also prudent knowing that the stock market has been frontrunning the Goldilocks scenario of the Fed perfectly executing a soft landing and seemingly ignoring the world around it, which includes a war in the Middle East, a war in Europe, a weak Chinese economy, struggling low-income consumers, an untenable debt situation in the U.S., and an election whose outcome will matter greatly for the path of fiscal policy in coming years.
Perhaps those things aren't being ignored completely. At the same time the stock market has run to record highs, so has the amount of money parked in money market mutual funds.
Higher interest rates have been the draw here, but as stocks have run to record highs on the belief the economy will achieve a soft landing and that the Fed will be cutting rates, there hasn't been any large outflows from these funds. In fact, there is $6.32 trillion parked there now versus $6.24 trillion when Fed Chair Powell gave his Jackson Hole speech and said the time has come for policy to adjust.
The uncertainty of the election outcome could be a tying factor; and rates haven't dropped yet. It is hard to ascertain if that money is there in anticipation of a more challenging investment environment or lying in wait to be deployed into riskier assets after the election. Time will tell, but there are a lot of unknowns wrapped up in that $6.32 trillion.
It's another item that makes you go "Hmmm."
It's Earnings
What is it about this stock market that has made it seem unstoppable. The AI enthusiasm will be top of mind for a lot of people, along with impending rate cuts and an economy that has weathered 11 rate hikes by the Fed since March 2022 and hasn't broken.
That is all part of it, but the catch-all answer is earnings and earnings estimates. The chart below shows a rising trend for next twelve-month earnings estimates. They stand at $266.61 today, according to FactSet. This is why continued economic growth is so important because earnings growth goes along with economic growth.
Recessions are terrible for earnings. As stated in a prior piece, the average peak-to-trough earnings drop in a recession since 1960 has been about 31%, according to Yale University Professor Robert Shiller's data.
Rising earnings estimates can temper valuation concerns, assuming they go up at a faster rate than stock prices. Profit margin expansion is harder to come by in a slowing economy that is accompanied by lower sales growth, unless companies find a way to cut costs.
That is being helped naturally right now by moderating cost pressures (i.e. lower inflation rates) and potentially by lower interest costs. Another pathway is cutting labor expenses, which thus far has not been a prevailing approach. That is evident in the relatively low level of weekly initial jobless claims.
Stability in the labor market is a key ingredient for the Fed to achieve a soft landing, and the Fed knows that, which is why Fed Chair Powell also said in his Jackson Hole speech that, "We do not seek or welcome further cooling in labor market conditions."
The unemployment rate remains low at 4.2%, but it is up from 3.7% at the start of the year, reflecting some loosening in labor market conditions along with a reduced number of job openings.
When jobs go away and can't be found easily, consumer spending gets cut, and when consumer spending gets cut, economic growth projections get cut and earnings estimates get cut. That is why so much attention needs to be paid to labor market conditions. So far, everything remains in a tolerable state, so faith in earnings estimates being revised higher remains intact.
When that trend is broken is when rich multiples will become a bigger problem for the stock market than they appear to be today.
Something Has to Give
Falling market rates have provided some valuation support. They have come down as inflation has come down, and as rate-cut expectations have gone up.
The fed funds futures market is pricing in 100 basis points of rate cuts before the end of the year and another 150 basis points by September 2025, according to the CME FedWatch Tool. The target range for the fed funds rate sits at 5.25-5.50% today.
If the market has it right, that would put the target range for the fed funds rate at 2.75-3.00% following the September 2025 FOMC meeting, which is consistent with the Fed's longer run (or neutral) target, but well below the 4.10% median estimate for 2025 based on Fed members' forecasts at the June 2024 FOMC meeting.
Something is going to have to give. Either the Fed needs to cut rates more rapidly than it thinks or the fed funds futures market needs to check itself (again) in terms of its dovish outlook. Here again, though, the current disconnect between the fed funds futures market's thinking and the Fed's thinking is something that makes you go "Hmmm."
What It All Means
The stock market is in a good spot -- or, maybe we should say in a good head space. It sees a soft landing; it sees rate cuts; it sees inflation coming down; it sees earnings estimates holding up; and it sees a labor market that remains in relatively good shape. It also sees a secular growth trend in AI possibilities.
What it doesn't see clearly is an election outcome, and it won't until November (hopefully, not beyond that). Key to that outcome is not just who is president, but what Congress looks like, because Congress will be at the center of fiscal policy when the 2017 tax cuts expire at the end of 2025.
There will be increased volatility leading up to the November election and certainly thereafter if it is a contested election.
The pull to year-end then promises to be exciting in more ways than one, but with a rich valuation on one hand, a full valuation on another, and a valuation fire potentially burning in the background, one needs to be more prudent in investment allocation decisions, because you are not starting at a low valuation point.
