The Top 10 Things We're Thinking About in US Equities Heading Into 2024

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Welcome to RBC’s Markets in Motion podcast, recorded November 23^rd, 2023. I’m Lori Calvasina, Head of US Equity Strategy at RBC Capital Markets. Please listen to the end of this podcast for important disclaimers.

Today in the podcast, our initial 2024 outlook. Our year-end 2024 S&P 500 price target is 5,000, for a 10% gain. Today the podcast will work a little bit differently, as we’re running through the top 10 things we’re thinking about in US equities as the new year comes into view. Most of these focus on the math that gets us to 5,000.

If you’d like to hear more, here’s another 7 minutes. While you’re waiting, a quick reminder that you can subscribe to this podcast on Apple and Spotify. Now, the details.

Takeaway #1: We are constructive on the year ahead, with a YE 2024 S&P 500 price target of 5,000.

Our 2024 target implies a gain of 10% vs. the November 22^nd
Our target is quantitatively driven. 5,000 is the approximate median of five different models that we use focusing on sentiment, valuations, earnings, cross asset dynamics, politics, and the economy.
The outputs of these models range from 4,500 (our bear case) to 5,300 (our bull case).

Takeaway #2: The sentiment set up is constructive for now.

Net bullishness on the AAII survey has been the best star in the sky by which to navigate the US equity market in 2023. Deep pessimism on this model was sending a strong buy signal last October and post SVB. The model turned tactically cautious in early August and was sending a buy signal again in early November.
Currently, sentiment is recovering off of the 1 standard deviation low seen a few weeks ago but is still in a range pointing to a 10% return in the S&P 500 over the next 12 months.

Takeaway #3: Valuations can stay higher than many investors realize.

One of the biggest things tripping up the bears in 2023 was using P/E assumptions that were too low.
Our model didn’t fall into that trap. We use average trailing P/E data dating back to 1962 and use consensus forecasts for inflation, interest rates, and GDP to forecast where that trailing P/E should be at the end of the year.
It’s been our most constructive model in 2023, calling for the trailing P/E to end the year at 21x.
For YE 2024, the model is baking in PCE that falls 2.3%, several Fed cuts, 10 year yields falling back down to 3.74%, and sluggish real GDP. All of this suggests a trailing P/E of 23x at the end of next year is justifiable.

Takeaway #4: Our earnings outlook is good enough to justify another year of gains, but also restrains our enthusiasm on 2024 performance.

There are no changes to our S&P 500 EPS forecasts – we’re sticking with $223 for 2023 and $232 for 2024.
When we use these with our valuation projections, the math argues that 4,700 is a reasonable place for the S&P 500 to end in 2023, and that 5,300 is a reasonable place for the S&P 500 to end in 2024.
The one wrinkle we see for the stock market from an earnings perspective is that the stock market is already baking in a strong EPS recovery in 2024 – we could experience some short term indigestion in stocks as forecasts get adjusted.

Takeaway #5: The greater appeal of bonds seems like a dampener of US equity returns, but not necessarily a derailer of them.

In our recent meetings one of the things we’ve talked a lot about is how the earnings yield of the S&P 500 has been close to parity with the 10 year Treasury yield.
We looked to see how the stock market tends to perform when that’s the case, and found that the S&P 500 tends to rise by more than 12% on average over the next 12 months.
The current readings on this indicator were pretty commonly seen in the 1990’s, when stocks did just fine.

Takeaway #6: We see the 2024 US Presidential election as a source of uncertainty in the year ahead.

There’s a lot of drama and noise around the election and it’s not clear what issues will drive turnout.
We’re staying focused on the numbers. On average, the S&P 500 rises by about 7.5% in Presidential election years, below trend, weaker than year three which we are exiting now.
In terms of cadence, Presidential election years usually have a weak start, rally into the fall, choppiness as election day draws near, and a post election rally.
One notable exception was 2000, when the election was too close to call initially and the traditional post-election rally failed to materialize.
We’ve gotten a lot of questions about the election from non-US investors and worry global investors could see the uncertainty it brings as a reason to reduce US equity exposure, given expensive valuations vs. Europe.

Takeaway #7: The sluggish US economy that many investors expect in 2024-2025 is the biggest headwind to stock market performance that we see.

Current consensus projections call for 2023 real GDP growth to come in at 2.3%, then to slow to 1% in 2024 and to stay below trend in 2025 at 1.8%.
In the 0-2% range the S&P 500 tends to be weak, with declines in the mid-single digit range on an average basis and flat on a median basis.
Offsetting this is the expectation for Fed cuts. Current consensus forecasts are calling for Fed cuts to begin in 2024. Generally, the stock market has performed well in the 6-month period before and after first cuts.

Takeaway #8: The new rules of thumb for the post COVID era are still emerging.

We’ve argued for quite some time that 2022 and 2023 have been similar to 2002-2003 and 2010-2011 – periods of messy post crisis normalization in which confidence has been fragile. We think we’re still early in the post COVID era, not near the end of a short-lived cycle.
For this new era, investors are figuring out what the new rules of thumb are. Consensus forecasts expect inflation and Fed Funds to go back to levels typical of the 1990s, ….
but for GDP to remain stuck at levels similar to its weakest decade, the post GFC/pre-COVID era. All of this begs the question of whether economic forecasts are too low.

Takeaway #9: We expect the tug of war between Growth and Value to continue a bit longer.

Our call on the Large Cap Growth trade is that we expect a tactical correction in Growth at some point, but a trigger is tough to identify and it’s hard to argue it will endure.
The problems we see for Growth are crowding…
and valuations that are close to peak vs. Value.
Earnings revisions trends are also no longer favoring Growth in a major way as was the case throughout much of 2023.
These data points all argue for a tactical correction in Growth stocks.
The problem is that economic growth is expected to stay below 2% for the next few years, and when economic growth is sluggish Growth stocks tend to outperform.
It may take economic growth surprising to the upside in a major way to break Growth’s dominance.

Wrapping up with Takeaway #10: Small Caps are intriguing in the year ahead.

For the last few weeks it seems like everyone wants to talk about Small Caps in our meetings.
We would be adding to positions heading into the new year.
Small Caps are deeply compelling on valuation vs Large Caps.
Small Caps have also been underowned, though positioning is starting to improve in recent weeks off levels that were close to post SVB lows.
Small Cap money flows have also been improving in recent weeks.
We’ve been telling people for a while that Small Cap balance sheets aren’t nearly as bad as feared…
and that Small Caps tend to outperform when the Fed starts cutting.
No one wanted to hear it until 10-year yields peaked, the unemployment rate came in higher than expected, and the latest CPI print came in better than expected. All of that finally seemed to convince investors the Fed was done, cuts could happen, and interest rate risk was abating.

That’s all for now. Thanks for listening. And be sure to reach out to your RBC representative with any questions.

Motion podcast, recorded November 7^th, 2023. I’m Lori Calvasina, Head of US Equity Strategy at RBC Capital Markets. Please listen to the end of this podcast for important disclaimers. Three big things you need to know today:

First, Growth sectors are typically the biggest beneficiaries of declining 10-year Treasury yields. This analysis was in focus in our meetings last week where investors were keen to explore what to own if yields have peaked.
Second, Small Caps, where balance sheet concerns have overshadowed attractive valuations, were also in focus in our meetings last week. Friday’s unemployment report also provided another reason to be taking a look at Small Caps now.
Third, there were a lot of interesting updates in our high-frequency indicators last week, with the most important one being that the deterioration in US equity investor sentiment finally has started to look too extreme. The stock market has had a strong start to November, and the move seems deserved in light of what we’re seeing in most, though admittedly not all, of our sentiment indicators.

If you’d like to hear more, here’s another five minutes. Now, the details.

Takeaway #1: Growth Sectors Are Typically the Biggest Beneficiaries of Declining 10-Year Treasury Yields

The biggest issue on the minds of the equity investors we spoke with in our meetings last week was whether 10-year Treasury yields have peaked. Generally, our view over the last month or so has been that if the surge in yields stopped soon, US equities could escape without incurring too much additional damage. Here’s what we’ve been highlighting:

First, we highlighted how when the earnings yield of the S&P 500 and the 10-year Treasury yield are close to parity, as has been the case recently, the stock market tends to keep rising. There have been times in the past few decades when this cross-asset gauge of equity valuation has signaled coming declines in the S&P 500, but we didn’t quite reach that level at the October 2023 highs.
Second, the surge in yields that has occurred since early April 2023 hasn’t been big enough to damage the US equity market too much. Historically, when increases in yields have totaled ~275 basis points or less, stocks have usually posted gains. It’s when the increases are more than that, as was the case in 2021-2022, that stocks tend to fall. The recent surged totaled 168 basis points, unlike the 2021-2022 surge which was more than 300.
Third, we highlighted how the S&P 500 Communication Services and Consumer Discretionary sectors have the strongest inverse correlation between their performance and trends in yields. These would be two sectors the historical playbook says to buy on a peaking yield thesis. We see better valuations in Communication Services than Consumer Discretionary. Within Small, Health Care is the sector that tends to be most negatively affected by higher rates and should benefit if the peak has been seen.

Moving on to Takeaway #2: Small Caps Are Another Beneficiary of Declining Interest Rate Angst, and Rising Unemployment Actually Helps Make the Case To Look at Them Now

The state of Small Caps was also in focus in our meetings last week.
We have been highlighting how angst around interest rates has been the main challenge that Small Caps have faced recently.
Small Caps tend to underperform when the Fed is tightening, and outperform when the Fed is easing, but the easing cycle has felt far off as investors have debated whether another hike is coming in December.
We’ve been reminding investors that Small Cap balance sheets are in better shape than feared.
For the average Russell 2000 company, the weighted average maturity is about 4.5 years. To the extent that there is a maturity wall Small Cap companies are about to run into, it’s in the 2-5 year window, not anytime soon.
Additionally, the effective interest rate that Small Cap companies are paying is still near historical lows. Small Cap companies, just like their Large Cap peers, have increased exposure to long-term debt in recent years.
Of course, interest rates aren’t the only potential driver of Small Cap performance trends. Friday’s jobs report was also particularly interesting from a Small Cap perspective. It showed that the unemployment rate moved up noticeably. Prior to the financial crisis, we often saw Small Cap performance start to inflect positively relative to Large Caps around the same time that the unemployment rate moved up. Sometimes the turn in Small Cap relative performance came ahead of the pivot in the unemployment rate, other times it came a bit after.
This chart is a good reminder that Small Caps tend to price in economic problems ahead of time.

Wrapping up with takeaway #3: an important shift in sentiment.

The biggest thing that jumped out on our high frequency indicators last week was that net bulls in the AAII survey finally reached levels suggesting pessimism in equity markets may have gotten too extreme.
In last week’s update, net bullishness fell to 2 standard deviations below the long-term average on the weekly data point and to 1 standard deviation below the long-term average on the four-week average. From these kinds of levels, the S&P 500 is typically up about 14% over the next 12 months.
Does this mean we are out of the woods for 2023? No, but it’s a promising data point for the year ahead.

That’s all for now. Thanks for listening. And be sure to reach out to your RBC representative with any questions.

The Top 10 Things We're Thinking About in US Equities Heading Into 2024 - Transcript