Will the Stock Market Keep Going Up? What to Know as the S&P 500 Hits New Highs.
Hope for interest-rate cuts has been replaced by stronger economic growth as fuel for stocks.
By Nicholas Jasinski
The story that investors are telling themselves has changed, and the stocks that rise most are changing with it. But one thing has stayed the same: It’s still a bull market.
Sure, the S&P 500 index has rallied 130% since March 2020 to a record-high, and now fetches 21 times expected earnings over the coming year, which isn’t exactly cheap.
Yes, the past year’s gains owed primarily to the outperformance of a mere seven “magnificent” stocks.
And who on Wall Street doesn’t know by now that the Federal Reserve will delay cutting interest rates until officials are convinced that inflation has been sufficiently subdued?
These factors, and others, leave the market vulnerable to a near-term correction, defined as a drop of 10%.
After all, stocks have averaged one correction a year all the way back to 1929, and the next is overdue.
If we get one, it will be an invitation to buy.
The best case for the stock market’s continued gains no longer depends on Fed rate cuts, but rests on the outlook for a strong economy, which will generate more earnings growth for more companies, allowing the rally to broaden.
“A good economy is good for earnings, full stop,” says Andrew Slimmon, a portfolio manager at Morgan Stanley Investment Management.
It also means the Fed can takes its time lowering rates.
“If the Fed was about to cut [rates], I would have to worry about an economic slowdown that jeopardizes the likelihood of the earnings growth we expect,” he added.
The economy isn’t showing many signs of a slowdown.
U.S. real gross domestic product grew by 2.5% in 2023, silencing a chorus of skeptics who had called for a recession, or worse—like a full-blown banking crisis.
GDP is on track to grow another 2.1% this year, and then downshift to 1.7% in 2025, based on the consensus estimates of economists tracked by Bloomberg.
But economists may still be underestimating the strength of the U.S. economy.
The Citi Economic Surprise Index, which measures actual U.S. economic data relative to consensus estimates, has been rising steadily since early this year, indicating that the economy’s performance continues to exceed expectations.
There is also ample earnings growth in the pipeline: Wall Street analysts are forecasting 11% earnings growth this year for S&P 500 companies, after gains of just 2% in 2023.
Next year, the consensus call is for a gain of 13%, hardly the stuff of which bear markets are made.
In recent years, investors have disproportionately rewarded the market’s largest companies, leading to outsize gains for the so-called Magnificent Seven—a group of fast-growing technology companies that includes Alphabet, Amazon.com, Apple, Meta Platforms, Microsoft, Nvidia, and Tesla.
The Magnificent Seven’s earnings growth far surpassed that of the average S&P 500 component in 2023, while the stocks’ gains accounted for more than two-thirds of the index’s 24% advance last year.
The Mag Seven are world leaders in artificial intelligence, cloud computing, and other technologies of the future, with plenty of earnings growth ahead.
But their stocks’ lead could diminish this year as economic growth enhances the earnings power of the rest of the market.
Analysts are forecasting the same earnings growth rate from the Magnificent Seven and the remaining S&P 493 by the fourth quarter.
What’s more, the benefits of AI and other technologies eventually will accrue to companies far beyond Microsoft, Nvidia, and their ilk, including companies with less demanding valuations.
Given the mismatch in valuations between the best performers and the rest, now would be a good time to lean into cheaper areas of the market that will benefit from a rising economic tide.
That would include more-cyclical and value-oriented stocks, and sectors such as industrials, energy, and financials.
“A solid economy and sticky inflation will mean that some of the high [price/earnings multiple] megacap growth stocks top out and the market broadens out,” says Barry Bannister, chief equity strategist at Stifel.
The S&P 500 Equal Weight Index is one way to play this theme; it weights all S&P companies alike, as its name suggests, while the S&P 500’s capitalization-weighted construction favors the market’s biggest names.
The Invesco S&P 500 Equal Weight exchange-traded fund (ticker: RSP) has lagged far behind the S&P 500 over the past 12 months, with a gain of just 13%.
Even so, the index hit a record high on March 7.
The equal-weighted index last outperformed the market-weighted version in 2022, when rising interest rates held back megacap growth stocks.
A reshuffling is happening even at the top of the S&P 500, with Microsoft now the largest company in the index, Nvidia climbing to No. 3, and Tesla dropping out of the top 10 altogether.
Berkshire Hathaway is now the seventh largest.
Rotations can leave the market vulnerable, especially after long rallies.
As of March 1, the S&P 500 had climbed in 16 of the prior 18 weeks—the first time that happened in 53 years, according to Deutsche Bank’s Jim Reid.
That fact alone doesn’t mean a pullback is in the offing, but there are several catalysts that could send stocks lower in coming weeks.
The release of the consumer price index reading for February, scheduled for March 12, is one.
A too-hot report following January’s higher-than-expected inflation data would force a further rethink of the Federal Reserve’s rate-cutting plans, probably pushing the first expected interest-rate cut into the year’s second half.
Bond yields could jump, weighing on highflying stocks.
The 10-year U.S. Treasury note yield was recently at 4.1%, down from 4.3% in mid-February and nearly 5% in late October.
“The balance of risks is skewed toward higher yields,” says Evan Brown, head of multi-asset strategy at UBS Asset Management.
“But what we’re seeing is an economy that’s in good shape and can withstand higher yields, even if a jump in yields can be a short-term headwind for equity [valuation] multiples.”
Futures-market pricing currently has Fed officials beginning to lower interest rates at the June Federal Open Market Committee meeting, according to the CME FedWatch Tool, on the way to a total of four quarter-point cuts in 2024.
That’s two fewer cuts, starting two meetings later, than markets were pricing in at the start of this year, and a quarter-point more of easing than the median estimate penciled in by policymakers in December, the last time the FOMC issued projections.
The Fed is effectively on hold, and recent data hardly suggest an economy in need of a kick from easier monetary policy. Employment remains near historic lows, hiring is still strong, and wages have been rising, helping to fuel continued consumer spending.
Plus, fiscal policy remains stimulative: The federal government is projecting a $1.5 trillion deficit in the fiscal year ending on Sept. 30, equal to about 5% of GDP.
And, corporate profits are at record highs.
“If the Fed is really as data dependent as it says, there is no good reason for a rate cut at all,” says Edward Yardeni, president of Yardeni Research.
“Even productivity growth has made a comeback, which suggests the economy can continue to grow with a higher fed-funds rate.”
ILLUSTRATION BY CARL GODFREYBut what about the stock market’s pricey valuation?
The S&P 500 is more expensive than average, based on 19 of the 20 metrics tracked by Savita Subramanian, head of U.S. equity and quantitative strategy at BofA Securities.
Its trailing price/earnings ratio is in the 95th percentile of historical readings.
The index’s long-term average forward P/E is 16, versus today’s 21 times.
Except that valuation isn’t a catalyst for a rally or a rout, says Subramanian, at least not in the short term.
Besides, a combination of better earnings, profit-margin expansion, and structural changes to the companies that make up the S&P 500 might well support a P/E that’s higher than the historical average.
“Forty years ago, around 70% of the benchmark was in asset-intensive sectors like manufacturing, financials, and real estate,” says Subramanian.
“Today, 50% [of the index] is in asset-light, innovation-oriented stocks, mostly in tech and healthcare.
It’s a reason to reconsider the overall valuation.”
Subramanian raised her year-end target for the S&P 500 on March 4 to 5400 from a prior 5000, which implies a gain of 4.7% from Thursday’s 5157, and a full-year gain of 13%.
She foresees a potential pullback in the near term, or around the November election, but expects buyers to swoop in before too long.
Richard Bernstein, CEO and chief investment officer of Richard Bernstein Advisors, sees the potential for big gains this year beyond the market’s current leaders.
“If you have a stronger economy and the Fed is on hold, the headline S&P 500 doesn’t do an awful lot,” Bernstein says.
“But the rotation within the stock market would be tremendous, with money moving out of the Magnificent Seven into other categories.”
Bernstein favors small-cap stocks and more-cyclical sectors, particularly industrials.
They are beneficiaries not only of stronger economic growth but also heavy government and corporate spending on infrastructure, the energy transition, and reshoring, or moving supply chains closer to home.
Stifel’s Bannister recommends that investors increase their exposure to more-cyclical sectors, as well, including banks, energy, and transportation companies.
Large U.S. bank stocks like JPMorgan Chase and Wells Fargo have rallied to 52-week highs.
S&P 500 industrial-sector stocks are up 7% in a month.
And Edson “Ted” Bridges, CEO and CIO of Bridges Investment Management, is looking for opportunities among mid- and smaller-cap companies, whose valuations are lower than those of large-caps.
In particular, he likes the prospects for Copart, which runs automotive auctions, and Cintas, a supplier of uniforms and office-cleaning products.
“The valuation disparity is so significant that there is a better chance for higher returns down-market, where you can still find plenty of profitable, competitively advantaged businesses,” Bridges says.
Keith Lerner, co-CIO of Truist Advisory Services, isn’t backing away from tech, even if the group appears extended after recent gains.
He also recommends financials and consumer-discretionary stocks on the premise that a strong economy and labor market will continue to support consumer balance sheets and spending.
With U.S. stock indexes at record highs, valuations appearing stretched, and leadership narrow, investors have ample cause to be skeptical about the prospects for more near-term gains, even with some $6 trillion in cash sitting on the market’s sidelines, waiting to be deployed.
And that’s before considering geopolitical risks or upheaval surrounding the U.S. presidential election.
But good news about the economy is good news again, and corporate fundamentals are back in the driver’s seat.
All of that is more than enough reason to stay invested—and bullish.
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