Throughout the first quarter of 2024, U.S. equity investors found themselves in an ideal market environment. Numerous, positive dynamics propelled stocks higher. The biggest three factors were: 1) continued economic strength driving corporate profits higher; 2) moderating inflation, providing some relief to consumers, businesses, and governments; and 3) prospects of near-term interest rate cuts by the Federal Reserve. The list of positives goes on, but the bottom line is that stock market performance was strong in the first quarter and investors remain upbeat.
U.S. stocks, as measured by the S&P 500 Index, increased 10.5% in the first quarter, including dividends. This stand-out performance came on the heels of an exceptional 2023 when the Index returned 26%. To make matters even better, the breadth of stock gains expanded in the first quarter. Unlike 2023, when the average total return of the 10 largest companies in the S&P 500 was a whopping 85%, and the S&P’s return on an equal-weighted basis was “only” 14%, stock gains so far in 2024 are more broad-based. Nearly 80% of stocks in the Index are positive year-to-date, and 40% of them are outperforming the market. The Index’s equal-weighted return is 8.6% so far this year, which is a lot closer to the actual Index return of 10.5%. Ten of eleven market sectors saw positive returns in the first quarter (Real Estate was the only sector to decline). Market leadership still remains narrow, with the average total return of the 10 largest companies coming in at 23%; however, the disparity is far lower than what we saw in 2023. In sum, positive market dynamics are extending beyond a select few AI-driven technology stocks, which bodes well for continued returns, in our view.
International stocks, as measured by MSCI’s All Country Ex-US Index, returned 4.7% in the first quarter, including dividends. This performance, while strong in absolute terms, once again lagged the U.S. stock market. We continue to view international performance as favorable, especially in the face of two major wars, ongoing macroeconomic weakness in China, historically high geopolitical tensions, and elevated inflation. That said, we continue to hold a far higher weighting of U.S. stocks in our clients’ portfolios because we see much better buying opportunities – despite recent market strength – in the U.S. Having lowered our exposure to international markets last year, we do not anticipate a change to this geographical positioning.
Drivers of First Quarter Market Performance
Similar to 2023, valuation multiple expansion was the key driver of stock performance in the first quarter. Today the S&P 500 Index valuation is 21.5x 2024 EPS and nearly 19x 2025 EPS. This compares to 19x 2024 EPS and 17x 2025 EPS just three months ago.
From an earnings perspective, estimates are stable versus three months ago. This stability is encouraging, given that expectations were high heading into the fourth-quarter earnings season, where results were reported over the last few months. Looking at consensus expectations for 2024, 2025, and 2026, aggregate S&P 500 Index earnings growth could be 11%, 13%, and 12.5% respectively. If these estimates prove true, then the market’s current valuation could be justified despite being greater than one standard deviation above its 30-year average of 16.6x one-year forward EPS. We should also once again point out the positive factors mentioned above as key drivers of present market sentiment and elevated valuations. The current environment for U.S. stocks appears to be quite favorable.
Outlook: The Glass is More than Half Full
Our outlook for stocks remains unchanged versus three months ago; there are many reasons to be optimistic. Inflation is normalizing towards the Fed’s 2% target. The Federal Reserve is looking smarter and smarter by the day as the “soft landing” thesis holds. The U.S. economy remains strong: unemployment is low, consumer sentiment is stable, rates look set to decline and corporate profit trends are robust.
Despite our positive outlook, we are mindful of the market’s elevated valuation, especially as it now sits more than one standard deviation above its long-term average. We remain committed to a solid allocation to stocks because we see additional opportunities for capital appreciation. We are not, however, tempted to chase the rally by increasing our clients’ exposure to stocks.
Rather, we are focused on reducing our clients’ exposure to stocks whose valuations have grown too stretched, and we continue to find good buying opportunities in individual stocks and areas of the market that have been left behind in the recent rally. One such example is the Consumer Staples sector. In this sector, we see moderating inflation as a positive catalyst for margins, a decent likelihood of improving sales growth in the coming quarters, and compelling valuations compared to other sectors of the market.
Our Base Case: We believe that forward aggregate EPS growth of 5-10% per year through 2026 is more reasonable than the consensus figures cited above. This earnings growth will most likely be driven by ~2-4% economic growth translating to comparable revenue growth and another ~3-4% growth as inflationary and supply chain pressures ease. Falling interest rates and improving free cash flow generation could add another small boost to earnings. Under this scenario, stocks may appreciate at a comparable rate to earnings growth if valuation multiples remain steady.
Downside Risk: Stubbornly elevated inflation and decelerating economic growth would be a bad combination for stocks at current valuation levels. We see the potential for earnings to fall at a low to mid-single-digit rate if it turns out the Fed cannot cut rates due to high inflation, especially if economic growth ends up declining at a modest rate. Rising inflation and a weakening economy would be even worse for earnings growth. In either case, we would not be surprised to see stocks decline. This scenario seems a lot less likely given the signals we are seeing across the economy, but with valuations at elevated levels, the risk to the downside has increased since the end of 2023.
