2023-12-21 09:25:00 ET
Summary
- The stock market experienced an epic rebound in 2023; however, the lag effects of the Fed's aggressive monetary tightening actions are yet to show up in the economy.
- While investors are all bulled up going into 2024 with "soft landing" being the consensus view on Wall Street, the S&P 500 is ripe for significant correction.
- Using simple yield math, we got to a year-end target of 4,000 for the S&P 500 index, implying a 15% decline in 2024.
- Henceforth, I rate the SPY SPDR® S&P 500 ETF Trust a "Sell" at $475, with a 12-month target of $400.
Introduction
Asset prices are a random walk , i.e., the stock market is unpredictable. I don't know, you don't know, and nobody else knows where the market is going next. However, guesstimating a 12-month price target for the market - via the SPDR® S&P 500 ETF Trust (SPY) - is a useful thought experiment for investors looking to set up a robust portfolio strategy for the year ahead.
Reviewing Our Market Outlook For 2023
At my investing group, we went into 2023 with an economic thesis of " Inflation collapses along with consumer demand, " which meant defensive positioning across all of our core portfolio strategies. Here's what I wrote in my 2023 outlook note for our subscribers:
As you may have noticed, I have been positioning our core portfolios for 2023 with great caution. My intended allocation (by the end of 2023) is 100% equity, but after this latest re-balancing, we are at ~45-55% equities, ~30-40% cash (short-term treasury bills are making 4.3-4.7%), and ~15% in option-based hedges across our core portfolios. The plan is to encash (sell) our tactical hedges in the second half of 2023 (hopefully, at big gains) to buy more shares in our high-conviction stock ideas (hopefully, at massive discounts).
Equity Cash Hedges TQI's GARP Portfolio $51.87K (~53.9% of portfolio) $29.2K (~30.3% of portfolio) $15.2K (~15.8% of portfolio) TQI's Buyback-Dividend Portfolio $52.9K (~53.5% of portfolio) $30.2K (~31% of portfolio) $15.2K (~15.5% of portfolio) TQI's Moonshot Growth Portfolio $43.0K (~44.5% of portfolio) $38.2K (~39.5% of portfolio) $15.2K (~15.8% of portfolio) With the Fed tightening aggressively into a deeply inverted yield curve, a richly valued equity market faces the double whammy of a multiple contraction and an earnings recession in 2023. While we can't predict interest rates and Fed's policy decisions, we can control our investment portfolios.
Here's my outlook for this hostile market:
- An asset's PE (price-to-earnings) ratio is directly governed by the risk-free rate in the market. So if the Fed moves risk-free rate to say 5%+ [terminal rate] and holds it there for a while, the market could end up demanding an earnings yield of 7-9% from equities (risk premium of 2-3%). Invert that and we get a PE ratio of ~11.11-14.28x.
- Historically, bear markets have bottomed with S&P500 ( SPX ) hitting the ~10-15x PE range. For 2022, S&P500 EPS is projected to come in at $225 based on consensus analyst estimates. In a typical recession, EPS tends to go down by 15-20%, and so, 2023 S&P500 EPS could land at $180 to $191.25.
- Assigning a 10-15x PE ratio, we are looking at a potential bottom for the ongoing bear market in the S&P500 to be in the range of 1,800 to 2,868 , which points to a decline of ~25-50% from current levels (SPX is at 3,839).
- In late 2023, SPX's chart flashed a bearish technical crossover (MA-50 falling below MA-100 on the weekly chart) that has previously preceded ~50% declines in broad market indices during the Great Financial Crisis and the Dot Com Bubble bust. If the S&P 500 plunges 35-50% from here, we get a range of 1,885 to 2,450.
The fundamental and technical views on a potential bottom for the S&P 500 are in alignment, and while this may sound scary, it is certainly a possible outcome of this bear market.
Source: Must Read - Exclusive: Bi-Weekly Portfolio & Market Update - November 4th, 2022
With the Fed pulling liquidity out of the market and leading economic indicators flashing signs of an impending recession (a view supported by the bond market - an inverted treasury yield curve), we need to be defensively positioned. Such an environment is ripe for a financial accident, and we have put tactical option-based hedges in place to guard against a potential 25-50% decline in equity markets.
That said, equity markets rarely have back-to-back negative return years. Inflation is collapsing, and the Fed may have wriggle room to loosen its monetary policy in 2023. If consumer demand stays resilient, we may see an epic rebound in the stock market. This is why our positioning is quite balanced.
We own high-beta names across our core portfolios, and I believe that even a 50% equity exposure should be enough to generate our target returns. On the flip side, we have tons of cash and tactical hedges to defend our portfolios against a continuation of the ongoing bear market.
With our balanced positioning, I feel confident that we are well-positioned to deal with whatever the market throws at us over the next few quarters.
Source: Bi-Weekly Portfolio & Market Update - December 30th, 2022.
With inflation moderating rapidly and consumer spending (labor market) holding up throughout 2023, equity markets have experienced an epic rebound this year, with the S&P 500 (SP500) up nearly 25% YTD on 20th December. While large/mega-cap tech companies have led the charge higher (powered by a red hot gen AI theme), the equity rally has been broadening out in recent weeks, with the equal-weighted S&P 500 ( RSP ) up a respectable 11% YTD.
At TQI, not losing money is our #1 priority. And, despite being wrong about the overarching macroeconomic thesis ["inflation will collapse along with consumer demand" has failed to play out ( so far )], all of our managed portfolio strategies are in the green for 2023:
The Quantamental Investor
While relative underperformance to broad market indices such as the S&P 500 is certainly disappointing, I am satisfied with the YTD outcome of our core portfolio strategies given how the year has unfolded thus far.
Now, self-introspection is an important part of investing, and I always like to test my thesis against real-world outcomes.
So, what went wrong for us in 2023?
As we foresaw, inflation collapsed (first part of our economic thesis) in 2023; however, consumer demand held up strong amid a persistently tight labor market (unemployment rate <4%). In addition to the labor market (abundant jobs and healthy wage growth), excess savings from the pandemic and tremendous amounts of fiscal deficit spending ($2T per year) have enabled consumer spending (and the labor market) to remain resilient in this cycle.
A recession (hard landing) did not materialize this year, which allowed S&P 500 earnings to hold up. And, given the lack of economic weakness [plus lots of AI hopium], trading multiples for the S&P 500 have expanded significantly (with AI stocks getting the most love from investors).
The one big surprise that I didn't see happening this year was Fed's backdoor QE [quantitative easing]. On the back of multiple bank failures (financial accidents) in March 2023, the Fed quickly pumped $400B of additional liquidity into the system (backdoor QE) to avert a banking crisis.
In my view, market participants viewed this depositor bailout (for poorly run banks like Silicon Valley Bank and First Republic Bank) as a sign of the " Fed Put " being active. This is probably a big part of Mr. Market's willingness to pay a much higher multiple for S&P 500 earnings.
Please note: S&P 500 earnings are expected to close flat(ish) y/y for 2023. Hence, the entire YTD stock market rally is based on trading multiple expansion [with S&P 500 forward P/E rising from ~16x to ~20x in 2023] and not fundamental earnings growth.
Now, I will share my market outlook for 2024, and then present a year-end price target for the S&P 500.
TQI's Market Outlook for 2024
Based on recent "Goldilocks" economic data (rapidly moderating inflation rates, ultra-low unemployment rates <4%, resilient consumer spending growth) and stock market rally, the "soft" landing narrative has become the consensus view in the investing world. Heading into 2024, broad U.S. equity indices have hit or are close to hitting new all-time highs (not inflation-adjusted), and bullish investor sentiment is through the roof right now:
With everyone on one side of the boat, I think the market can spring a surprise in the other direction, which is essentially what happened this year. Going into 2023, investor sentiment was extremely bearish, and we know how things turned out (S&P 500 is up 25% YTD).
While our economic thesis "inflation will collapse along with consumer demand" failed miserably in 2023 (due to reasons I shared in the previous section), I believe the lag effects of Fed's aggressive monetary policy tightening actions (federal funds rate hiked from 0% to 5.25-5.5% over the last 18 months and ongoing QT [quantitative tightening] of $95B per month) are set to adversely impact the economy (and corporate earnings) in the next 6-12 months.
Yes, the Fed recently guided for 3 rate cuts (monetary policy easing) in 2024 in the latest dot plot , which is being celebrated as a "pivot" in the equity markets. However, with inflation still running ahead of Fed's target rate of 2%, the cuts are unlikely to come until the second half of next year. And by then, I think the economic damage would have already been inflicted. The Fed is always late, and it will be late again!
Leading economic indicators have come in negative consecutively for the past 19 months, and continue to point toward an imminent recession:
Furthermore, the bond market is pricing in 6 rate cuts for 2024 (front-running the Fed by a long way) and screaming "recession ahead" via a deeply inverted yield curve:
As you may know, the 10-year treasury yield (US10Y) has dropped precipitously from its cycle high of ~5.2% on 29th October 2023 to ~3.9% as of today (20th December 2023). While equities have celebrated this rapid drop in long-duration treasury yields (by rallying up more than 15% from October 2023 lows), the bond market could be pricing in recession or deflation risk via this aggressive re-pricing. Only time will tell if the bond market is right or wrong, but I think it is fair to say that bonds and stocks are at odds with each other once again.
For 2024, I view deflation as a much bigger risk to the economy compared to inflation. While the Fed has guided 3 rate cuts for 2024, the ongoing quantitative tightening (balance sheet reduction) is likely to adversely impact liquidity in the financial system at a time when -
- The consumer is running out of excess savings
- Household debts are reaching new highs
- Consumer loan delinquencies are rising rapidly
- Corporate bankruptcies are spiking.
In my view, the U.S. economy is set for a significant slowdown next year. The Fed is projecting 1.4% GDP growth for 2024, but I remain very skeptical about the idea of a "soft" landing. History shows that every hard landing looked like a soft landing until it didn't! For 2024, my base case prediction is that we will see some kind of recession, which will eventually be the trigger for monetary policy easing.
My Magic Number For S&P 500 Is 4,000
With the Fed still tightening monetary policy into a deeply inverted yield curve, an even more richly valued equity market is facing the double whammy of a multiple contraction and an earnings recession in 2024.
Here's my outlook for the S&P 500 in 2024:
- An asset's P/E (price-to-earnings) ratio is directly governed by the risk-free rate in the market. Given the massive amount of treasury supply about to hit the markets, I can see long-duration treasury yields staying elevated for a while (even if we see a recession next year). Assuming the 10-year treasury yield stays in the 4-5% range in 2024, I expect market participants to demand an earnings yield of 6-8% from the S&P 500. Invert that earnings yield and we get a P/E ratio of ~12.5-16.7x. With the Fed expressing a willingness to ease monetary policy (before inflation reaches the target rate of 2%), I believe the S&P 500 can trade closer to the higher end of that P/E range. To formulate my 2024 price target for the S&P 500, I am assuming an exit trading multiple of ~16x P/E (which also happens to be the long-term mean P/E ratio for S&P 500).
- As of today, S&P 500 EPS is currently projected to rise by 12% to $250 in 2024 according to consensus analyst estimates. In a garden variety recession, EPS tends to go down by 15-20%, but even if we see only a mild recession, S&P 500 earnings are likely to disappoint bullish investors. In our view, S&P 500 earnings growth for the next couple of years will be in the mid-single-digit range, and we will hit $250 in S&P earnings only in 2025.
- Assigning a forward P/E of ~16x to 2025 S&P 500 EPS of $250, we reach an end-of-year target of 4,000 for the S&P 500 index ($400 for the SPY ETF). This target implies a downside of -15% from current levels.
Concluding Thoughts
The immutable laws of money dictate that risk assets such as equities offer a positive risk premium relative to the risk-free rate in the market. Despite the long end of the treasury yield curve moving down to ~4% in recent weeks, the S&P 500 earnings yield still needs to rise to the 6-8% range for equity markets to become attractive once again.
Given the current state of the economy (Goldilocks), long-duration treasury yields should stabilize here and potentially move higher in Q1 2024. However, if yields continue to collapse further, the bond market would then be signaling an economic recession.
At ~20x forward P/E, the S&P 500 is priced for a "soft" or "no" landing scenario, and I remain skeptical about the "soft" landing narrative given a deeply inverted yield curve and negative leading economic indicators continue to point toward a hard landing in the economy.
As we noted in our article , "SPY: You Have Been Warned By Jerome Powell," there are uncanny similarities between 1987 and 2023. Will we see a 1987-esque crash? Frankly, I don't know, but under the given set of economic and financial conditions, I simply cannot rule out a stock market crash.
Winston Churchill once said:
Those that fail to learn from history are doomed to repeat it.
Heading into a potential recession, the equity market (S&P 500) valuation reflects a high degree of investor complacency. A stock market crash may or may not materialize in 2024; however, prudent investors must prepare themselves for a wide range of possible outcomes [tail events] in this uncertain environment.
Key Takeaway: Considering the simple yield math behind stock valuations, the S&P 500 is ripe for a significant correction. We see the S&P 500 index declining to 4,000 by the end of 2024. Henceforth, I rate the SPY S&P 500 ETF a "Sell" at $475.
Editor's Note : This article was submitted as part of Seeking Alpha's 2024 Market Prediction competition , which runs through December 20. With cash prizes, this competition -- open to all contributors -- is one you don't want to miss. If you are interested in becoming a contributor and taking part in the competition, click here to find out more and submit your article today!
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2024 S&P 500 Outlook: A Year Of Reckoning Lies Ahead For A Complacent Market