Written by: David Waddell | Waddell and Associates
Bottom Line:
Santa Claus overstuffed investors’ stockings in November as rates fell and investor sentiment levels soared. Negative earnings growth over the past year amplified the market’s reliance on these two inputs. Typically, earnings grow, sharing the burden of influence beyond rates and sentiment. Good News! Earnings growth restarted last quarter and should accelerate from here throughout 2024, cranking up a missing engine of support. This will reduce the stock market’s reliance on interest rates and sentiment for direction, which should improve the ride, and the odds, of continued returns for investors.
The Full Story:
S&P 500 earnings declined (compared with year ago levels) in the 4th quarter of 2022, the first quarter of 2023, and the second quarter of 2023. Without earnings supporting markets, valuation calibrations hold greater influence, relying primarily on interest rates and investor sentiment. Rising interest rates lower valuations while rising sentiment increases them. With earnings growth offline, these two factors alone hold sway. Let’s examine the influence of interest rates first.
On October 1st, 2022, the 10-Year Treasury yielded 3.8%. Today, it yields 4.3% for a 0.5% increase, applying valuation downforce of 12%. Fortunately, while the correlation between interest rates and valuations are high, they are not perfect. Here, we compare the year-over-year percentage change in the 10-Year Treasury yield with the year-over-year percentage change in the S&P 500:
Overall, while the Treasury yield rose 12% against year-ago levels, the S&P rose nearly 30%, challenging our calibration assertion. Upon closer inspection, however, there are clear patterns at work. Between October 1st, 2022, and July 30th, 2023, interest rates went nowhere. This afforded the market uplift as the Magnificent 7 AI frenzy took hold. Then, as we entered August, rates increased 30% against year-ago levels, leading to an 11% decline for the S&P 500. Fortunately, rates reversed on October 20th, igniting a powerful rally in the S&P, bringing it back to July’s highs. Clearly, there is causation between rates and stock market performance, but for more notable correlation, let’s examine investor sentiment:
For this analysis, I zoomed out a little bit more for additional perspective. The purple line represents the percentage of retail investor survey respondents that describe themselves as “bullish”. The orange line represents the level of the S&P 500. Note that the correlations look loose on the left side of the chart as the market rose strongly in 2021 despite a steady decline in sentiment. Earnings growth offset the sentiment decline, with S&P 500 earnings up 49% that year.
Moving forward, as earnings growth dwindled, sentiment variations became more determinant. Study the lines from July, 2022 onward and you will see they nearly overlap! This high correlation pattern prompted our focus on sentiment levels as the most useful market forecasting tool. Our clients will recall our highly-contrarian, bullish outlook entering 2023. Low sentiment levels informed this projection.
Our clients will also recall a flurry of trading activity at the end of October as we harvested tax losses and repositioned portfolios in anticipation of a Santa Claus rally. Low sentiment levels informed this decision. In turn, the S&P 500 now stands 20% higher on the year and the November rally contributed half of that advance. With the 10-year Treasury rate now down to appropriate levels and sentiment back near July highs, has Santa Claus come and gone?
Earnings Returning
S&P 500 earnings grew more than 4% in the 3rd quarter of 2023, well above the -1% analysts expected prior to the reporting season. For the 4th quarter, analysts expect additional earnings growth of 3%. For the first quarter of 2024, they expect 6.5% growth, 10.4% growth in the second quarter and 12% growth for the full year. Analyst projections typically prove too conservative, as chronicled by the earnings surprise summary below:
While many forecasters find it hard to imagine that earnings could grow substantially in 2024—and we are not ready to refute them just yet (much more work to do on our 2024 outlook)—history does support a bullish outlook for earnings based upon the expectations of today. Extrapolating last quarter’s upside earnings surprise level of 5% to the coming year, a 12% expected growth rate becomes a 17% real growth rate. That may seem nutty given the expected downshift in GDP, so cut those expectations in half. A 6% gain in earnings feels more achievable, but once you tack on the historic quarterly net upside surprise…
…You arrive right back above double digits (6% growth expectations, +5% surprise). Will this transpire? Unclear, but the return of earnings alone will reduce the S&P 500’s reliance on sentiment as we enter 2024. As strategists ponder what’s possible for 2024 earnings while they start populating their forecast models, fear of missing out could kick in to help offset a probable sentiment decline. 2023 was all about sentiment. 2024 will be all about earnings. Welcome back, big E!!
Have a fantastic week!
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