Three Positive Signs for the Bulls

Key Takeaways:

  • Stocks rose last week, including the S&P 500 reaching a record high. Except for the domestic inflation report, it was a quiet week on the economic data calendar, meaning markets were focused on, and powered by, incoming quarterly corporate earnings announcements, which have largely beat expectations. 
  • The combination of rising corporate profits, the avoidance of a recession, and a more friendly monetary-policy outlook looks to us to be a favourable backdrop for market performance this year. It appears the market may be increasingly aligned to this view, as evidenced by the rather calm reaction in the stock market to the recent adjustment in expectations for U.S. Fed rate cuts to begin later in the year than markets were previously anticipating. 
  • Reaching new record highs has not typically marked an exhaustion point for markets, though we think it's reasonable to expect a breather in the near term given the speed and size of the recent rally. Nevertheless, we think markets can build on gains over the course of this year, with the next leg getting help from a broadening of leadership in asset classes and sectors that have lagged more recently.

The stock market added to 2024 gains last week, with the S&P 500 now up 24% and the TSX gaining 14% since October.1 With this sharp rally sending the S&P 500 to a record high, you wouldn't think it would be hard for investors to find good news, and you'd be right. After all, we don't believe this run higher has been a fluke. It's been backed by credible tailwinds, like the Bank of Canada and U.S. Fed that will be cutting rates later this year and an economy that has resisted gravity on the backs of an enthusiastic consumer.

Stocks added to 2024 gains last week.

 Chart showing the year-over-year percentage change in U.S. and Canadian headline and core CPI.
Source: FactSet.

At the same time, this rally is not infallible. Leadership has been rather concentrated (underpinned by tech performance that is giving off whiffs of an AI mania), valuations are full (though not unsustainable), and it's far from guaranteed that the Fed will perfectly thread the needle that seamlessly sews together a growing economy alongside persistently falling inflation.

This is not a cautionary tale, however. We think the run in equities has been reasonable, and the broader bull market looks to have more gas left in the tank. But we also know that even the best markets run out of breath periodically. The good news is that such episodes, while not painless, should prove temporary, in our view. Here are three signs which tell us that even after the surge to all-time highs, investors can still have confidence in this market:

  1. Earnings are backing up the gains. 
    • Market returns are guided by earnings - Over the last 30 years, the price of the S&P 500 index has risen by well over 900%.1 Importantly (but not surprisingly), earnings per share for the S&P 500 rose more than 900% over that time as well.2 This highlights the long-term relationship between stock prices and corporate earnings. They don't, however, move in perfect lockstep with each other. Instead, market movements reflect expectations, occasionally overshooting to the upside and the downside, as investors become overly optimistic or pessimistic.

Earnings estimates have trended higher, including a move higher last week.

 Chart showing consensus estimates for S&P 500 earnings have trended higher over the past year.
Source: Bloomberg, consensus estimates.
  • 2024 profits will be key for justifying the recent rally - Corporate earnings rose slightly last year while the S&P 500 gained more than 26%, reflecting the anticipation of a more friendly Fed and healthy earnings growth. To justify the gain, profits this year will need to make good on those expectations, and the latest quarterly earnings announcements suggest that is a reasonable outcome. After last week, 92% of companies have reported fourth-quarter 2023 results, with a more than 7% upside surprise versus consensus expectations. Based on the announced results, S&P 500 profits rose 6.8% year-over-year in the fourth quarter, providing an encouraging handoff to 2024.3
  • A look back at the tech bubble – The mania around artificial intelligence looks to us like shades of euphoria. Not because the future impacts of AI on the economy are misguided or overstated (we think there are significant near- and long-term economic benefits), but because simply looking at the price appreciation of certain technology investments (and to a lesser extent, the market as a whole), at least gets our Spidey Senses going.

A 26% return in the stock market in 2023, powered by a nearly 60% gain from the tech sector, hearkens back to the 1990s.1 But more concrete comparisons to the tech bubble are, to us, both premature and overstated. First, while last year's stock-market gain looks similar to calendar-year gains during the late 1990s, it shouldn't be lost that the bubble was filled by five consecutive years (1995-1999) of annual returns exceeding 20%. Perhaps more importantly, earnings across the dot-com stocks didn't back up those gains. In the 1990s, meteoric gains were occurring in unprofitable dot-com companies, many of which had tantalizing growth prospects but no viable or sustainable earnings base. Today, the enthusiasm is concentrated in the largest companies with prolific as well as defensible earnings. NVIDIA, Microsoft, Alphabet (Google), Amazon and Meta (Facebook) generated a quarter of a trillion dollars in earnings in 2023.3  Could we see some slivers of reckoning in the most overheated spaces? Of course. Does this raise the potential for disappointments that spark a temporary pullback? Yes.  Does this pose a more structural threat that sends the overall equity market in a sharp or severe dive? We don't think so.

While the current rally has been strong, it's a long way from a bubble.

 Chart showing price performance of the S&P 500 Index, indexed to 1 from January 1995 - March 2000 and from October 2022
Source: Bloomberg, Edward Jones. Price performance of the S&P 500 indexed to 1.

We are not, however, dismissing some noteworthy characteristics of the current market. Currently, the top 10 stocks in the S&P 500 account for roughly 29% of the market's capitalization.4 This compares with 33% during the dot-com era. Last year, the majority of the S&P 500's gain was attributable to just a small number of mega-cap technology stocks.  There's no denying that market concentration has increased and leadership has been narrow.  This makes the market more vulnerable to swings in sentiment, as well as to company- and sector-specific risks. For example, last week's better-than-expected quarterly earnings announcement from NVIDIA provided the fuel that sent the tech sector and the overall market surging higher. However, an opposite announcement would have likely had, in our view, an equally negative effect on the broader market. We do have some indigestion toward a market that is so focused and sensitive to the outcomes of a single company or handful of names. These conditions don't herald an imminent downturn or an outcome anywhere near that which followed the dot-com bubble, but instead highlight the importance of overall earnings in supporting sustainable growth for the equity market.

  1. The stock market's recent response to the Fed has been, dare we say, calm. 
    • Expectations needed to be adjusted - For some time now, we have viewed expectations for Fed interest-rate decisions as the most prevalent catalyst for market volatility. Our reasoning is twofold: 1) Financial markets are incredibly tightly (almost myopically) anchored to Fed policy. This has been the case for the last two years, and we anticipate this will continue to be so in 2024. Monetary policy (particularly tightening and easing phases) is a very powerful driver of economic and market outcomes, so this is not an unreasonable condition. 2) We have felt consensus market expectations were unrealistic when it came to Fed rate cuts this year. It has been our expectation since last fall that the Fed would wait until this summer to begin cutting rates. Up until the last few weeks, markets have been pricing in rate cuts to begin in March. Over the last few weeks, in response to the Fed's latest policy announcement and the most recent inflation report, markets have moved closer to our view, removing an expected rate cut in March and pushing back both the commencement and magnitude of cuts in 2024.
    • Equites have kept a level head - Here in lies the good news for investors: Fed expectations have been recalibrated without the stock market freaking out. This has not been the case over the past year and signals to us that markets are willing to look at the bigger picture. That picture is one in which the economy appears poised to power ahead without experiencing a significant recession, the Fed will eventually begin to take its foot off the monetary-policy brake, and the corporate profit cycle is in an upswing.

Looking back in 2023, there were two prominent episodes during which the market was forced to adjust its expectations toward a less accommodative Fed. At the beginning of February 2023, the market abruptly raised its expectation for the policy rate by 50 basis points (0.50%) following hawkish commentary from the Fed around its commitment to bringing down inflation. The stock market fell more than 7% over the next month. Then in the summer of last year, the Fed instilled a "higher for longer" interest-rate message that sparked a 10% correction from August through October.1

Prior adjustments to higher rates spurred equity-market pullbacks.

 Chart showing market expectations for the fed funds rate at upcoming FOMC meetings.
Source: FactSet. S&P 500 Index and 2-year U.S. Treasury Yield.

We doubt the coast is clear when it comes to market (over)reactions toward Fed expectations, but the fact that the stock market has come around to the expectation that the Fed will wait longer before cutting rates and cut less this year than previously anticipated without a knee-jerk sell-off response, tells us that there is growing confidence in the broader fundamentals of this bull market.

  • The Bank of Canada received some help – While financial markets are primarily focused on moves from the Fed, decisions from the BoC will be an important influence on domestic economic conditions this year. Last week brought good news on this front, as the January consumer price index (CPI) report showed that domestic inflation cooled last month. Year-over-year headline CPI fell below 2.9%, within a whisper of last June's post-pandemic low. Looking at the month-over-month trend, the three-month average fell to its lowest since September 2020. We don't expect the Bank of Canada to overreact, but we do believe this gives the central bank a bit more flexibility to pursue a rate cut in the coming months. We think there's a likely chance the BoC may cut rates ahead of the U.S. Fed given this favourable trend in inflation alongside recent economic data that have shown the domestic economy is notably softer than the U.S. economy.

Inflation has turned lower after the uptick late last year.

 Chart showing headline Canadian CPI ticked lower in January,
Source: FactSet. Year-over-year percent change in Canadian headline CPI.
  1. All-time highs are not the finish line.
    • The S&P 500 surged to a record high last week, having eclipsed the previous high in January 2022 on the back of a new bull market that has delivered a 45% return since October 2022.1 The upshot is that bull markets do not tend to reach exhaustion upon hitting new highs. In fact, history shows that the initial breach of an all-time high tends to be more of a mile marker on the way to further gains.

Equities have typically logged strong and extended gains after new highs were reached.

 Chart showingS&P 500 has historically continued to rise after setting a new
Source: Bloomberg, Edward Jones. Price return of the S&P 500 Index.
  • It's positive to see the recent broadening out of sector performance. Over the past year, the technology and communication services sectors are the runaway leaders, each gaining more than 57%, with the next closest being consumer discretionary (30%) and industrials (21%).1 However, over the last month, leadership has been more balanced, with energy, communication services, consumer discretionary, industrials and financials representing the top-five performers.

Sector performance has become more balanced recently, including leadership from cyclicals.

 Chart shwoing performance of the S&P 500 GICS level 1 sectors over the past 1-year and 1-month.
Source: FactSet. S&P 500 GICS level 1 sectors.

Craig Fehr, CFA
Investment Strategist 

Sources: 1. FactSet. 2. Robert Shiller S&P 500 earnings data, Bloomberg 3. Bloomberg  4. Morningstar

Weekly market stats

Weekly market stats
S&P 500 Index5,0891.7%6.7%
MSCI EAFE *2,288.421.4%2.3%
Canada Investment Grade Bonds * 1.0%-1.8%
10-yr GoC Yield3.46%-0.1%0.4%
Oil ($/bbl)$76.55-2.4%6.8%
Canadian/USD Exchange$0.74-0.1%-2.3%

Source: FactSet, 2/23/2024. Bonds represented by the Bloomberg Canada Aggregate Bond Index. Past performance does not guarantee future results. *Source: Morningstar Direct, 2/25/2024.

The Week Ahead

Important economic releases coming out this week include domestic fourth quarter GDP and U.S. PCE inflation data.

Craig Fehr

Craig Fehr is a principal and the leader of investment strategy for Edward Jones. Craig is responsible for analyzing and interpreting economic trends and market conditions, along with constructing investment strategies and asset allocation guidance designed to help investors reach their financial goals.

He has been featured in Barron’s, The Wall Street Journal, the Financial Times, SmartMoney magazine, MarketWatch, the Financial Post, Yahoo! Finance, Bloomberg News, Reuters, CNBC and Investment Executive TV.

Craig holds a master's degree in finance from Harvard University, an MBA with an emphasis in economics from Saint Louis University and a graduate certificate in economics from Harvard.

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