Raymond James CIO Larry Adam discusses why we were due for the recent market volatility.
To read the full article, see the Thoughts on the Market publication linked below.
Downside equity market volatility can be unsettling, but it is important to put the pullback in perspective and identify the drivers of the negative market reaction. First and foremost, the equity market was due for a modest pullback. In fact, historically (dating back to 1980), the S&P 500 experiences an average of three to four pullbacks of 5% or more in a year. Prior to this most recent ~8% decline, the S&P 500 only had one other pullback of 5% or more which occurred during the banking turmoil back in March. In addition, after the S&P 500 notched its best start to a year (through July) since 1997 and rallied well above our year-end target of 4,400, we cautioned investors in our August 4 Weekly Headings to prepare for a potential pullback in equity prices. We highlighted four main reasons for our caution that included elevated expectations for the economy (remember that the Atlanta Fed GDPNow indicator had at one point estimated 3QGDP at 5.9%), optimistic bullish sentiment (remember many Wall Street analysts raised their S&P 500 targets), expensive valuations (the P/E multiple rose to ~20x on a trailing basis), and the negative seasonal patterns (August and September tend to be the weaker months of the year, September in particular has now been in negative territory for each of the last four years)..
It is difficult to time a bottom and downside volatility may continue in the near term. But given that we have had a pullback, the current upside to our year-end target of 4,400 and 12-month target of 4,650 is ~4% and 10% respectively on a total return basis. The reason we remain modestly constructive on the equity market is that none of our forecasts that take us to those levels have changed.
- Economy | We have not changed our call for a mild recession in the first half of 2024—driven by slowing job growth, depleted excess savings and the lagged impact of higher borrowing costs. Importantly, we are already starting to see a moderation in the consumer as September
consumer confidence declined for the second consecutive month and forecasts suggest a weaker holiday shopping season. However, as we expect the second mildest recession in history (both in time and magnitude of the economic contraction), earnings should remain resilient throughout the recession. This should allow the S&P 500 to avoid retesting the October 2022 lows.
- Federal Reserve | The Fed is in the late innings of its tightening cycle, with possibly one more rate hike this year before ultimately cutting interest rates in mid-2024. The important point is that, historically, the S&P 500 rallies after the last Fed rate hike.
- Interest Rates | Yes, the 10-year Treasury yield has risen to ~4.60%, but our expectation is that it will not stay there long as we expect longer- term interest rates to fall toward 3.5% over the next 12 months. Recessionary concerns, decelerating inflation and the Fed ending its
tightening cycle should force interest rates lower. This will be significant as higher rates are likely the biggest factor negatively impacting the
P/E multiple of the S&P 500 and causing the recent equity decline; so, if interest rates fall, the P/E multiple should move higher.
- Inflation | We expect inflation to continue to trend lower over the next several quarters. Yes, the ‘headline’ inflation trend has risen due to higher energy prices but now that oil prices have reached our year-end target of $85 to $90/barrel, the future impact should be less. We expect
core prices to continue on a disinflationary path even if headline inflation moves higher. A continuation of goods prices falling and shelter/rent prices decelerating should contribute to the downward trend. Reduced inflation should drive interest rates lower and take pressure off the Fed.
- Changing Seasonality | The negative seasonality pattern should turn more favorable as we enter the fourth quarter. Historically, mid- October through the end of the year has been strong. In addition, it does appear as if the market in the near term is oversold as market sentiment has moved to more negative levels and the 14-Day RSI declined into oversold territory (a level below 30).
Other than the Fed meeting, the last few weeks have been void of important economic and fundamental data for investors to assess. But that changes over the next several weeks as we get more economic data and earnings season ramps up in mid-October. From an economic perspective, we anticipate the data will confirm an economy that is slowing (not imploding) and that inflation is on a firm downward path. Important catalysts to watch to support our view include PCE (this Friday), ISM on Monday 10/2, JOLTs on 10/3, the employment report on 10/6, PPI on 10/11, and CPI on 10/12. From an earnings perspective, we expect earnings growth to stabilize and grow for the first time in four quarters. The important thing to watch is that companies are likely to beat their earnings on the back of expense management, normalizing supply chains and falling input costs. The point is that we do not expect guidance to suggest a steep decline in earnings moving forward. While we are well below consensus earnings for 2024 ($220 vs $247), our earnings estimate supports our 12-month target of 4,650.
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