The Dangers of Market Timing
If ever there was a reminder to avoid market timing and stay invested in accordance with one’s long-term goals, 2023 was it! Twelve months ago, few, if any, investors predicted such significant gains for stocks in 2023. Our forecast was for a mid-single-digit increase, and we felt like a positive outlier. Most predictions were dour.
The consensus narrative was that interest rates had come up too far, too fast; the Fed was tone deaf; economic growth was faltering; stocks were weak in 2022 and 2023 was shaping up to look a lot worse. In reality, none of these fears materialized and instead, global stock markets experienced significant, broad-based strength in 2023.
U.S. stocks, as measured by the S&P 500 Index, increased nearly 12% in the fourth quarter, including dividends. This exceptional performance capped off a banner year, with the Index returning 26%. As a reminder, the S&P 500 Index is market capitalization weighted, which means that larger companies have a greater impact on index performance. This is particularly noteworthy because the average total stock return of the 10 largest companies in the S&P 500 was a whopping 85%. In fact, if each constituent of the S&P 500 Index carried equal weight, the Index’s 2023 return would have been 14% – still strong but a lot lower than 26%! In addition, while two-thirds of stocks in the index saw gains in 2023, only one-quarter of stocks outperformed the market.
International stocks, as measured by MSCI’s All Country World Index Ex-US, also experienced strong performance in 2023. The Index returned 10% in the fourth quarter, including dividends. This strength capped off the year at 15%, underperforming the S&P 500 Index yet again, but roughly in line when compared to an equally weighted S&P. We should also point out that international performance was quite remarkable in the face of two major wars: macroeconomic weakness in China, historically high geopolitical tensions, and persistently high inflation. Few would have predicted this either, once again underscoring our view that market timing is a fool’s errand; staying invested in accordance with long-term plans is key.
Drivers of 2023 Market Performance
Earnings growth and, to a greater degree than in most years, multiple expansions (rising valuations) were the key drivers of U.S. stock performance this year. In terms of earnings, investors widely expected 2023 corporate profits to decline nearly 5% versus 2022. Instead, as of the end of 2023 (before fourth quarter earnings are known), it appears S&P 500 Index earnings for 2023 will actually have risen at a low single-digit rate versus 2022. This improvement in expectations since the beginning of the year contributed roughly four points of the Index’s 26% total return in 2023.
From a valuation perspective, the S&P 500 Index ended 2022 trading at 17x forward P/E, or 2023 estimated earnings per share of $210. Today, the market sits at a forward P/E of 20x 2024 earnings per share (EPS). This multiple expansion of nearly 20% was a major contributor to the Index’s 2023 performance (and for those running the math, dividends contributed the other 2%). Exceptional multiple expansion in 2023 was driven by a numerous factors including: stabilizing interest rates, falling inflation, a surprisingly resilient U.S. economy, stand-out performance by large technology companies, and improving market sentiment, which was clearly too negative at the end of 2022.
2024 Outlook: Pessimism has Shifted to Optimism
If 2023 started from a depressed level, the pendulum is certainly swinging in the opposite direction to start 2024. There are many reasons to be optimistic, as the outlook on so many fronts is improving. Inflation is normalizing towards the Fed’s 2% target. In fact, the Fed looks pretty smart; consensus is building that the Fed orchestrated the ever-elusive “soft landing.” In other words, it ratcheted up interest rates to slow economic growth just enough to tame inflation without sending growth into negative territory. To make matters even better, unemployment remains low. Consumer savings post-COVID are depleted but remarkably still in positive territory.
We are encouraged by inflation coming down, by the Fed’s performance under Powell, by the U.S. consumer’s resilience, and most importantly, by the encouraging earnings trends we are seeing. Having said that, we are not tempted to chase the rally by increasing our clients’ exposure to stocks beyond the long-term targets we have carefully laid out with each of them. Valuations have come a long way in twelve months, and while there certainly could be room for further stock market appreciation through rising valuations as interest rates fall and the overall outlook brightens, we are not banking on that. The current market multiple of 20x 2024 EPS leaves less room for error.
On the earnings front, consensus expectations are for S&P 500 Index EPS to rise 12% in 2024 to $244 and another 12% in 2025 to $274. We think those expectations are quite optimistic, again leaving less room for error. Having said that, if 2024 and 2025 earnings turn out to be anywhere near consensus, then the market currently trades at a reasonable 17.5x 2025 EPS. We are optimistic that stocks can rise from here if this is true.
Our Base Case: We believe forward aggregate EPS growth of 5-10% is more reasonable, driven by ~2-4% economic growth translating to comparable revenue growth. Beyond that, we see positive operating leverage resulting in another 3-4% growth as inflationary and supply chain pressures ease. Lower interest rates and improving free cash flow generation could add another small boost to earnings. Under this scenario, we are optimistic that stocks can appreciate at a comparable rate to earnings growth if valuation multiples remain steady.
Downside Risk: We see the potential for earnings to fall at a low to mid-single digit rate if it turns out the Fed pushed rates up too far, too fast and economic growth ends up declining at a modest rate (i.e. a hard landing instead of the consensus soft landing). In this case, we would not be surprised to see stocks decline based on both falling earnings and valuation multiple compression. This scenario seems a lot less likely given the signals we are seeing across the economy – barring any unforeseen, far worse events precipitating greater declines in corporate earnings – but as we have learned over and over in the last few years, anything can happen.
We conclude where we started, and that is to remind readers that very few predicted how well stocks would perform in 2023. It may be repetitive to state, but it pays to remain patient and fully invested. This was far from easy to do after the declines seen in 2022, but certainly achievable with an informed, customized, and disciplined long-term plan in place. Optimism is abundant right now and for good reason, but just as pessimism last year was not a reason to reduce equity exposures below long-term targets, today’s optimism is not a reason to chase the rally and increase equity exposures beyond those targets.