Powered by spectacular gains in the so-called “Magnificent Seven,” the stock market delivered surprisingly strong gains in 2023, with the S&P 500, Dow Jones Industrial Average and NASDAQ Composite sporting respective gains of 24.23%, 13.70% and 43.42% for the year. After a dismal 2022 took the same indices down -19.44%, -8.78% and -33.10% respectively, these important market barometers are now flattish over the last two years. Indica-tive of the extraordinary concentration of this year’s gains in a limited number of mega-cap technology stocks, an astounding 72% of S&P 500 constituents underperformed the index in 2023. Indeed, the approximate 75% collective jump in Apple, Microsoft, Alphabet, Amazon, Nvidia, Tesla and Meta trounced the average stock and the Magnificent Seven now account for almost 30% of the market capitalization of the S&P 500, the highest concentration of any seven companies on record.
While this heavy tech concentration harkens memories of the late 1990s dot-com bubble, the potential for artificial intelligence (AI) to usher in an era of productivity not seen since the advent of the internet seems like the real deal to us. According to Wedbush Securities, corporate spending on AI is expected to increase from just 1% of the overall IT budget to 10% in the coming year. With global spending on IT pegged at $4.7 trillion in the current year, the stock market seems to have appropriately sniffed out the bud-ding winners in the rapidly growing AI space. UBS similarly sees corporate revenues associat-ed with AI to increase 15x over 2022 levels by 2027 and views AI as the “the key theme driving global tech stocks again in 2024 and the rest of the decade.” While valuations of the Mag Seven may be stretched, especially in comparison to the many other constituents of the S&P 500, this premium may be warranted considering unparalleled balance sheet strength, tremendous cash flow generation and accelerating earnings growth in the wake of the ongoing AI revolution.
While AI stole the show in 2023, we expect market breadth to widen in 2024 as the rest of the market plays catch-up to the renewed bullish trend. In addition to AI enthusiasm, the stock market is increasingly pricing in a Fed-engineered soft landing. Having held interest rates steady for the third consecutive meeting of the FOMC in December, it has become clear that the Fed now has a more balanced view of the tradeoff between tightening rates enough to curb inflation and monetary policy that may be too restrictive. The final 2023 meeting of the Fed gave investors much to cheer about. Indeed, the Fed telegraphed that the federal funds rate has reached its peak and FOMC consensus projections call for three quarter-point rate cuts in 2024. While it remains premature to “declare victory” over inflation, Fed Chair Powell did not push back on market expectations for an easing of rates to commence as soon as March of the New Year. Powell also testified that “inflation keeps coming down, the labor market keeps getting back into balance, and it’s so far so good. We kind of assume it will get harder from here, but so far, it hasn’t.”
The personal-consumption expenditures (PCE) price index fell 0.1% in November, the first de-cline in PCE since April 2020. Core PCE, which excludes volatile food and energy prices and is the Fed’s preferred inflation gauge, rose just 0.1% in November and is now up only 1.9% on a six-month basis, below the Fed’s 12-month 2% target. This very encouraging news on inflation has been accompanied by consumer spending that surprised to the upside in November and a resilient labor market. The U.S. added 216,000 jobs in December, while unemployment held steady at 3.7% and the labor-force participation rate ticked lower to 62.5% from 62.8%. Some-what remarkably, the collective data indicates that the Fed may have succeeded in bringing inflation to the cusp of its long-range target with-out too much disruption to the labor market and overall economy. The demand for labor has clearly cooled with previous monthly gains re-vised lower and the current pace well below the average monthly gain seen over the last two years. With yields on the benchmark ten-year Treasury bond having fallen from 5% to approximately 4% since mid-October, the bond market has taken notice. All of this should be viewed as welcome news for the Fed and investors alike.
Supply chains disrupted by the pandemic are again running smoothly. Durable goods inflation, spiked higher by supply shortages, combined with higher demand from consumers flush with stimulus cash, has abated and prices have fallen year-over-year for five consecutive months. The surge in supply of goods and services accompanied with post-pandemic normalization has helped bring balance back to the economy with-out need for any massive disruption in demand. Now within the market’s crosshairs, the Federal Reserve may be able to cut rates because inflation is falling faster than expected, not because of imminent economic danger. As inflation continues to ease, real rates become overly restrictive, giving the Fed more leeway to cut.
To be sure, it’s not all peaches and cream on the economic front. Credit card delinquencies have risen above pre-pandemic levels, manufacturing has slowed, the national office vacancy rate at 18.2% sits at a 30-year high, and unemployment is penciled to increase to over 4% this year. The lag effect of the rate hike cycle is finally reverberating throughout the economy. While the ability to avert recession remains to be seen, the data thus far is very encouraging and bodes well for the potential return of the Goldilocks economy.
Meanwhile, continued turmoil in Ukraine and Israel and a looming U.S. Presidential election will give markets plenty of headline risk in the coming year. In addition, incoming economic and inflation data points will be carefully examined over the coming months for any sign that the economy is cooling faster than anticipated. Especially since the year-end stock market rally leaves valuations towards the higher end of their historical range, we expect to see continued volatility in the year ahead. However, with approximately $6 trillion invested in money markets, there is ample cash on the sidelines to fuel a buy-the-dip mentality.
With the Fed on the path to accommodation from restriction and with consensus 2025 earnings expectations at $274 for the S&P 500, we see the stock market trading to and through new all-time highs in the coming year. If we apply the same present-day earnings multiple to the forward 2025 consensus, we can see the S&P 500 reaching 5,400 with a range of 4,200 to 5,700, implying approximate 10% downside risk and 20% upside potential over the coming year or two. As reversion to the mean kicks in for the vast majority of companies and as the Mag Seven catches a potential breather, we believe an equally weighted strategy will outperform the indices in the coming year.
The opinions expressed herein are the sole views of Osher Van de Voorde Investment Management. Supporting data and factual information used throughout is deemed to have been obtained from reliable sources.
