A version of this story first appeared on TKer.co
Stocks rallied to new all-time highs, with the S&P 500 setting a record intraday high of 5,447.25 on Wednesday and a record closing high of 5,433.74 on Thursday. For the week, the S&P gained 1.6% to end at 5431.60. The index is now up 13.9% year to date and up 51.8% from its October 12, 2022 closing low of 3,577.03.
Earlier this month, we talked about how bull markets tend to last much longer and generate much stronger returns than the one we continue to experience.
But prices don’t go up for the sake of going up.
They go up because earnings are going up.
Sure, oftentimes prices may decouple from fundamentals (i.e., a company’s ability to make money) over short-term periods — which is why market-timing is so difficult.
But many analysts argue that’s not what’s going on right now. They’ll argue that prices are up because the fundamentals are favorable.
Here’s a sampling of what Wall Street’s top stock market pros of pointed out in recent weeks:
Cash flow generation is strong
One of the more repeated concerns in the stock market is that valuations are elevated above their long-term averages.
UBS’s Jonathan Golub argues today’s historically high valuations are justified.
“S&P 500 companies have been generating more cash flow over the past 3 decades, justifying higher valuations,” Golub wrote on Monday.
Resilient profit margins are amplifying earnings growth
With the economy cooling, sales growth isn’t as hot as it used to be. But that hasn’t had too much of an impact on earnings growth.
“[W]e think it’s important to point out that S&P 500 trailing earnings growth is turning higher (now 4% Y/Y up from -1% to start the year),” Morgan Stanley’s Michael Wilson observed on Monday. “Margin improvement is fueling this rise in earnings growth as top line growth has remained steady throughout the year.”
Earnings are driving stock prices
Expanding valuations were a large driver of stock market returns over the past year.
More recent gains appear to be driven by earnings.
“Good news – the baton seems to be being passed from valuation to earnings,” Fidelity’s Jurrien Timmer wrote on Wednesday. “This is exactly what is needed to sustain the cyclical bull market. Per the weekly chart below, the year-over-year change in the trailing P/E ratio has slowed from +30% to +15%, while the year-over-year change in trailing earnings has accelerated from -2% to +6%.”
Fundamentals suggest it’s not a tech bubble
The megacap tech names have drawn a lot of attention as they’ve been responsible for much of the stock market’s gains in recent years. But their outperformance is supported by outsized earnings growth, which makes the current run up in prices very different from the dotcom bubble.
“As asset bubbles form, a key reason volatility rises is that stocks start trading purely on momentum, decoupling from their fundamental tether (where fundamentals exist),” BofA’s Benjamin Bowler wrote.
Increased market concentration isn’t a sign of trouble
As we’ve discussed, market concentration in itself is not a reason to be too concerned about the market.
Global Financial Data (GFD) has a great post exploring market concentration going all the way back to 1790. High market concentration is not a new phenomenon.
“Based upon our analysis of the past 150 years, there seems no reason to believe that the increased concentration of the past ten years is the harbinger of a major bear market,” GFD’s Bryan Taylor wrote. “Increased concentration is the sign of a bull market and bear markets reduce concentration.”
Earnings growth is broadening out
Yes, it is the case that the megacap tech names have been responsible for much of the earnings growth in the market. But that narrative is shifting.
“Perhaps the most important near-term support for the stock market is the ongoing acceleration of corporate earnings,” Richard Bernstein Advisors’ Dan Suzuki wrote on Wednesday. “Earnings growth has been accelerating since the end of 2022, and we forecast further acceleration over the next several quarters. Not only is growth accelerating, but critically, it’s also broadening out.”
The bottom line
The “bottom line” is an idiom that’s often used as a metaphor to characterize “the essential or salient point.”
The term actually comes from accounting. On an income statement, the top line is revenue. As you move down the income statement, you see costs, expenses, interest, taxes, and other items, all of which you subtract from revenue. And what you’re left with is the bottom line: earnings.
Analysts agree the prospects for earnings are looking favorable for stocks.
And in the stock market, earnings are the most important driver of prices in the long run.
That is to say: The bottom line is the bottom line.
Goldman Sachs raises its target for the S&P 500
On Friday, Goldman Sachs’ David Kostin raised his year-end target for the S&P 500 to 5,600 from 5,200. This is his third revision from his initial target.
“Our 2024 and 2025 earnings estimates remain unchanged but stellar earnings growth by five mega-cap tech stocks have offset the typical pattern of negative revisions to consensus EPS estimates,” Kostin wrote. “We expect roughly unchanged real yields by year-end and strong earnings growth will support a 15x P/E for the equal-weight S&P 500 and a 36% premium multiple for the market-cap index.”
Kostin is not alone in tweaking his forecasts. His peers at UBS, Morgan Stanley, Deutsche Bank, BMO, CFRA, Oppenheimer, RBC, Societe Generale, BofA, and Barclays are among those who’ve also raised their targets.
Don’t be surprised to see more of these revisions as the S&P 500’s performance, so far, has exceeded many strategists’ expectations.
Reviewing the macro crosscurrents
There were a few notable data points and macroeconomic developments from last week to consider:
The Fed holds steady. The Federal Reserve announced it would keep its benchmark interest rate target high at a range of 5.25% to 5.5%.
From the Fed’s statement (emphasis added): “Recent indicators suggest that economic activity has continued to expand at a solid pace. Job gains have remained strong, and the unemployment rate has remained low.
Inflation has eased over the past year but remains elevated. In recent months, there has been modest further progress toward the Committee’s 2% inflation objective.”
The central bank’s new “dot plots” imply fewer rate cuts in 2024 and 2025 than what it previously forecast after the Fed’s March meeting.
Basically, the Fed will keep monetary policy tight until inflation rates cool further. That means the odds of a rate cut in the near term will remain low.
Inflation cools. The Consumer Price Index (CPI) in May was up 3.3% from a year ago, down from the 3.4% rate in April. Adjusted for food and energy prices, core CPI was up 3.4%, down from the 3.6% rate in the prior month. This was the lowest increase in core CPI since April 2021.
On a month-over-month basis, CPI was unchanged as energy prices fell 2%. Core CPI increased by 0.2%.
If you annualize the three-month trend in the monthly figures — a reflection of the short-term trend in prices — CPI was rising at a 2.8% rate and core CPI was climbing at a 3.3% rate.
Overall, while many broad measures of inflation continue to hover above the Fed’s target rate of 2%, they are way down from peak levels in the summer of 2022.
Inflation expectations were mixed. From the New York Fed’s May Survey of Consumer Expectations: “Median inflation expectations at the one-year horizon declined to 3.2% in May from 3.3% in April, were unchanged at the three-year horizon at 2.8%, and increased at the five-year horizon to 3.0% from 2.8%.”
Gas prices fall. From AAA: “Another week, another slide in gas prices as the national average for a gallon of gasoline dipped two cents since last Thursday to $3.46. The main reasons for the decline are lackluster gasoline demand and burgeoning supply. … According to new data from the Energy Information Administration (EIA), gas demand crept higher from 8.94 million b/d to 9.04 last week. Meanwhile, total domestic gasoline stocks jumped from 230.9 to 233.5 million barrels as production increased last week, averaging 10.1 million barrels per day. Mediocre gasoline demand, increasing supply, and stable oil costs will likely lead to falling pump prices.”
Mortgage rates tick lower. According to Freddie Mac, the average 30-year fixed-rate mortgage declined to 6.95% from 6.99% the week prior. From Freddie Mac: “Mortgage rates continued to fall back this week as incoming data suggests the economy is cooling to a more sustainable level of growth. Top-line inflation numbers were flat but shelter inflation, which measures rent and homeownership costs, increased showing that housing affordability continues to be an ongoing impediment for buyers on the house hunt.”
There are 146 million housing units in the U.S., of which 86 million are owner-occupied. 39% are mortgage-free. Of those carrying mortgage debt, almost all have fixed-rate mortgages, and most of those mortgages have rates that were locked in before rates surged. All of this is to say: Most homeowners are not particularly sensitive to movements in home prices or mortgage rates.
Unemployment claims tick higher. Initial claims for unemployment benefits rose to 242,000 during the week ending June 8, up from 229,000 the week prior. This was the highest print since August 2023. While this is above the September 2022 low of 187,000, it continues to trend at levels historically associated with economic growth.
Sentiment deteriorates. From the University of Michigan’s June Surveys of Consumers: “Consumer sentiment was little changed in June; this month’s reading was a statistically insignificant 3.5 index points below May and within the margin of error. Sentiment is currently about 31% above the trough seen in June 2022 amid the escalation in inflation. Assessments of personal finances dipped, due to modestly rising concerns over high prices as well as weakening incomes. Overall, consumers perceive few changes in the economy from May.”
Card spending is holding up. From JPMorgan: “As of 07 Jun 2024, our Chase Consumer Card spending data (unadjusted) was 1.7% below the same day last year. Based on the Chase Consumer Card data through 07 Jun 2024, our estimate of the US Census May control measure of retail sales m/m is 0.67%.”
From Bank of America: “Total card spending per HH was up 1.6% y/y in the week ending June 8, according to BAC aggregated credit & debit card data. Retail ex auto spending per HH came in at 0.4% y/y in the week ending Jun 8. Card spending appears to be off to a solid start in June.”
Small business optimism improves. The NFIB’s Small Business Optimism Index ticked higher in May.
Importantly, the more tangible “hard” components of the index continue to hold up much better than the more sentiment-oriented “soft” components.
Keep in mind that during times of perceived stress, soft data tends to be more exaggerated than actual hard data.
Near-term GDP growth estimates look good. The Atlanta Fed’s GDPNow model sees real GDP growth climbing at a 3.1% rate in Q2.
Putting it all together
We continue to get evidence that we are experiencing a bullish “Goldilocks” soft landing scenario where inflation cools to manageable levels without the economy having to sink into recession.
This comes as the Federal Reserve continues to employ very tight monetary policy in its ongoing effort to get inflation under control. While it’s true that the Fed has taken a less hawkish tone in 2023 and 2024 than in 2022, and that most economists agree that the final interest rate hike of the cycle has either already happened, inflation still has to stay cool for a little while before the central bank is comfortable with price stability.
So we should expect the central bank to keep monetary policy tight, which means we should be prepared for relatively tight financial conditions (e.g., higher interest rates, tighter lending standards, and lower stock valuations) to linger. All this means monetary policy will be unfriendly to markets for the time being, and the risk the economy slips into a recession will be relatively elevated.
At the same time, we also know that stocks are discounting mechanisms — meaning that prices will have bottomed before the Fed signals a major dovish turn in monetary policy.
Also, it’s important to remember that while recession risks may be elevated, consumers are coming from a very strong financial position. Unemployed people are getting jobs, and those with jobs are getting raises.
Similarly, business finances are healthy as many corporations locked in low interest rates on their debt in recent years. Even as the threat of higher debt servicing costs looms, elevated profit margins give corporations room to absorb higher costs.
At this point, any downturn is unlikely to turn into economic calamity given that the financial health of consumers and businesses remains very strong.
And as always, long-term investors should remember that recessions and bear markets are just part of the deal when you enter the stock market with the aim of generating long-term returns. While markets have recently had some bumpy years, the long-run outlook for stocks remains positive.