It’s (Always) Just Around the Bend
The media would have you now believe that the recession, which for so long had been just around the bend, has now become a less than fifty-fifty prospect. Hooray! We can all sleep better and even enjoy our summer vacations. The ongoing market rally reflects more than that relief, however. It also reflects renewed enthusiasm for the growth potential of the U.S. economy. This has led to an expansion of stock valuations across nearly all sectors of the market over the last several months as investors build faster (though distant) earnings growth into their outlooks for hundreds of companies. This may be reasonable, but it does put stocks in a precarious position as we enter the heart of earnings season. Investors should be prepared for severe reactions to even slight disappointments, as we saw last week with Tesla and Netflix, but that need not disrupt long-term investing strategies.
Fears of recession have receded as consumers continued to spend and the labor market offered a job to almost anyone who wanted one. While some firms laid off staff, others hired those let go and aggregate employment continued to climb, pushing total disposable income, adjusted for inflation, higher over the last several months. Even though consumers may be running down excess savings, and many have struggled with budget challenges in the face of so much inflation, aggregate spending has held up reasonably well. This could change, of course, but for now firm managers, while cautious, appear to be content to trim expenses around the edges rather than resort to drastic cost-cutting measures.
The relief from the immediate recession risk triggered an additional equity market rally beginning at the start of June, allowing the S&P 500 to double the gains it delivered from January through the end of May in just six short weeks. Moreover, the stocks that powered the market higher recently were not confined to the Super Seven technology and consumer discretionary companies that dominated the first 5 months of 2023. Instead, we saw investors rotate into stocks in health care, industrials, and financials, including the banks. Year to date, over 200 stocks are now up by more than 10%.
As recession fears abated, valuations also moved higher, as stock prices rose more than near-term earnings forecasts. Investors are seeing improved prospects for growth not only for this year or early next year, but also into 2025 and well beyond. That more optimistic outlook is due in no small part to the sudden arrival of generative artificial intelligence (AI) in the investor consciousness. Countless reports have appeared purporting to show the productivity gains that AI will bring across the global economy.
The 12-month forward price-to-earnings ratio (P/E) for the S&P 500 is now over 19.5, which has been pulled higher by dozens of companies trading above 30 times earnings. Still, many others remain quite attractive at 15x or less. Those higher multiples are not necessarily unreasonable if those companies are likely to deliver earnings growth well above historical averages for many years to come. But those companies must keep investors convinced of this potential, and there’s the rub. When is the last time a company delivered flawless results quarter after quarter, and year after year? Bumps in the road for firms are almost always unavoidable. And a company’s stock price reflects the value of that company’s profits for its entire future, so if expectations change about that future—whether it be a drop in potential growth or higher risks in achieving that growth—the current stock price will see an abrupt adjustment. This implies that higher multiple stocks, including the Super Seven, carry more risk than the average stock, even if they are also likely to grow faster. They are already priced for considerable growth. And keep in mind, while the risk of recession has declined, it hasn’t been eliminated. If inflation does not recede to the Fed’s target, the Fed might need to implement more rate hikes down the line, raising anew the risk of an economic decline.
As investors, we do not know if or when such a bump might be right around the bend. In the end, a company that has the right stuff will ride over those bumps and deliver that growth. Exposure to those higher growth companies can play an important role for the long-term investor, even when there may be bumps in the road. Knowing that those bumps can happen, though, means investors need to be properly diversified and positioned—conservatively or aggressively, for income or for appreciation, for near term needs or for long term goals—so that regardless of when those bumps come along, investors can ride through the disruptions.
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