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What Does the Market's Resilient P/E Tell Us About the Impact of Rising Rates?


And will the anticipated recovery in corporate earnings come to fruition?

The first quarter of 2024 was largely a continuation of the strength the stock market exhibited in 2023. The S&P 500 advanced nearly 11% in Q1, following a strong 2023 that saw the index rise 26%. Large-capitalization technology companies again led the way, as the Magnificent Seven averaged a 13% gain for the year through March, while the remainder of the S&P 500 was up a more modest 6%. In contrast to the lockstep move amongst the Magnificent Seven last year, the dispersion of returns amongst this celebrated group in the first quarter was notable. Nvidia was the strongest performer, riding investor enthusiasm over artificial intelligence to a greater than 80% gain in Q1. At the other end of the spectrum, Tesla shares fell 29% as demand for electric vehicles cooled.

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Overall investor sentiment has been supportive of risk assets, as belief has increased the Federal Reserve will be able to engineer the historically difficult “soft landing” by bringing down inflation without a meaningful economic slowdown. Inflation has come down from the peaks achieved in 2022, the economy has remained resilient, and consensus expectations reflect double digit earnings growth in each of the next two years. Add to this Fed’s indications it has likely reached the end of its hiking cycle along with expectations for multiple rate cuts this year and it makes sense why market participants have been bullish.

Investors’ collective expectations for interest rate cuts have come down from six or seven at the start of the year to two currently, but this is due to a stronger-than-anticipated economy. The Labor Department reported U.S. employers added 303,000 jobs in March, well ahead of the consensus of 200,000, with continued strength in the healthcare, leisure, and hospitality sectors. The unemployment rate declined slightly, to 3.8%. March retail sales were also well ahead of expectations, as consumers kept spending. Consumers continue to be supported by wage growth, with average hourly earnings up 4.1% in March versus the prior year. While this was the smallest yearly gain in average hourly earnings since June 2021, it remains high relative to the Fed’s 2% inflation target.

Investors will gladly trade rate cuts for a stronger economy, provided the trend in inflation remains lower. The most obvious concern to markets would be if inflation remains sticky or starts ticking higher. This was evident in the reaction to the March Consumer Price Index (CPI) report, which came in hotter than expected, showing inflation pressures remain. The headline March CPI report indicated a 3.5% increase from the prior year. Core prices, which exclude food and energy, rose 3.8%, breaking a 12-month streak where the annual change in inflation had declined. Importantly, this also marked the third consecutive CPI report with higher-than-expected readings. Members of the Fed had downplayed the January and February reports due to potential seasonal issues, but that excuse no longer held water in March.

However, the Fed’s primary inflation measure is not the CPI, but the core personal-consumption expenditures (PCE) price index. The next release on April 26th will be closely scrutinized, though forecasters who incorporate other inflation readings anticipate core PCE grew 2.7% versus the prior year, which would represent a decline from 2.8% in February. A continued downward trend in the Fed’s preferred measure could help ease some inflation concerns. The Fed’s own base case forecasts reflect a decline in core PCE to 2.6% by year end with three rate cuts of 0.25%. As things currently stand, it does not appear we have deviated meaningfully from that path, even if the consensus currently expects one fewer rate cut.

While some have questioned whether the Fed will cut rates at all this year, the Fed appears biased towards lowering rates in 2024. Prior to the release of the CPI report Chair Powell indicated the Fed is not far from gaining the confidence it needs regarding the path of inflation to begin cutting rates. Clearly the CPI report does not add to their confidence but as noted, the inflation data also isn’t far from the Fed’s own base case projections and would be consistent with an expectation for multiple rate cuts this year. While the Fed is focused on doing what is necessary to get inflation to return to its 2% target, the argument for cuts would be supported by the second component of its dual mandate, full employment. Powell has indicated rates, which are the highest in 23 years, currently are “well into restrictive territory,” meaning leaving rates where they currently are for too long could result in unnecessary harm to employment.

The surprisingly hot CPI report had a noticeable impact on bonds, with yields increasing sharply. The yield on the 10-year Treasury jumped from 4.3% to nearly 4.7% in the days following the release. Since the start of the year, the 10-year Treasury has risen from 3.9% but remains below the recent high of nearly 5.0% achieved last October. Two-year Treasury rates have also increased from 4.3% at the start of the year to nearly 5.0%, reflecting the reduction in rate cut expectations. Interestingly, gold has been a strong performer as rates have moved higher, up 14% this year and setting record highs. This is the opposite of the typical relationship between rates and the yellow metal, as gold, which produces no income, becomes relatively less attractive as rates move higher. Some have attributed the recent move for gold to its status as a safe haven, as concerns over geopolitical conflicts increase.

The price-earnings ratio for the S&P 500 has also been resilient in the face of higher interest rates, supported by the anticipated recovery in corporate earnings. After modest earnings growth in 2023, consensus expectations are for 11% earnings growth this year and 13% growth in 2025. The forward P/E multiple for the S&P 500 is nearly 21x, modestly above the 10-year average of about 18x according to FactSet. While optically rich, the multiple is not unreasonable provided earnings deliver as expected over the next couple of years.

Though stocks have wobbled following a recalibration of inflation expectations, it is worthwhile for investors to note stocks have been on an impressive run since the recent lows achieved last October. While not as enjoyable as market runs higher, pullbacks are a part of investing. It is nearly impossible to predict what the market will do over the short run, but building a portfolio of profitable, growing companies trading at reasonable valuations helps long-term investors more confidently navigate the inevitable periods when the sledding becomes tougher.

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The commentary is excerpted from the issue of the Investor Advisory Service newsletter published at the end of April. To receive commentary like this in a more timely matter and receive actionable stock ideas each and every month, subscribe today. The Investor Advisory Service stock newsletter was named to the Hulbert Investment Newsletter Honor Roll for the 14th consecutive year for outperforming every up and down market cycle since 2007

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