While the US Economy Continues its Resilience, US Equity Market Fundamentals & Valuations Remain Deeply Concerning

US GDP Comes in Above Consensus Estimates, Reaffirming the US Economy is Still Growing

Starting this newsletter with the biggest economic data this week: 4Q23 US GDP released, which came in above 2% consensus expectations at 3.3%. A breakdown of 4Q23 GDP is below and we have a few points on the major contributions noted.

Personal consumption was by far the biggest contributor, followed in second by government expenditures. While consensus seems to universally see this as extremely positive and we don’t necessarily disagree – it’s pretty undoubtably a positive GDP print – we see this story potentially unfolding in a very different way as we get deeper into 2024 and 2025. We maintain our bearish long-term outlook for the US economy.

A Growth Slowdown is Only One Obstacle Facing the US Economy

As we identified the US economy is in a deflationary macro regime and thus we would expect growth and inflation to decelerate. So far growth has come in above consensus estimates, but also crucially the US economy has been outgrowing other global advanced economies. We believe while that’s likely propelled the US equity market to outperform expectations, that’s also been the catalyst for equity market valuations to rise to a premium. The issue of high valuations relative to the rest of the world also becomes increasingly more relevant when the MSCI equity market index of your country represents ~64% (nearly 2/3rds) of the global public equity market.

At the same time the US equity market is the most expensive relative to the economy of all its global rivals, the US economy still faces what we’d describe as a “triple threat” of macro obstacles. We were hit with surge inflation similar to the 1970’s preceding the stagflation recession, a public debt crisis like the one preceding the post-WWII recession in the mid-1940’s, and equity market valuations & somewhat broader conditions with similarities to the early 2000’s tech bust.

While each of these three threats could be elaborated on in considerable detail individually, we’ll just briefly summarize what this kind of macro setup means for financial markets. We already saw that surge inflation leads to asset devaluations and indirectly leads to much more restrictions on growth, creating a slowdown in the business cycle. Simply put, the result of surge inflation means what we thought was worth $100 is worth $90 (for example) when adjusted for inflation. When it comes to the public debt crisis, my sense is it's a major potential detriment to US financial markets, but I also think it’s like the banking crisis in that we don’t know how it’s going to play out yet. We know it definitely exists and we’re going to face some economic challenges from it, but in my judgement we don’t know great specifics on what they are or when they’ll materially set into the economy yet. Lastly when it comes to valuations – specifically P/E ratios, but virtually any other metric you look at will confirm this market is expensive – that’s not a straightforward comparison to suggest the equity market or even tech stocks specifically are necessarily in the same trouble as in early 2000.

Then we also have a still inverted yield curve, though worth noting it’s been rapidly un-inverting as illustrated in the chart below. Historically, an inverted yield curve has foreshadowed a major volatility event, typically originating in private credit markets. While the consensus view appears to be that’s out of the question in this cycle, we don’t believe that to necessarily be the case. So to top off the three aforementioned “triple threats”, we have elevated credit risk and that really creates a potentially dangerous macro environment.

Why We Strongly Disagree a “Hard Landing” is Priced into US Equity Market Valuations

I was extremely surprised to hear so many financial market participants on mainstream financial media, following the US GDP data coming in particularly, all essentially repeating the same narrative: this should be a big boost to the US equity market because most were already pricing in a recession, etc. We completely disagree and our research actually shows the data suggesting almost the opposite.

In our evaluation of whether this US equity market is pricing in even a very mild recession of two slow quarters of GDP growth, let alone a hard landing like we foresee materializing. We can look at how a CAPE ~32 is historically extremely high, but I thought it would be more beneficial to assess the valuation of this market relative to historic market cycles. More specifically, we wanted to look at a slightly nuanced group of bear markets dating back to the Great Depression and from there, we want to see how the equity market was broadly priced in the first month of the new secular bull market. In other words, where did US equity market valuations get repriced to by the conclusion of a given bear market. For this example, we looked at bear markets that began when the S&P 500 was at an ATH then declined -20% or more from the peak. Note a bear market could not include any market drawdown that didn’t last at least 30 days (> 1 month). We found 15 of such market cycles and included the time periods below, the corresponding drawdown, and lastly the average (-36%) & median (-29%) in the chart below. The simple reason we decided to look at these bear markets is because the S&P 500 closed at a fresh new ATH for several consecutive days this week.

We’ve reiterated why we believe cyclically adjusted earnings (CAPE ratio) is the most historically accurate and appropriate gauge to use to determine valuation. It’s imperfect and perhaps doesn’t tell the entire story necessarily, but again if we were to pick one equity market valuation metric to assess where today’s market is from a valuation perspective relative to history, it would undoubtably be CAPE. Below is the CAPE ratio the month after each bear market ended, or the first month a new business cycle had begun. We feel this is very convincing evidence that our thesis on the equity market valuation is correct.

Looking a little closer at most recent market cycles specifically for a more ‘current’ range of data, below is the S&P 500 and 11 sectors of their absolute P/E percentile rank since 1995. The S&P 500 current P/E is in the 76th percentile rank dating back to 1995, another indication of valuations being on the expensive side today. Furthermore we looked at the current S&P 500 & 11 sector 12-month forward P/E, compared to their 5YR & 10YR averages. Once again and perhaps unsurprisingly by now, the S&P 500 forward P/E is above both its 5YR & 10YR averages.

Apart from just looking at the US equity market relative to itself historically, we compared valuations to many global equity market peers, comparing their 12-month forward P/E & 10YR average. As we expected, the NASDAQ leads all comparable global equity market indices and is well above its 10YR P/E average too. I thought it was quite noteworthy the MSCI All Country World ex-US index priced at 13.9x forward earnings is not only almost 3 times less than the NASDAQ’s 36x, but it’s also below its own 10YR average of 14.9. Then looking at the CAPE ratio of various MSCI World equity indices taken at the end of 3Q23, the US equity market ranks the most expensive using that metric as well with CAPE at 25.9; Japan ranks the second most expensive at 22 CAPE even.

US Equity Market Fundamentals Continue Declining: Concerning Indications Contractionary Monetary Policy Lag is Starting to Materially Impact the Stock Market

I think this section is the most important because from my perspective, it shows that not only are historic contractionary monetary policy cycles against current valuations in the US equity market, but what we’re already seeing specific to this cycle should make it clear the market is grossly overvalued. The supporting charts detailing these findings are included below. Estimates were compiled and calculated using FactSet’s research.

• Net profit margins have clearly begun to come down substantially for S&P 500 large-caps. On an annual basis, net profit margins for 4Q23 are down at the S&P 500 index level and in 7 of 11 sectors. Additionally, in 4Q23 net profit margins declined from 3Q23 in all 11 of 11 S&P 500 sectors.
• Based on a majority of S&P 500 large-caps already reported 4Q23 results, the S&P 500 net profit margin for 4Q23 is expected to be 10.7%. This is the lowest quarterly profit margin since 2Q20. Excluding the 1Q20 & 2Q20 – the quarters when the C19 pandemic hit and immediately after – this is the lowest quarterly net profit margin the S&P 500 had in at least 5+ years. Per FactSet, it’s below the 1YR, 5YR, & 10YR index averages.
• Earnings growth and corporate fundamentals have already been under substantial downward pressure in the S&P 500 from elevated interest rates. S&P 500 blended earnings are projected to decline -1.4% on an annualized basis in 4Q23. This would mark the 4th of 5 quarters for the S&P 500 where YoY earnings have contracted.

While the US Economy is Outperforming Expectations, we Remain Deeply Concerned Regarding Significant Misconception in Markets About how the Lag at which Monetary Policy Operates

What I’ve found especially shocking was both the current situation of how many companies actually contribute positively to YoY earnings, as well as analyst forecasts for 2024 & 2025 given the macro dynamics discussed above. We’re only in the very beginning stages of seeing material deflation consistent in the US economy, however monetary policy lag hasn’t begun to set in. Not only that, but the probability of a -25bps cut in March went from ~95% to under < 50% in about a week. It’s not our base case, but it’s also not out of the realm of possibility for the Fed to continue pausing on the back of consistently stronger than expected economic data. That’s to say if we’re not at the point of seriously debating interest cuts yet, how could we expect the kind of stellar earnings & revenues growth the equity market has priced in? Unfortunately, I don’t see this outcome coming to fruition at all.

As the data below will very clearly show, the US equity market has priced in a robust earnings rebound. This is despite the US Fed maintaining a “higher for longer” position on interest rates, the entire underlying reason why we’ve started to see downward pressure on corporate fundamentals to begin with. In addition, CPI has been reaccelerating to some degree; sticky labor market inflation will make the Fed’s job of getting to 2% inflation nearly impossible (if there’s no hard landing). ?

The above chart is the most important part to the remaining analysis, as it’s highlighting what I believe is a major miss by consensus. As we can see, earnings are going to decline modestly from 2022 to 2023, again pretty undoubtably due to all the negative factors to economic growth that come with higher interest rates. However, 2024 has priced in a little over >+10% EPS growth and 2025 has priced in roughly ~12%. That’s substantially above the average years in chart and those are during the post-GFC secular bull market in US equities. We remain highly skeptical equity market participants have correctly priced in earnings growth given where we currently see the macro and business cycle.

Below is a breakdown of EPS earnings growth estimates for the S&P 500 at the sector level for 2023, 2024, & 2025. As observed, 2023 “estimates” are considerably lower than 2024 & 2025 in just about every sector. Obviously 2023 has ended and we’re just finishing reporting 4Q23 earnings, which means “estimates” for 2023 have had time all year to come down. We remain highly convicted this earnings growth pricing is extraordinarily optimistic and especially so given the current macroeconomic backdrop.

While it’s not surprising given the earnings estimates, we have the same exact situation with revenues. While it would only make sense that with a massive projected increase in EPS for 2024 & 2025 the same would be expected for revenues, but nonetheless it really is stark visualizing what we believe are excessively optimistic expectations.

The final group of charts below show a quarterly breakdown of S&P 500 earnings estimates, sector level analyst ratings, the “Magnificent Seven” performance, and finally S&P 500 sector level & major US equity market index performance. The “Magnificent Seven” stocks are especially important to pay attention to as we’re going to close out this week’s newsletter with what I suspect will be some eye-opening earnings statistics.

“Weight” of the ‘Magnificent Seven’ to the Broader US Equity Market is Both Completely Unprecedented & Seemingly Quite Dangerous

With 4Q23 & 1Q24 being the two quarters we have the best ability to estimate accurate data on currently – just simply due to the timing – with FactSet’s data we were able to calculate the annual EPS revenue contributions for the S&P 500 in 4Q23 & estimated for 1Q24. The earnings results for all of 2023 really, but especially in 4Q23 particularly, highlight how significant the “Magnificent 7” truly is to the US equity market. Not just from a market cap perspective, or other valuation metric, but as you’ll see below a few of the “Magnificent 7” – not even all – contributed to quite literally all of the S&P 500 annual EPS growth in 4Q23 and an even greater concentration is expected for 1Q24. Kindly note what I found to be a few astonishing equity market earnings data points:

• 4Q23: Apple, Microsoft, NVIDIA, Google, Meta, & Amazon contributed +53.7% to YoY S&P 500 EPS growth. The remaining 494 members in the index collectively contributed a -10.5% EPS decline.
• 1Q24: Amazon, Google, Meta, & NVIDIA are projected to contribute +79.7% YoY S&P 500 EPS growth. The remaining 496 members combined are expected to cumulatively add +0.3% to S&P 500 YoY EPS growth.

One point to that is perhaps their outperformance is more explainable as they’re the only companies actually contributing to annual EPS growth, but one has to admit that level of market risk is extremely concerning. In an era where we’ve found out how essential diversification and risk management is the hard way, this really outrageous concentration in a handful of businesses succeeding is admittedly worrisome to our longer-term outlook.

Conclusion: Historic Market Cycles Proved the Equity Market Really Doesn’t Pay Attention to Monetary Policy Lag, until it Really Matters. We Continue to Expect the Same Outcome to Repeat.

As the sub-title says and historic data does prove, the equity market doesn’t pay a whole lot of attention to the macroeconomic environment until there’s an emergency. The best and most recent example of that is the 2008 GFC, where market participants continued trading up through a mess of economic problems until Lehman Brothers collapsed in October 2008. Later with hindsight, the NBER officially declared the GFC recession to have begun in December 2007. When we look at basically any market cycle historically in the specific context of Fed hiking cycles, valuations can really ‘hang out’ without much justified fundamental support, a bullish consensus narrative always seems to emerge, and basically ‘everything is fine’ – until it isn’t. From a combination of not just quantitative data, but the general narrative that seems to have prevailed in this cycle to this point makes me think we might ultimately see a very similar outcome where the majority is shocked & caught off guard by economic disappointment.

As I’ve said many times when it comes to Fed hiking cycles and monetary policy lag, my belief is the best way to estimate its arrival – as well as confirm when it does arrive – is through labor market deterioration.

The phrase ‘history often rhymes but never repeats’ is perfectly used in that context as historic Fed hiking cycles have told us we can expect labor market deterioration by looking at an interval after the first Fed hike. I’m sure like most of us who follow macroeconomics know well by now, lag times have historically varied. However the concept of monetary policy lag itself and what we should expect to see in terms of economic impact has general similarities from cycle to cycle. After a period of lag, the US unemployment rate begins to rise and then takes off into recession.

As you can see in the chart below, the time between when the Fed Funds rate begins to rise and the US unemployment rate begins to rise historically vary, but not by a completely unreasonable margin. This is likely a large part of the reason why as a rule of thumb, some of us who studied macroeconomics likely learned a Fed hike materially impacts the economy about two years after it occurred. At the March 2024 FOMC, we’ll be exactly two years removed from the first US Fed hike. That’s when history tells us we should begin seeing signs of labor market deterioration. That’s all to say that the notion we’ve achieved a “no landing” and it’s all smooth sailing from here on out is patently incorrect. History suggests in the coming quarters we’ll find out how adverse the impact from monetary policy lag will be to the labor market in this cycle.

While the US labor market is a good metric of when to expect monetary policy lag to set in, the Fed hiking doesn’t only lead to recessions from a direct breakdown in labor. Sometimes that’s a byproduct of an adverse economic event or in financial markets, such as a major volatility event in private credit markets. In that respect and as it relates to the above chart specifically, there’s potential for this cycle to play out like the “dot com bubble” did in some ways.

The chart shows the largest CAPEX was invested in the “Information Technology” segment where we obviously have all the ‘unlimited growth potential’, AI hype. If we have a credit cycle downturn like we should the more time monetary policy lag has to set in, there will be a contraction in economic growth that’s far more significant than the one currently being anticipated. Right now economic consensus is overwhelmingly in the “no landing” camp. So if we do start to see economic and credit downturn, there could be wider ranging ramifications. Similar to what happened conceptually when FTX collapsed, private equity and venture capital firms who heavily invested in the ‘AI hype’ could get caught in systemic contagion if AI doesn’t realize the level of economic or financial benefit some believe it has.

Our Weekly ‘Top 3’ Watchlist

With that we’re wrapping up this week’s newsletter with a new, reoccurring section we’ll begin ending weekly posts with. We decided to start unofficially adding and keeping track of three ideas in our weekly newsletter. They’re in no particular order, not meant to be misconstrued as investment advice, and will generally be represented with a chart and short 1-2 sentence explanation. Without further ado, this week’s ‘Top 3’.

"XLU" – S&P 500 Utilities Sector ETF

Our research shows Utilities are the most interest rate sensitive segment. Our assessment includes Fed rate cuts this year, which we expect to be a significant tailwind for the already generously priced segment, so we think there’s at least a good possibility utilities could wind up outperforming the broader S&P 500 composite.

"EEM" – Emerging Markets ETF

With such a low relative valuation combined with some emerging market economies seemingly on the verge of potential secular growth breakouts, we continue to feel confident in the longer-term prospects for emerging markets.

GDX – Gold Miners ETF

We’ve discussed why we believe there’s a significant possibility the next decade could be a “supercycle” for some commodities. In such historic instances, gold was the most profitable hard asset to own. Based partly on the above chart, we believe gold exploration firms (gold miners) are currently undervalued even relative to that specific industry.

Thank you as always for taking the time to read and participate in my weekly markets’ newsletter. Hope you enjoyed this week’s update and if you have any questions, feedback, concerns, etc., please don’t hesitate to email me at:

[email protected]

Best of luck to all market participants this upcoming week & year!

Disclaimer: The information and publications are not meant to be, and do not constitute, financial, investment, trading, or similar advice. The material supplied is not intended to be used in making decisions to buy or sell securities, or financial products of any kind. We highly encourage you to do your own research before investing.

Disclaimer: Returns from ETFs do not match the index they’re meant to track on a 1:1 scale. ETFs contain shares of securities comprising a given market metric an ETF is tracking and the composition of the ETF is often not identical to the index its tracking. For example, SPY (SPDR S&P 500 ETF) tracks the S&P 500. A committee ultimately agrees on the companies from the S&P 500 included in the ETF, using guidelines including liquidity, profitability, & balance.