Amid "goldilocks" economic data in the first half of 2024, Mr. Market has priced a "no" landing scenario into the equity markets.
However, rising unemployment and impending yield curve uninversion threaten to break the "soft/no" narrative.
The top-heavy market rally off of 2022 lows has been driven by P/E multiple expansion. If we get a hard landing (recession), S&P 500 investors are set up for a rude awakening.
Introduction
In my outlook note for 2024, I provided the following economic scenarios-based outlook for the S&P 500 ( SPX )( SPY ):
TQI's Market Outlook For 2024
Heading into 2024, the equity market (S&P-500 trading at ~20-21x forward P/E) is priced for a "soft/no" landing with consensus analyst estimates calling for double-digit earnings growth in 2024 & 2025. If the consensus view is correct, I can see the S&P-500 climbing to new all-time highs on a nominal and inflation-adjusted basis over the next 12-24 months.
A soft landing looks a lot more tenable now than it did a few quarters ago; however, it is still not an outcome I would bet on blindly due to very real deflation and stagflation risks! The Fed could end up being too late or too early in easing up monetary policy, which could result in a recession (+ deflationary bust) or stagflation.
While the Fed's aggressive monetary policy tightening hasn't driven the economy off a cliff just yet, we could still end up in a recession of some sort in 2024, which is my base case scenario. The bond market is pricing in 6-7 rate cuts for 2024, well ahead of the Fed's guidance for 3 rate cuts. Yes, inflation is collapsing; but the bond market's positioning seems too aggressive and indicative of an impending recession. In my base case scenario, I see mid-single-digit earnings growth and a trading multiple compression that takes the S&P-500 down to 4,000 by the end of 2024.
Author
In the event of a severe hard landing in the economy (recession), S&P-500 earnings can contract by 15-20%. A double whammy of multiple contraction (normalization) and earnings contraction, could lead to a massive 50-70% decline in S&P-500 from current levels. Yes, such a downside move is still very much on the table despite "soft landing" being the prevalent market narrative. While I see deflation as a much bigger risk at this point in the cycle, pre-mature easing of monetary policy could still lead to another wave of inflation like in the 1970s.
My Magic Number For S&P 500 Is 4,000
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 this 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 the 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 my 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.
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 - moderating inflation, ultra-low unemployment rate), 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, in my view, be signaling an economic recession.
At ~20-21x 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.
Considering the simple yield math behind stock valuations, the S&P 500 is ripe for a significant correction. As my base case scenario, I see the S&P 500 index declining to 4,000 by the end of 2024. The era of free money is over, with long-duration treasury yields likely to stay in the 4-5% range for a while (even if the Fed cuts short-term rates). As you can see in the chart below, the S&P-500 Shiller PE ratio is sitting at ~32x (only lower than 2021 and 2000), and given the immutable laws of money, equity valuations will matter at some point!
S&P-500 Shiller PE ratio (Multpl)
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. Yes, the Fed is probably done hiking rates and several cuts are penciled in for 2024; however, the damage could already have been done. Monetary policy works with long and variable lags, which means economic data could still weaken considerably in the next 6-12 months, i.e., an economic recession can strike soon regardless of the Fed cutting rates. Hence, I remain skeptical about the idea of a "soft/no" landing after such an aggressive monetary policy tightening cycle that ended 15 years of free money (ultra-low interest rates).
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