The ‘rubber is hitting the road’ in early 2024 after the ‘everything rally’ in the 4th quarter of 2023 that was fueled by excessive optimism over an anticipated pivot in Fed policy and interest rate cuts in 2024.  Stocks rallied and a jump in bullish sentiment into year-end pushed stock valuation and sentiment to record highs.  Now we are starting to deal with the reality of a more mixed economic outlook, higher loan losses, deteriorating credit conditions and a tougher lending environment as outlined by bank CEOs in recent earnings reports.  We are also seeing broader economic warnings in some areas of tech (witness slowdown in data centre from Intel and slower industrial numbers from Texas Instruments) as well as more pricing pressure on electric vehicles due to lower demand and strong supply from China (Tesla seems to be on the verge of getting kicked out of the so-called Magnificent 7 after falling over 25% in January).  We have also seen some pushback from Central bankers against market bets for interest rate cuts.  Their message seems to be that ‘March is too soon’ and ‘six are too many’ in terms of rate cut expectations.  In the absence of new stimulus from lower interest rates, stocks reverted to the pattern of last year, which was to increase the multiples on the large tech stocks, particularly those focused on artificial intelligence.  Leading the way in January were the winners of last year with Nvidia and AMD leading semiconductor stocks higher and Microsoft moving to a new all-time high, even surpassing the market capitalization of Apple.  Amazon, Alphabet and Meta also rallied, which pushed the Nasdaq index to a monthly gain of over 4%.  The broader, economically-oriented Russell 2000 index, which had a stellar 4th quarter in 2023, sunk back into a lagging role again with a negative return in January.  Canadian stocks also repeated the pattern of 2023, trading in line with ‘value-oriented’ indices due to weak returns from the heavyweight financial and energy sectors, while technology stocks lead the winners list.

Also, like 2023, the economic news continues to surprise on the upside as consumer spending remains strong despite sharply higher interest rates.  Much of that is due to strength in the U.S., which has been supported by the residual pandemic support payments and the massive spending under the fiscal spending programs such as the Chips Act and the Inflation Reduction Act.  On the subject of inflation, it continued to fall last year but the core rate has become ‘sticky’ in the 3.5% range while consumer spending has been resilient.  Both of those points argue against market expectations of aggressive rate cuts anytime soon.  Commodities and luxury good are also stumbling a bit driven in large part by weakness in China, which is still contending with major challenges from deflation pressures and the property crisis and investors underwhelmed so far by policies to keep economic momentum going in that economy.  The U.S. consensus is for a soft landing, but we are less convinced.  The U.S. has been buying ‘growth’ with massive deficits.  Not only does this strategy require ever bigger debts to sustain, but the short-term funding provided by the last hangover from Covid money-printing, will be all but exhausted by end-Q1 2024.  Bottom line for stocks is that they have gotten ahead of fundamentals and might either ‘mark time’ before continuing the Q4/23 advance or else see a correction in the first half of 2024.

We remain slightly underweight stocks but did take profits in our bond portfolios after a very strong rally in 4th quarter.  While we expect growth to deteriorate in 2024, we are more inclined to wait for the 10-year yield in the U.S. trade back up above 4.2% before re-initiating overweight U.S. bond positions.  On stocks, we reduced positions in the 4th quarter in the economically sensitive sectors such as Industrials, Financials, Basic Materials, Consumer Discretionary and Technology.  We remain overweight defensive/interest sensitive sectors such as utilities, pipelines and telecom.  In the technology sector, we have moved ‘down market’ a bit where valuations are more attractive.  While we continue to hold Nvidia and Alphabet, we added to mid-sized names Nuvei, Lightspeed, Open Text and Telus International.  Top telecom names include Telus and Rogers, with Capital Power and Northland Power in utilities and the three big pipelines (Enbridge/TC Energy and Pembina) accounting for the bulk of our energy sector weighting.  In the U.S. we also added to Health Care (XBI for biotech, CVS Health and Pfizer) due to attractive valuation and long-term growth.

The path of interest rates was down for most of the past 40 years and decidedly down over the past decade until central banks began reversing that trend two years ago to tame the rampant inflation that developed after the pandemic shutdown. Going forward we believe that the forces of disinflation and slow global growth will re-assert themselves, meaning that the path of rates should be downward again.  That suggests that bonds will once again be a good investment after three very difficult years. 

The tendency to optimism.  When I used to do an annual lecture at York University to the MBA class, one of my favourite charts to show to demonstrate the predisposition of analysts to be too optimistic is shown here.  The individual lines are the composite consensus earnings estimates for the years as marked.  The trend of each line is how those estimates evolved throughout that year.  It doesn’t take a degree in mathematics to see that the directional trend of almost all the lines is down, meaning that consensus estimates continued to be revised downward throughout the year in all of those times.  The simple reality is that analysts come into every year with too much optimism.  The year 2022 was one of the few where estimates rose from their initial value.  However, the first round of estimates was done when we were still in the midst of the pandemic and therefore biased downward.  Fiscal spending initiatives announced after that gave more lift to economic growth and therefore earnings.  Interesting also to see that the 2024 earnings line has been on a steady downward path since their initial release.  In our view they are still too optimistic, with expectations of earnings growth of over 10% this year.

The bigger question for the stock market in 2024 will be the magnitude and direction of corporate profits.  In that regard we have a conundrum that will need to be resolved through actual reporting results.  The chart below shows the operating earnings of the S&P500 companies.  While profits have had an exceptionally strong recovery over the two years following the collapse in the early days of the pandemic in 2020.  But over the last year they have stalled despite ongoing economic strength.  The consensus ‘top-down’ earrnings projection for this year by economists and strategists is for relatively flat S&P500 earnings of $215 versus $220 last year.  However, the ‘bottom-up’ (i.e. the sum of the individual stock estimates) estimates is for a rise to $244, more than 10% ahead of the prior year.  Clearly there is a sharp difference between what is expected by the two measures and will only narrow as first quarter results begin to come out and corporate guidance for the current year are updated.  Our guess is that the bottom up numbers will fail to meet those growth expectations and will fall in line with the top down numbers.  That could prove a headwind for stocks as they tend to be driven by the individual company estimates as opposed to the top down consensus.  Look out below!

Don’t ‘follow the money!’  Energy stocks are out of favour.  Fund managers had less exposure to energy stocks heading into 2024 than at any time since December 2020, according to the latest Bank of America Global Fund Managers Survey. With energy prices slipping, investors went from 4% more exposure to energy stocks than their benchmarks in November to 11% less exposure in December, the largest month-to-month decline since January 2016.  The same survey showed those managers had 23% more exposure to tech than their benchmarks.  Investors should remember that being ‘contrarian’ can often work in their favour.  Those who bought energy stocks in December 2020, the last time they were this out of favour, did very well as the SPDR ETF rose 53% from December 2020 to December 2021, more than double the return of the S&P500 over that same period.  On top of that, energy stocks are undervalued, with many Canadian producers trading at under four times cash flow and free cash flow yields over 15%.