Navigating rangebound equity markets

From the March lows after the collapse of Silicon Valley Bank, the S&P 500 gained 19% to the end of July. The rally was driven by a more resilient-than-expected US economy, falling inflation, the winding down of the Federal Reserve’s rate hikes, and investor enthusiasm about artificial intelligence.

But since the start of August, price developments have been choppy, with markets buffeted by contradictory evidence and conflicting interpretations of economic data, asset pricing, and the outlook for Fed policy. We think the market could remain rangebound in the coming months, and our December 2023 and June 2024 S&P 500 price targets are 4,500 and 4,700, respectively.

• On the positive side, it’s highly likely that the earnings recession (year-over-year decline in reported profits) that began in the fourth quarter last year and continued into the second quarter this year is over. Bottom-up 12-month forward S&P 500 earnings per share (EPS) expectations have staged a notable rebound in 2023 and are now back to all-time highs. The profit improvement is fairly broad. Expectations are at or above all-time highs in every sector except energy, healthcare (due to the falloff of COVID-related benefits), and materials. To be sure, most of this year’s S&P 500 gains have been driven by valuation expansion, but investors should not lose sight of the fact that profit dynamics have also been supportive. Our 2023 EPS estimate is in line with the bottom-up consensus—USD 220 (0% y/y), although our 2024 estimate of USD 240 (+9% y/y) is a bit lower than expectations for USD 248.

• Uncertainty resides more with the macroeconomic outlook, and the low-hanging fruit on inflation improvement has already been picked. Fading base effects, healthcare price adjustments, and an expected temporary rise in month-over-month inflation could cloud the disinflation story. Brent crude oil prices, for example, had fallen 45% year-over-year (y/y) at the June lows, but have since rebounded to be closer to flat y/y. Energy prices are not part of core CPI, but the risk is for second-round inflation impacts. And with headline inflation above target, it will be more difficult for the Fed to point to imminent rate cuts, which would be needed to drive the equity market substantially higher.

• Turning to growth, the US economy is slowing. Tracking estimates of GDP growth remain at high levels (the Atlanta Fed’s 3Q GDPNow measure is at 5.6%), but the most compelling evidence for a slowing economy is from the labor market. Monthly job growth has been gradually declining for more than two years, while the fall in job openings appears to have picked up pace. Alongside a cooling labor market, excess household cash is dwindling and student loan repayments are resuming. At present, the cooling of the economy is not progressing at a pace that suggests an imminent recession, but there is uncertainty over the further support stocks can expect from resilient consumption.

Evidence in the coming months pointing to a soft landing should eventually be positive for risk assets, in our view, but the final approach to the landing won’t be without turbulence for data-dependent markets. That’s why we expect a soft-ish, rather than soft, landing. It’s also why bonds are our most preferred asset class—buying high-quality bonds at current yields is attractive—and why equity laggards offer a better risk-reward than the overall equity market, in our view.

This article draws on two recent blogs “Seat backs and tray tables” by Jason Draho published on 5 September, and “S&P 500 profits—back to all-time highs” by David Lefkowitz also published on 5 September.