Welcome to RBC’s Markets in Motion podcast, recorded May 28th, 2024. I’m Lori Calvasina, Head of US Equity Strategy at RBC Capital Markets. Please listen to the end of this podcast for important disclaimers.
The three big things you need to know:
- First, Small Caps are retesting their relative low vs. Large Caps once again, as Fed rate cut optimism has faded once again. We remain neutral Small vs. Large for now.
- Second, investor sentiment has almost returned to the highs in place to start the year (as well as the summer of 2023) on the AAII survey, reinforcing our neutral stance on the broader US equity market for now.
- Third, our S&P 500 valuation model continues to suggest that the broader US equity market is fairly valued, with some modest downside risk if current inflation, interest rate, and Fed assumptions end up being too rosy. For a material move higher in the market by year end to be justified on the math, we think investors will need to start focusing on the outlook for 2025, where visibility still seems a bit limited.
If you’d like to hear more, here’s another 5 minutes. While you’re waiting, a quick reminder that II season is starting soon. If you’ve found our work helpful, we’d appreciate your vote in the Portfolio Strategy category this year. Voting begins June 3rd and lasts through the end of the month.
Now, the details.
Starting with Takeaway #1: Small Caps ended last week retesting their late 2023 and early 2024 low relative to the S&P 500, as Fed optimism faded again.
Small Caps last made a relative bottom vs. Large Caps in mid April, and in early May were attempting to rally on the back of renewed Fed rate cut optimism. That rally once again proved premature.
We’ve been telling investors we’d prefer to stay neutral on Small relative to Large for now. While we’ve thought Small Caps could benefit from continued improvement in domestic GDP growth forecasts, we felt like some investors had gotten a little too optimistic about Fed cuts after the last Fed meetings, and reminded investors that Small Caps tend to inflect relative to Large after cuts begin, not before.
We also noted that while Small Caps looked intriguing from a positioning perspective (CFTC’s weekly data has suggested Small Cap futures positioning has been down around SVB lows)…
…valuations had gotten less appealing (with the Russell 2000 forward P/E back up to it’s long-term average of a little over 15x).
Earnings dynamics have also been better for Large Caps, particularly on earnings estimate revisions.
Moving on to Takeaway #2: Investor sentiment on the AAII survey is almost back to its late summer 2023 and early 2024 highs, or one standard deviation above it’s long-term average.
In last week’s meetings, we noted that one of the things really bugging us about the stock market right now from a shorter-term, tactical perspective was how net bullishness in the AAII survey had been tracking at around 17% for the past few weeks. It was just a matter of time, we thought, before this widely followed gauge of investor sentiment got back to one standard deviation above its long-term average, the level that was in place last year in late July/early August before the S&P 500 embarked on its 10% drawdown. This was also the level that was in place as 2024 began. Historically, the S&P 500’s return on a 3 month forward basis has been a little better than flat from these kinds of levels.
In last week’s update, the weekly data point (which we acknowledge can be volatile) rose to 20.7%, just shy of the one standard deviation mark of 22.1%. With that reading, the four-week average has moved up to 15%, still dragged down by the 6% reading in place at the beginning of May. Rather than alleviating our concerns, all this does is reinforce to us how rapid the recovery in sentiment has been.
Wrapping up with Takeaway #3: The S&P 500 continues to look fairly priced on our valuation model, with modest downside risk if current inflation, interest rate, and Fed assumptions end up being too rosy.
For those who aren’t yet familiar with it, our valuation model is fairly unique. It forecasts a trailing P/E for the S&P 500 based on consensus assumptions for inflation and interest rates by leveraging data back to the 1960’s. We update this model weekly, and note that consensus views on these macro inputs have shifted. Expectations for how much inflation will moderate, how much the Fed will cut, and how much 10-year yields will fall were all reined in and are now closer to the view of RBC’s US Rates/Economics team.
The model is now projecting a year-end trailing P/E of 21.5x (down from 21.8x) which implies an S&P 500 price of 5,100-5,300 (depending on whether one plugs in RBC’s 2024 EPS view of $237 or the 2024 bottom-up consensus of $245).
Importantly, our stress test that bakes in no cuts, stickier than expected inflation, and higher than expected 10-year yields points to slightly lower P/E at 20.8x and a range of 4,900-5,100 on year-end S&P 500 pricing.
It’s worth noting that the investors we met with last week, mostly long-onlies, were generally in the “no cut” camp (which we confess is the view that we on the US equity strategy team lean towards as well). The idea that cuts aren’t coming any time soon didn’t seem to phase them much, however as they also tended to believe that the US economy, particularly their local economy, is strong.
As we discussed what could drive stocks higher between now and year end, it became clear to us that a focus on 2025 seems needed to take the market materially higher. And there, visibility still seems a bit limited, with one investor noting that the November elections may be contributing to the fog.
That’s all for now. Thanks for listening. And be sure to reach out to your RBC representative, with any questions.