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Hang on; we do not want to try to time the fluctuations

February 26, 2024

With last week’s gains, the S&P 500 now has rallied more than 25% since the October lows in just over four months. Certainly, that is impressive and very beneficial for our accounts, and the rally broadly has been justified by hopes of Fed rate cuts, falling bond yields, declining inflation, Goldilocks growth, and momentum. At 5,100, the S&P 500 is now trading nearly 22X forward earnings, a multiple previously only reserved for periods of QE (Quantitative Easing…reducing interest rates) and 0% rates, not QT (Quantitative Tightening or raising interest rates) and 5.37% fed funds. So, as the market march higher continues, let’s step back and look at the change in fundamental factors that have fueled this rally.


Factor 1: Dovish Fed expectations. In mid-October, the S&P 500 was threatening to break below 4,000 as yields screamed higher, amid fears the Fed would be higher for a longer time. However, that all changed with Fed commentary that implied inflation was set to drop sharply and that, in turn, would lead to a less hawkish Fed. The market took those sentiments and ran with them, as expectations for rate cuts in 2024 exploded from just two expected cuts in October to seven expected cuts by December! Even though I did not for a moment believe that rosy picture, I did believe that we had reached a bottom and the markets were poised for a nice rally starting in October.


However, so far this year, those expectations have been substantially reversed. Rate cut expectations have dropped back to around four for this year, and all the while, fed funds have remained unchanged since October at 5.375%. So, the S&P 500 has rallied 25% while fed funds are unchanged, and the market expects four rate cuts, down from seven, but still higher than the Fed’s projection of two.


Factor 2: Yields. On Oct. 19, the 10-year Treasury yield hit (essentially) 5.00%. Over the next three months, pressured by extremely dovish Fed expectations, the 10-year crashed lower to below 4.00%. Since then, the 10-year has rebounded to 4.25%, and it’s threatening to break out of the 3.75%-4.25% trading range it’s inhabited for the past several months. So, the S&P 500 has rallied 25% while the 10-year yield has declined from 5.00% to 4.25%, a level it held last summer.


Factor 3: Declining inflation. Inflation has fallen sharply from the highs of over 5% in May to around 4% in October (using Core CPI [consumer price index or consumer inflation] as the metric). But since then, inflation has been flat as core CPI is still sitting, essentially, at 4.0% y/y. The Core PCE Price Index (core inflation) has fared slightly better, with year-over-year inflation declining from 3.39% to 2.93%. So, the S&P 500 is up 25% while inflation metrics have drifted slightly lower.


Factor 4: Earnings. Back in October markets expected 2024 S&P 500 EPS (Earnings Per Share) to be between $245- $250/share, far above the $225/ share in 2023. But since October, earnings expectations have declined to around $243/share. Yes, it’s still solid earnings growth, but not quite as great as expected. So, the S&P 500 is up 25%, while 2024 expected earnings have declined very slightly since then. Earnings are the most important metric for us to follow going forward since the Fed has stopped raising interest rates, inflation has declined, and the fear of recession has disappeared.


Factor 5: Goldilocks economic growth. Economic growth has continued to point towards a No Landing/Soft Landing, with the labor market remaining very strong while there have been some hints of weakness from the consumer (credit card default rates, soft January retail sales). So, the S&P 500 is up 25%, while economic growth has remained stable.


Here’s the point of this analysis: The fact that stocks have rallied since October makes sense. The Fed will cut (it’s just a question of when), yields have fallen sharply allowing multiple expansion, inflation has continued to (slightly) decline while growth has remained resilient.


However, if we look at the facts, I cannot help but feel as though this relentless rally has gone far beyond either actual improvement in the fundamentals and reasonable expectations of continued improvement. Put simply, at 22X earnings, this market is pricing in perfection while there’s absolutely been positive motion since October, I urge investors to view 5,100 in the S&P 500 as enjoyable but extremely vulnerable to a sudden, potentially violent reversal if the proverbial “music” stops in this game of financial musical chairs. My preferred tactical strategy essentially reflects the desire to reduce beta (risk) as the market moves higher yet stretches well beyond even very aggressive fundamental justifications.


But at this point, with markets this stretched near term, I can’t help but worry any “bad” news could cause a 10% drop in this market a lot easier than any “good” news could cause a 10% rally. We have a position in value in our portfolios for this reason. The downturn is probably going to happen in the next few months, but it is not time to get out because 1. The Fed could decrease interest rates during the downturn, and 2. Timing a short downturn is almost impossible.


I still believe the markets will end the year up around 15% or better, so hang on; we do not want to try to time the fluctuations.

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