Stock markets are in a sweet spot

The writer is global head of investment strategy for JPMorgan Private Bank

After a powerful fourth quarter rally, equity investors were a bit skittish at the start of 2024. But they have since driven the US S&P 500 index to new highs. More gains lie ahead.

Stock markets are in a very sweet spot and we expect they will make more new highs in 2024. This can be chalked up to moderating but continued economic growth, cooling inflation and upcoming central bank cuts to interest rates. But we also point to these key reasons:

The positive earnings outlook. With US earnings season under way, companies look well-positioned to increase their profits in a slowing (though still resilient) growth environment in 2024.

US large cap corporates have already gone through an earnings recession. Nine of the 11 major sectors in the S&P 500 reported negative earnings growth for three consecutive quarters in 2022-2023.

Companies have emerged with leaner cost structures and stronger balance sheets. When rates were low, companies sensibly extended the maturities on their debt. And today 70 per cent of the debt of S&P 500 companies is at fixed rates, compared with less than 50 per cent in 2007.

More gains tend to come after markets hit new all-time highs. Investing at all-time highs has traditionally signalled further gains ahead. Here’s what we find when we examine data back to 1970: on average, one year after investing at a new record, the S&P 500 was up more than 70 per cent of the time, with a median return of 12.1 per cent. That return is higher than the overall median of 10.5 per cent returns over one year from investing at any one point. Indeed, the S&P 500 rarely makes a new high and then fails to make another.

Strong gains can come even the year after strong rallies. Last year, the S&P 500 delivered a 26 per cent total return. We looked at what happens after calendar years with rallies of 20 per cent or more. Out of the 14 other instances since 1970, 11 of them (nearly 80 per cent) ended the next year higher. What’s more, the median return the following year was 13.7 per cent. Of course, past performance is no guarantee of future results. But if we map that trend on to 2023’s year-end close of 4,769, it puts the S&P 500 north of 5,400 in December.

Federal Reserve cutting cycles that coincide with soft landings are usually a good time to get invested. Going back to 1970, the S&P 500 typically rallies by roughly 16 per cent on average in the 12 months after the first Fed rate cut when a recession is avoided over that period. What’s more, five of the 10 best years of the past 40 for the S&P 500 have occurred when the Fed was cutting rates without a recession: 1985 (32 per cent), 1989 (32 per cent), 1995 (38 per cent), 1998 (29 per cent), 2019 (31 per cent).

Admittedly, stocks are not cheap. US equity valuations trade at the high end of the range for the market cap-weighted S&P 500 over the last 20 years and closer to the median for the equivalent index where constituents are all equal weighted rather than weighted to their relative size.

At first glance, the Magnificent Seven — the megacap tech stocks that accounted for more than 60 per cent of the S&P 500 return last year — seem quite expensive relative to the broader market. But Magnificent Seven valuations seem less excessive considering their distinctive strengths: strong free cash flow growth (14.5 per cent compound annual growth rate versus 7 per cent for the rest of the index since 2018), superior profit margins (19 per cent versus 9 per cent for the rest of the index) and higher earnings growth expectations.

In our equity portfolios, we like a blend of quality growth (technology), quality cyclicals (industrials) and quality defensives (healthcare). On a regional basis, the US is our preferred market. Anticipating a soft landing for the US economy, we estimate 8 per cent S&P 500 profit growth in 2024 and 2025.

We acknowledge two main risks to our outlook. If inflation were to accelerate (if, say, escalating geopolitical conflict leads to a commodity price shock or wage growth proves sticky), the Fed could be forced to postpone rate cuts or even raise rates. In such a scenario, both stocks and bonds would struggle.

Alternatively, economic growth data could disappoint. That might reflect geopolitical tensions or the lagged effects of higher rates and tighter financial conditions on corporate profits.

But neither scenario is our base case. So to those who look at last year’s market rally and the new January high and conclude they missed their moment, we say — don’t worry. Historical data and current fundamentals tell us that equity markets can hit new highs over the coming year.