Stock market looking to run the table

One mystery that the Bears forever struggle with is how stock markets are fueled by the Wall of Worry. Try as we all might to find problems that the market doesn’t already know about it, and hasn’t already reflected in valuations, time after time the markets rally into those very concerns. Everyone is analyzing the same data points, and collectively, the market’s clearing mechanism finds its way to the highest probable outcome. Then, as the worry news simply gets “less worse,” the market gradually adjusts pricing accordingly. By the time the worry is gone, it’s too late. The market has already discounted the much awaited “all clear” signal.

As we survey the five big worries that we outlined a few weeks ago, our conclusion is that the rally we’ve been experiencing since largely reflects investors’ collective attempt to discount the growing evidence that all five worries are to fade. Or said differently, that we might be about to run the table.

For sure, all five risks are still out there to some extent. But in a remarkable run, all five have clearly gotten “less worse” in the last few weeks, and appear to be on their way to fading completely. In that spirit, last week Federated Hermes’ PRISM^® committee, rather than pulling back on what has been a successful overweight to the “Great Rotation trade,” instead threw another log on the fire, adding to small-cap value stocks. Our stock overweight now stands at 40% of max (or 400 basis points in our moderate risk balanced portfolio model), along with a 500 basis point underweight to bonds and a very modest 100 basis points left in our overweight money markets position. If we do get a near-term pullback on election or earnings volatility in the weeks ahead, we are likely to deploy the rest of this cash, as well. In short, we think the market setup for the balance of 2024 and for 2025 remains positive, particularly among the value/small-cap/emerging markets stocks that have lagged this two-year long bull market.

Let’s review the five big worries and where we stand on each:

1. Earnings. One issue for stocks coming into this present earnings season was how much the soft patch we experienced this summer would negatively impact earnings in the third quarter. Indeed, coming into this quarter, analysts cut their forecasts more than usual, by about 5%. As we guessed in our memo from early this month, results are, so far, coming in ahead of these worries. Last week’s blowout numbers in the banking space, which suggested that the credit cycle may have peaked and that net interest margins were heading higher next year, were welcome news for the large-cap value indices, where we are holding our largest overweight position at 300 basis points. This positive surprise from the financials augers well for the outlook ahead, as it suggests the earnings cycle in more cyclical/value side of the stock market is in fact bottoming as we’ve expected. GM’s and 3M’s reports today are more fuel for this fire. A key reason for our call on the Rotation Trade has been that the earnings growth gap between the Magnificent Seven and “everything else” had already peaked out in the first half of this year and that the growth disadvantage of the cyclical/value stocks would begin to fade. So far, that appears to be happening. For instance, in the first quarter of this year, the large-cap growth indices’ earnings growth outpaced their large-cap value peers by a whopping 26%; that gap is expected to decline to 18% this quarter and to only 6% next year. Given the start we’ve had so far, our guess is the gap could close even more by the time all the reports are in. Given the fantastic valuation premium that large cap growth stocks carry (28x versus 17x), our bet is this valuation gap will close somewhat. Not all the way, for sure; the large-cap growth companies are fantastic cash flow generators and carry a valuation premium for a reason. But for the last two years until now, these stocks were the only game in town for investors seeking earnings growth. From this point forward, that looks like it will no longer be the case. Given the substantial outperformance of growth stocks since this bull market began in October 2022 (anywhere from 42% to 52%, depending on what area of “everything else” you look at), we anticipate the catch-up trade that started in early July and has advanced in fits and starts since will continue as the earnings growth gap closes.

2. Interest rates/economy. Another big worry for the markets has been the economic outlook, which has lurched back and forth from “too hot” to “too cold” to “too hot” again. Our own view on this has been that following the historically dramatic pace of the Federal Reserve’s rate-hiking cycle in 2022 and 2023, the economy has been experiencing a “Rocky Landing” that has seen most sectors of the economy move briefly into recession in a rotating, sequential fashion that kept the overall economic numbers ok. That continues to be the case, with now the low-end consumer/retail and consumer staples spaces the latest to face difficult times. The result has been that at a macro level, the aggregate numbers have given mixed reads. Here again, though, the incremental data points are suggesting that the economy may finally be returning to a more normal course by next year. Labor market readings suggest some softness but perhaps only enough to keep wage demands in check, not spark a full-blown recession. Inflation readings, though still above the Fed’s official target, suggest we are finally below 3% and may soon settle at 2.5%, which we think is the Fed’s unofficial target. In fact, the most recent average reading of the six indicators the Fed most closely watches (Headline and Core CPI, PCE, and PPI) is exactly 2.5%. GDP growth seems to be settling in at roughly the same pace. So it looks increasingly likely that Chair Powell and the Fed have finally landed the plane “softly” after the wild swings that began with the 2020 pandemic lockdowns.

3. The Fed. With the above economic picture growing more clear, it is also becoming obvious that the Fed has plenty of rate cuts ahead. As Powell has stated, these future cuts are less about stimulating the economy than removing excessive monetary restrictiveness. With Fed Funds currently running 250 basis points above inflation, the markets are right to assume we have 200 basis points of interest rate cuts ahead of us on the short end of the curve; the current debate around Fed policy is notably more about the speed of rate cuts than the destination. Our own expectation is gradual pace but one that will nonetheless get us to about 3.0% on fed funds by early 2026. At the same time, long rates seem stuck in the 3.5% to 4.5% range, which with a 2.5% inflation rate, would imply a return, following 15 years of quantitative easing programs brought on by the 2008 Global Financial Crisis, to more normal levels for the 10 year. The resulting shift from an inverted curve to a more normal, upwardly sloped curve, is a Big Thing, which we first pointed out in our August memo, Five Big Things. This favors the asset heavy small-cap, value and emerging markets stocks, which typically finance themselves at the short end of the curve. Large-cap growth stocks, on the other hand, don’t need debt financing; they are cash flow machines! So, they are impacted by rates mostly on the long end of the curve, which factors into their stock valuations and price-earnings. With the long end stuck at more elevated levels, and valuations on large growth historically high, this is one reason we remain underweight this side of the market.

4. China. Another big worry that may be fading is China. Like it or hate it, China is the world’s second largest economy, and its economic health and momentum matters a lot to most US and especially European companies, who benefit substantially from economic growth around the world. Over the last four weeks, investors have been treated to a series of monetary and fiscal pronouncements out of China that suggest policymakers there are finally focusing on addressing the liquidity, banking, and real estate crises that have plagued its economy. Though more specific policy measures are needed, and likely, it seems that China’s markets, and with it, emerging markets more broadly, have finally bottomed after a three-year bear market that has left emerging markets stocks trading at less than 13x earnings, half the valuation of large-cap growth. With interest rates also likely headed lower, which tends to favor emerging markets, we are overweight this space.

5. The election. The fifth big worry out there for investors is the election. Although markets tend to rise over time regardless of who is in the presidency, government policy does impact which sectors of the market do best. As noted in previous memos, a Trump win would likely favor the old economy financial, industrial, energy and small cap stocks we like; those companies would benefit most from the promise of improved economic growth, lower regulatory cost burdens and lower taxes. Although the outcome of the election remains difficult to call, the markets at least are sniffing out a Republican sweep, and perhaps an electoral/Senate landslide. Should this occur, and we think it very well might, we’d expect the modest rally we’ve experienced since July to pick up steam—particularly the rally in the value and small-cap stocks where we are overweight.

As we exit the always tricky month of October, the market outlook to us remains favorable. It appears to us that stock market investors may be about to run the table on the five big worries they’ve been focused on, and the election’s outcome could spark a final year-end rally taking us to yet new highs. New worries will crop up, for sure. In fact, a few new ones would be welcome to rebuild the Wall for 2025. Sooner or later, we’ll get some. Meanwhile, we remain long.