Graphic courtesy of Wetherall’s.
I offer a belated “Happy One-Year Anniversary” wish to the S&P 500’s October 2022 bear market low. By June 2023, the stock market index had increased 20 percent from its recent lows, the threshold commonly used in labeling a bull market. While I am thankful for the 12-month gain of 21.6 percent, it was rather blasé compared to past bull markets.
The median one-year return for a new bull market has historically been 36.9 percent, according to Bespoke.
Reason #1: An earnings turnaround
Even less lackluster were the returns for the previous 24 months. Over the two years up to that anniversary date, the stock market index was down about five percent. That makes intuitive sense, given the S&P 500 companies’ operating earnings per share (EPS). For 2021, EPS was $208.21. In 2022, EPS was $195.95. The third quarter of 2023 is expected to be the index’s fourth quarter of such declines, but I suspect earnings will come in ahead of analysts’ guidance—even if barely.
In reaction to punk profits, the stock market corrected about six percent over the last few months. I suspect the S&P 500 is now consolidating and setting up for a good rally. The index may touch its 200-day moving average before a rally begins, but, even then, it would still just be a garden variety eight percent correction.
The stock market should turn up based on year-over-year profits finally stabilizing after a long stretch of year-over-year declines. Contrary to the consensus, I predict a positive turn for earnings in the third quarter because the U.S. Gross Domestic Product (GDP) ran hot last quarter. The AtlantaFedGDPNow model puts Q3 GDP at 5.1 percent. That number will probably come down about one percentage point as September 2023 data flows into the bank’s model. That is not unusual. However, what is notable is that not only has the model shown a significant increase since the middle of the quarter, but it also actually ticked a bit higher toward the end, suggesting economic growth had momentum going into this quarter. That turn in earnings should lift stock prices through the remainder of 2023 and into early 2024 (emphasis on “early”).
Reasons #2 & #3: Progress on inflation puts a lid on interest rates
Inflation data continues to improve. If inflation is kept in check, the Federal Reserve won’t have to keep interest rates as high for as long. That is important because if interest rates are left too high for too long, it won’t just push the U.S. into recession; high interest rates for too long will beat the U.S. economy into a pulp and step on its neck, leaving it unable to get back up without shedding the weight of millions of jobs.
About a year ago, I foresaw that peak inflation, as measured by the Consumer Price Index (CPI), would be cut in half. That happened: CPI dropped from 9.1 percent to 3.7 percent. I am going to double down on my prognostication and go even further.
The CPI is the most popular inflation metric. However, the Fed’s price gauge is the Core Personal Consumption Expenditures Price Index. Core PCE remains uncomfortably high at 3.9 percent. I believe Core PCE will be about 2.5 percent a year from now, close to the Fed’s two percent target. There are a lot of risks to that call; many variables could reverse the direction of inflation and thrust it higher. One factor that could assist my prediction is lower household savings, at least in the U.S.
The U.S. savings rate dropped below its pre-pandemic average while savings rates elsewhere have held up, according to the Federal Reserve Bank of New York. That household spending partly explains why U.S. economic growth has performed so well compared to the rest of the globe up until now.
However, future household consumption should wane due to running out of savings and because pent-up demand and revenge travel were satisfied. In the intermediate term, that is good news for the stock market as the economy experiences economic growth in the face of slower inflation.
Reason #4: As a contrarian, I often see negative sentiment as bullish
Another reason I expect a rally in the stock market is the contrarian evidence from the National Association of Active Investment Managers Index. According to their website, the “NAAIM Exposure Index represents the average exposure to U.S. equity markets reported by their members.” Although the group says the index is not predictive, I have found that they are aggregately wrong at turning points. Below, in blue, is the NAAIM Index. And, in green, is the S&P 500.
Active investment managers have turned bearish and reduced their U.S. equity holdings considerably. The NAAIM Exposure Index is approaching a level historically coincident with an upward turning point for the stock market.
Still, I predict a recession to begin in the U.S. by early 2025; it is just a matter of whether it is a hard or soft landing.
Allen Harris is the owner of Berkshire Money Management in Dalton, Mass., managing more than $700 million of investments. Unless specifically identified as original research or data gathering, some or all of the data cited is attributable to third-party sources. Unless stated otherwise, any mention of specific securities or investments is for illustrative purposes only. Advisor’s clients may or may not hold the securities discussed in their portfolios. Advisor makes no representations that any of the securities discussed have been or will be profitable. Full disclosures here. Direct inquiries to Allen at AHarris@BerkshireMM.com.