December 26, 2023Scroll down
The CIO’s Take:
In the final Perspectives note of 2023, we look toward the year ahead: specifically, running through popular equity strategists’ 2024 forecasts for the S&P 500. Sure, we know these predictions are just as often wrong as they are right, but it’s still interesting to see the dispersion among outlooks, with Oppenheimer and Goldman predicting a stellar year ahead for US stocks, while JP Morgan has the market nearly 12% lower twelve months from now. As will be obvious reading our commentary over the last 52 weeks, we’re allocating to both bonds and stocks—it pays better to be fully invested—but, like JPMorgan, we see plenty of risk in US stocks, which appear to have baked in not just a Fed pivot, but a rather aggressive series of rate cuts in 2024. Our asset allocation thus remains globally diversified into markets with differentiated features and cheaper valuations, and we still think Treasuries at the front end of the curve put investors in a good position if we’re correct and the Fed’s timeline for easing disappoints. With that, we wish our readers Happy Holidays, a Merry Christmas, and a very Happy New Year (with better than 2% equity returns).
Analysts see modest upside for stocks in ’24
Trading had already been winding down going into last Friday’s close, when many on Wall Street officially checked out for the holidays. Before setting their email out-of-office messages, the big sell-side prognosticators put in their year-end outlook for 2024, predicting where markets are likely to land at the end of next year. We’ve spent time reviewing those, and thought it might be interesting to spend some time in Perspectives’ last issue of 2023 breaking down those forecasts and what to make of them. Just a year ago, nine months into the most aggressive Fed tightening campaign in recent memory, the majority of analysts were predicting a relatively weak year for equities. What we got instead was an AI-fueled tech rally, a surprisingly resilient US economy, textbook disinflation—and, with less than a month to go before those 2024 outlooks hit banks’ and wealth managers’ websites, Fed messaging of a pivot to rate cuts, which investors expect to begin as early as next March. The result is a slightly rosier picture in the median analyst’s crystal ball, with Wall Street forecasting a 2% return on the S&P 500 in 2024 (see below).
Pundits’ predictions often miss the mark
When deciding how heavily to weigh the predictions you see in the chart above, it helps to consider the record of Wall Street analysts in their year-end predictions. Looking back at how they’ve done historically, it turns out investors are well served taking those forecasts with more than a grain of salt. Remember last December’s median sell-side target of a 6% gain for the S&P 500 in 2023? As of last Friday, the market was actually up 24% for the year. Taking an even longer view, the New York Times’ Jeff Sommer recently reported some interesting stats from Paul Hickey at Bespoke Investment Group, who found that from 2000 through 2023, analysts’ predictions of the US market’s return were off by an average of almost 14% percentage points, more than double the average return of the market over that period: a margin of error so large as to make the predictions completely useless in one’s asset allocation. Indeed, despite the Fed beginning to message a tougher approach to inflation at the end of 2021, Wall Street saw the market rising by nearly 4% in 2022, though it ended up falling around 19% for the year. This could be the year they get it right—but should you bet on it?
On average, don’t sell the US market short
In the long-term and over multi-year horizons, investors take risk and assets exposed to it should deliver positive returns to compensate. That’s why Rayliant’s strategic view includes a healthy allocation to risky assets like equities, and it’s why despite an occasional tactical shift to a more defensive footing, we still advise clients to stay fully invested and wouldn’t sell out of stocks completely, even in the face of a relatively cautious outlook. For that reason, it’s also not surprising that analysts generally forecast a winning year for equity markets, regardless of what’s happening in the macroeconomy: predicting negative returns for US stocks is a losing game over longer horizons. Over shorter spans, of course, the expected average positive stock market performance isn’t assured. That’s true in a rational model for how markets operate, and it’s certainly the case for those taking a behavioral view on asset prices, in which fear and greed can take hold and push prices below or above where they should be in light of fundamentals. That’s where tactical views come into play.
The glass half-full seems fully priced to us
With that in mind, it’s worth thinking about where stocks stand going into 2024. Given risk factors we highlighted in last week’s Perspectives—including the potential that inflation turns out to be more persistent than the Fed now expects, leading the central bank to disappoint on next year’s cuts, or the possibility the Fed has already overshot and the US experiences a hard landing—it should give investors with an overweight to US stocks pause to see the S&P 500 just about 2% off an all-time high and the NASDAQ already setting a new high-water mark for the first time in two years. It seems to us that the market was already pricing in good things prior to December’s FOMC. When investors got somewhat better news than they expected, they moved to bake in an even more exuberant forecast of this cycle’s outcome into prices. For better or worse, that also appears to be the consensus among sell-side analysts predicting just 2% upside for the S&P 500 over the next 12 months. Although we continue to own stocks in our balanced asset allocation models for reasons described above, we’re also not ready to rule out some less favorable scenarios in the year ahead, and maintain a defensive and opportunistic orientation (i.e., more of a “JPMorgan” than an “Oppenheimer”).
What do pricey US stocks predict?
One critique you’ll often hear leveled at end-of-year forecasts like those analyzed above is that they’re so short-term. Investing is supposed to be about the “long game.” Above, we also made some comments about a tactical component to our asset allocation strategies, which may sound short-term. In fact, we agree that investment plans are really best made over many years, and our research—also, our decades of experience—tell us that short-run market timing is extremely difficult. Over the longer-term, however, it can get a little more straightforward. To that end, Bloomberg’s John Authers recently profiled a tool created by Nobel prize-winning Yale economist Robert Shiller to track stocks’ prospects over longer horizons called the “CAPE ratio”: the Cyclically Adjusted Price-to-Earnings ratio. We’ve mentioned it before in Perspectives. CAPE effectively tells us how expensive the market is today versus its last 10 years’ worth of earnings, where the longer lookback smooths out cyclical fluctuations in companies’ profits. In the chart below, we plot the S&P 500 CAPE ratio for each month, from Jan. 1881 to Dec. 2012, against the next 10 years’ average real return for the index.
It’s easy to see the inverse relationship: The higher the CAPE (i.e., the more expensive stocks are today) the lower the returns have generally been over the next decade. CAPE actually turns out to be pretty lousy as a means of short-run market timing, but it has proven itself over a very long period as a reasonably good yardstick for longer-term asset allocators. That red band in the chart above shows how returns have been in past cases where the S&P 500’s CAPE sat near 32x, about where it is today. It’s interesting to note that subsequent 10-year returns center around the low single digits—very close to what Wall Street analysts are predicting for next year’s return. But remember, we’re now talking about average returns for the next decade; that’s an awfully long time to be suffering such low real gains on our risky stocks. There are other criticisms of CAPE, including that it might be rising over time for various technical reasons, but we still think the above visualization sheds some light on how opportunities change when equities already price in a lot of good news, as we believe they do now.
Not all markets’ stocks look so expensive
Importantly, the chart above and the stats discussed so far only address US stocks. Valuations around the world naturally won’t look exactly the same. Barclays puts out CAPE figures on a bit of a delay for a range of global markets, and we can see significant country-level variation there. European stocks, for example, come in at a CAPE of 19.5x, quite a bit cheaper than the US (which won’t surprise anyone following that market in the years since Russia invaded Ukraine, and even before that). Japanese stocks, struggling with low growth for a long time—but recently seeming on the verge of a rebound—sport a CAPE ratio of just over 22x, still pretty reasonable. In emerging markets, valuations are likewise all over the place, with some markets looking cheaper than others. In India, where enthusiasm over a relatively strong economy and the prospects of “friend-shoring” have driven stocks higher, the CAPE clocks in at 33x, even pricier than the US market. Taiwan looks a little better at 23x. In China, meanwhile, a disappointing zero-COVID exit recovery, property woes, and the country’s tense relationship with the US have pushed sentiment and prices down, such that the index trades at a CAPE of less than 11x.
What does this all mean for investors?
That divergence in valuations is part of the evidence for international diversification, which has us allocated to “all of the above” in appropriate proportions. With US valuations predicting longer-term weakness in local returns, we have a bit less than we would on average allocated there, and we’ve got a little more than usual allocated to the cheaper emerging markets. That’s not aggressive short-run market timing; you can think of it more like prudent medium-term “country rotation.” Another upshot of the analysis above is that even in markets like the US and India, which seem a bit pricey at the moment, individual stocks can buck the trend, creating opportunities for active stock pickers. Even in cheaper markets like China, there’s potential value in spotting shares that will recover and avoiding the cheap-for-a-reason “value traps” abundant amidst tough macro conditions. Indeed, if the CAPE’s forecast manifests as year after year of lackluster US equity performance, it might be just what active managers asked for from Santa for Christmas: a classic “stock-pickers market.”