Continued Strength
Strong stock market performance continued through the second quarter, but at a more moderate pace and with fewer positive contributors when compared to the first quarter. Three months ago, we highlighted strong economic growth, falling inflation, and hopes of near-term Fed rate cuts as the three key positive dynamics sending stocks higher in 2024. Today, that list has narrowed to two. Economic growth remains strong and inflation is still moving in the right direction. As mentioned above, while some investors are still hoping for a series of rate cuts by the Fed in 2024, the likelihood of this happening, in our view, is now quite low.
U.S. stocks, as measured by the S&P 500 Index, increased 4.3% in the second quarter, including dividends, bringing the year-to-date return to a strong 15.3%. The breadth of stock gains narrowed in the second quarter as mega cap technology stocks stole the show once again, much like we saw in 2023.
Despite further gains for the market cap weighted S&P 500 Index in the second quarter, the Index’s equal-weighted return fell to 5.1% year-to-date versus 7.25% at the end of the first quarter. These seemingly conflicting dynamics can be explained by the fact that the outlook for mega cap technology stocks’ earnings have risen relative to the market, and positive sentiment is sending their valuations higher. In addition, the average total return of the ten largest companies by market cap in the S&P 500 Index is +37.3% versus +23% at the end of the first quarter. Eight of these ten stocks are technology companies. Of the remaining two, Berkshire Hathaway is being driven in large part by Apple, which makes up over 40% of its investment portfolio.
International stocks, as measured by MSCI’s All Country Ex-US Index, returned 1% in the quarter, including dividends, bringing the year-to-date return to 8.8%. This performance, while decent in absolute terms, continues to lag that of the U.S. stock market, thanks to the persistence of numerous headwinds, including but not limited to a strong dollar, geopolitical turmoil, political changes in Europe, and economic weakness in China.
Drivers of Second Quarter Market Performance
At a high level, valuation multiple expansion was the primary driver of U.S. stock market performance in the second quarter. The S&P 500 Index rose 4.3% in the quarter, and so did the market multiple. Three months ago the S&P 500 Index was trading at 19x 2025 earnings estimates. Today, that multiple is 19.8x, or 4% higher.
The market – at least at the aggregate level – appears to be shrugging off a lack of interest rate cuts by the Fed largely because earnings are turning out to be stronger than expected. First quarter earnings, as reported during the second quarter, were better than expected, resulting in positive estimate revisions for 2024, 2025, and 2026. Upward revisions of earnings estimates are important because stocks trade on forward earnings estimates; as expectations for future earnings rise, so do stocks. As the economy remains strong and investors look to future estimates with higher conviction, positive estimate revisions are helping market sentiment even though inflation, while falling, remains high enough to prevent the Fed from cutting rates.
Outlook
Our outlook for stocks remains favorable despite the market’s strong year-to-date performance and narrow leadership. There are three points to our thesis. First, the outlook for earnings growth is favorable. The U.S. economy remains on solid footing despite persistently elevated inflation and high interest rates. Howland Capital’s Investment Committee is increasingly mindful of the impact these factors are having on the U.S. consumer’s ability to borrow and spend. Despite the challenges presented by current inflation and interest rates, consumer spending remains fairly robust, driven by increases in wages and productivity as well as low unemployment.
Second, while valuations are elevated versus history, they appear sustainable in light of the economy’s resilience, improving market sentiment despite tempered interest rate expectations, and prospects for earnings growth.
Third, the Fed still has not cut rates and this represents a potential positive catalyst at some point in the coming quarters. The probability of rate cuts in 2024 has been falling, but lower rates are coming. Unless accompanied by a weakening economy, rate cuts could be another benefit for stocks.
Overall, barring any major and unforeseen shocks to the global economy, our expectation is for valuations to remain stable and for the market to appreciate in-line with earnings growth. The key question is how fast will earnings grow. We outline some scenarios below. Our base case calls for a 6-10% growth rate, with a few points of return beyond that from dividends. When compared to current U.S. Treasury rates in the ~4-5% range, the risk premium for stocks looks fairly attractive.
In our base case scenario, we believe annual market earnings growth in the 6-10% range through 2026 is reasonable. This estimate is underpinned by ~2-4% economic growth translating to comparable revenue growth with another ~4-5% growth as operating leverage, moderating inflation, and supply chain pressures benefit margins. Improving free cash flow generation could add another small boost to earnings. Under this scenario, stocks may appreciate at a high single or low double digit pace, assuming valuation multiples remain steady.
Forward earnings estimates for the S&P 500 Index remain resilient and, in fact, are actually rising. Consensus expectations for S&P 500 Index earnings per share in 2024, 2025, and 2026 are $243, $278, $309, respectively, which represents 11%, 14%, and 11% EPS growth. While we acknowledge that a 19.8x forward P/E multiple leaves little room for error. In our bull case scenario, if expectations for double digit earnings growth in the next few years turn out to be either accurate or – dare we say – too low, we would not be surprised to see the market multiple go up, sending stocks higher at a solid double-digit annual rate.
Downside Scenario: In our downside scenario, persistent, above-trend inflation, stubbornly high interest rates, and disappointing economic growth would be a bad combination for stocks at current valuations. If these three factors were to dominate, earnings have the potential to fall at a low to mid-single-digit rate, especially if the economy ends up contracting modestly. In this case, we would expect stocks to decline. This scenario seems a lot less likely given the signals we are seeing across the economy, but with valuations at elevated levels, risks to the downside have increased since the end of 2023.
