The First 50% Is Always the Hardest


How many investors reading their asset statement in mid-October of 2022 would have believed that 50% percent appreciation in the S&P 500 was possible over the next two years? Our statement reader had just absorbed a 25% meltdown in the S&P 500 over the previous ten months and was being bombarded by negativity on many fronts. One “talking head” after another tried to outdo the other with a bearish economic forecast or a dire outlook for Federal Reserve interest rate policy. But since October 13, 2022, the S&P 500 has risen from 3,492 to 5,261—up 50.7% on an intraday basis. It has been a nice, nearly two-year upcycle but additional upside potential awaits. This article discusses the reasons for such optimism.

Investment strategists, economists, and former Fed governors all took turns at the piñata preaching the merits of 5% cash as the best tactic for investors to avoid an almost-certain recession and the Fed’s rate-hiking cycle. They were so confident and indignant when asked what, if anything, could go right. Many remain so nearly two years later, although “green shoots” in some of the economic data reports and the prospect of the Fed cutting rates in the next few months have a few becoming more timid in their forecast. The most fascinating aspect of the stock market is that it is a fear and greed laboratory experiment. It is as much about how people are acting, not how they are talking. In the weeks leading up to the October 2022 low, there was intense selling with 1,200-1,500 weekly new lows recorded on the New York Stock Exchange (NYSE). This was a sign of capitulation and an oversold condition was created, happily assisted by savvy investors nailing down tax losses for 2022.

S&P 500 – Expensive & Narrow

The S&P 500, a capitalization-weighted index, is expensive on conventional metrics (P/E, yield). It trades at 21x forward earnings per share (EPS), which is about 1.5 standard deviations above its long-term average of 16x. The S&P 500 yields 1.4%, one-third of a ten-year US Treasury bond’s yield-to-maturity of 4.25 percent. The gain in the S&P 500 has been concentrated in three sectors and in a dozen stocks or less. Price-to-earnings (P/E) multiples are elevated and have accounted for two-thirds of the 50% increase, with only one-third coming from higher earnings expectations. The term “Magnificent Seven” was coined to describe the leadership being concentrated in seven names out of the 503 index constituents.

Not only have large market capitalizations dominated, but so too have Russell 1000 Growth stocks dominated over Russell 1000 Value stocks. The rolling twelve-month percentage spread between the S&P 500 and the unweighted S&P 500 is extremely wide in favor of the few dominant large-cap stocks. The same can be said stylistically with large-cap Growth dominating large-cap Value. A scarcity of earnings growth in an uninspiring economy at a time of artificial intelligence (AI) excitement provided a fertile backdrop for such index-dominated performance. On both of these metrics, a reversion to the mean is overdue and the favorable backdrop of overall inflation trending to 2% and the potential for AI to boost margins is on the horizon for the next few years.

To further highlight this leadership concentration issue, Table 1 displays the recent-year trend toward concentration since 2021 and how it has worsened.

Table 1

Note: There are 503 stocks in the S&P 500. Source: FactSet data, Woodstock

[1]Universal Health, Pulte Group, Martin Marietta, Eli Lilly, Axon Enterprises, NVR, Eaton, Fair Isaac, Lennar, United Rental, GE, Carnival, Deckers Outdoor, WW Grainger, Trane, Nvidia, KLA, Jabil, Advanced Micro, Paccar, Netflix, Micron Tech, Cadence Design, Parker Hannifin, Lam Research, Quanta Services, Synopsys, Royal Caribbean, DR Horton, Western Digital, Ralph Lauren, Arch Capital, Oracle, Intuitive Surgical, Caterpillar, Copart, Booking Holdings, Applied Materials, Chipotle, Monolithic Power, TransDigm Group, Arista Networks, Ingersoll Rand, SalesForce, Broadcom, Bulder First Source, Super Micro Computer, Constellation Energy, Pentair, Veralto, Meta Platforms, ServiceNow, Howmet Aerospace, Uber, GE Healthcare, and Kenvue.

Thus far only 56 stocks have outperformed over the bull market since October 13, 2022. On one hand, that it is a discouragingly low figure. On the other hand, it is very encouraging, as it indicates there must be a lot of upside potential in a host of other companies should inflation trend lower and the AI phenomenon generate a broadening out of its financial beneficiaries and investors take notice. This augurs for a return to a stock picker’s market, which would be a big disrupter to the investment fund flows of the last decade into exchange-traded funds (ETFs). Stark investment performance differences between the average stock and the S&P 500 index would probably need to occur for one to two years before a definitive reversal could be announced.

The extent to which the current bull run has been momentum-based can be grasped by comparing the 55% constituent outperformer average (2009-2021) with the 19% outperformer average (2022-2024). Benign inflation readings and a Fed on the sidelines should result in a broadening out of the market and a return to outperformer rates consistent with historical experience which has implications for stock leadership.

Dissecting Performance

Table 2 decomposes the last 18 months’ appreciation of several popular benchmark indices, along with the 11 S&P 500 economic sectors that comprise the index into its EPS and forward price-to-earnings (F P/E) change components.

While three sectors had the best growth in earnings expectations from the October low (Communication Services, Consumer Discretionary, and Information Technology), 25%, 23% and 21%, respectively, Communication Services, Information Technology, and Industrials had the best stock price performance, 81%,73% and 45%, respectively. As has been well chronicled, investment performance has been quite concentrated in a few sectors since the October 2022 low. Of the 56 outperformers referred to earlier, 46 (82%) fell into just three sectors: Consumer Discretionary, Information Technology, and Industrials.

Table 2 – October 2022 market low until now*

*Now is 3/27/24
NYFANG constituents (10) are either unprofitable o r barely profitable.
Source: FactSet data, Woodstock calculations

Our Take on Inflation

Our overall investment optimism is built on our interpretation of the Consumer Price Index (CPI) reporting methodology over the short and intermediate term. This will reinforce that we are in a lower, return-to-pre-Covid inflation cycle which has room to run and is a positive. It also supports our longer-term belief that the corporate world’s adoption and implementation of AI will be a structural force for combating inflation. It could well be a deflationary force longer term, but for the next few years it isn’t necessary to be that prescient. For the intermediate-term horizon (three to five years), there will be the assist from CPI’s methodology in reducing inflation over  the next year. In the longer run, AI will be a positive influence in controlling inflation.

The following three CPI charts should make it clear why CPI will continue to trend lower towards the Federal Reserve’s long-standing 2% target.

The first chart (see Figure 1) is the widely reported CPI on a year-over-year (YOY) basis. It peaked at 9.1% in June 2022 and has declined 65% to its latest 3.2% reading in February. (The lowest YoY reading was actually 3.0% in June 2023.) Nevertheless, much progress has been made, with inflation falling nearly 80% of the peak-to-destination range of 9% to 2 percent.

Figure 1

The second chart (see Figure 2) is the CPI ex the shelter cost component. It peaked at 10.8% in June 2022 and has declined 83% to its latest 1.8% reading in February. (The lowest YoY reading was actually 0.7% in June 2023.) Here too, much progress has been made, with shelter inflation peaking at 9.0% and falling 67% to 3%, or nearly 80% of the expected peak-to-trough range of 9% to 2 percent. CPI ex shelter inflation has fallenfurther and has been at or below 2% for the last nine months. And it appears to be back within the range it occupied pre-Covid. If 64% of CPI remains at recent-month levels and 36% of CPI will decline for months to come, then reported CPI has to come down.

Figure 2

The third chart (see Figure 3) is the CPI shelter cost component. This represents 36% of CPI whereas the chart in Figure 2 comprises 64% of CPI. This CPI of the shelter component peaked at 8.2% in March 2023 and has declined 30% to its latest 5.7% reading in February 2024. (This is the lowest reading this down cycle but it is expected to trend lower for another six-to-twelve months.) Much progress has been made thus far—about 0.2% per month over the last 11 months—and this pace can continue for several more monthly reporting periods. It seems clear from the Figure 3 chart that its down cycle has further to go on the downside than the previous two charts. Whereas the previous two chart declines are back to the pre-Covid time period, CPI shelter still has a way to go in terms of time (months) and percentage decline, in this author’s opinion. A decline to the 2%-3.5% pre-Covid level would appear to be normal for this data series. This has the potential to reduce reported CPI inflation by 1.0% to 1.3 percent. Alert observers know of this potential, which is why many believe the Fed is confident that it has already achieved its objective and should begin easing before 2%+ “real” interest rates do further harm to the economy.

Figure 3

Assuming the margin benefit of AI deployment is not offset by higher effective corporate tax rates (the Trump-era tax rates expire in 2025), nominal (real gross domestic product [RGDP] growth rate plus Inflation) type top-line or revenue growth, one can see the potential for $275 and $300 of S&P 500 EPS over the next three years as per the model shown in Table 3.

Table 3 – S&P 500 Revenues & EPS Per Share

Source: Dow Jones data, https://www.spglobal.com/spdji/en/search/?query=earnings >>then search index earning
s>> open the downloaded excel file>>enable editing>>quarterly data tab then apply analysis

Capitalizing forward EPS prospects at 20x-22x, while elevated relative to history, is defensible in a benign Federal Reserve policy, interest rate environment and puts a 6,000 S&P 500 price objective clearly in view over the next few years. While not as rewarding as the 50% move from October 2022 to now, it should be more than competitive with ten-year Treasury bonds or cash, which should be facing lower reinvestment returns from their current prized 5% level as lower reported inflation and Fed rate cutting dominate news headlines over the next year.

CBO Omits Mention of AI

The Congressional Budget Office (CBO) just recently released its thirty-year budget forecast for 2024-2054. The letters “ai” appeared 235 times. Not one of them was associated with artificial intelligence (AI), the dominant investment theme of the past year and the source of P/E multiple expansion and high earnings expectations for those companies that have been designated as the big winners in the stock market. Perhaps that is only appropriate that the CBO, a long-term think-tank kind of organization, did not get all wrapped up in the latest Wall Street craze. Yet in a very real sense, it is remarkable that AI did not warrant any mention, as it will likely have a huge effect on the US economy, productivity, employment and corporate profits over the next several decades. As with any “big new thing” that comes onto the investment scene, AI gets priced into company valuations quickly, for good or for ill. Valuing stocks is about calibrating the impact of change and the rate of change (i.e., the second derivative) and that often leads to significant and sudden change in investor perceptions. The perception of reality is what matters, not reality itself.

For the US and global economy, AI may come to also stand for “arresting inflation” as it promises to be an important driver of productivity, operational efficiency, and speed of production, delivery and fulfillment of goods and services. It also has the very real potential of being a job killer, as AI could cannibalize many existing jobs. There are frequent press reports about how automation will impact up to 50% of today’s jobs. While other tasks and jobs could spin out of the changes in the workplace over the next few decades, one has to hope that major strides in efficiency, combined with proposals for a shorter workweek will not result in dramatically higher unemployment rates. If that were the case, then resulting higher corporate profits and higher corporate tax revenue might just go to fund the inevitable increase in transfer payments to those negatively affected by automation and AI.

Up until now, stock market focus has been on the perceived winners in an AI-dominated world (think Magnificent Seven). NVIDIA’s accelerating revenues in recent quarters are capital expenditures by its clients believing that their expenditures will either generate incremental revenues, reduce costs or improve margins. Investors have been scouring the landscape for AI winners and/or companies with any hint of AI exposure because of the obvious valuation allure that can rub off on a stock. Over time, a more nuanced view of AI is likely to take place. Right now the economic rents of AI are accruing to the chip developers and manufacturers. Given the passage of time and the ascending valuation metrics of AI’s beneficiaries, it is inevitable that interest will spread to those companies that will benefit from using AI. More and more peripheral companies are sneaking in investor conference call references to AI because they know of the halo effect possible on their share price.

Because it is early days, the outline of who these beneficiaries might be is hard to specify, but any company or sector that is employment- or repetitive process-intensive would be a ripe target for the efficiency and process speed that AI could bring to the business. In time, many nonglamorous businesses could turn out to be big beneficiaries of AI. Banking and insurance come to mind easily. Headcount-intensive and business processes like loan underwriting, mortgage origination, and insurance underwriting of automobiles, homes, and commercial buildings would seem candidates for margin improvement in the future.

Low-margin businesses of today could experience fairly dramatic margin improvement. MRI imaging and CT scans are already benefitting from technology and faster speed. MRIs that used to take 30 to 45 minutes can now be done in 15 to 20 minutes with their results captured in almost breathtaking clarity and color and sent to the doctor’s inbox faster than ever, leading to quicker decisions about surgery or follow-up physical therapy. The big retailers employ many people and have numerous business processes that can undoubtedly be improved and made more profitable. Oil and gas exploration companies, although low users of manpower, can see times reduced for drilling and developing oil and gas wells, which directly reduces costs and reduces time to bringing those wells on production. Healthcare and biotech companies can similarly be positively impacted by faster R&D timelines, and FDA application and approval time frames.

The potential exists for and within almost every economic sector and company to benefit from AI. That is why it was a little surprising that at least some mention of AI and how it would impact the next three decades did not appear in the recent CBO outlook. Then again, the future is so open-ended at this point that it is hard to speak very precisely on what the benefits will be down the road.

Valuation in Key Economic Sectors

The charts in Figures 4 and 5 display current valuation realities of the eleven economic sectors of the S&P 500 on three bases. First are the forward next 12-month P/E multiples and second are the Equity Risk Premiums of the eleven S&P 500 economic sectors. All on three bases—current, average and median over the last 180 months (i.e., 15 years or just about the length of the bull market since March 9, 2009).

The vertical axis of the chart in Figure 4 plots the Forward P/E of the eleven economic sectors, from left to right, along with the S&P 500 (it was alphabetical until Telecommunication Services was changed to Communication Services). Both average (mean) and median F P/E’s are shown, as EPS cyclicality can have impact.

Most average and medians are fairly close together but there are a few obvious gaps: the Energy and Information Technology sectors are standouts in this regard. Depressed earnings in Energy’s case and investor excitement bidding up Technology shares would explain the uniqueness. The second valuation chart in Figure 5 relates the sector equity risk premium (ERP), its earnings yield (reciprocal of F P/E) to the 10-year US Treasury yield. The S&P 500’s current ERP is ~0.50% vs. the average/median just under 2.0 percent. Two sectors (Consumer Discretionary and Information Technology) currently sport negative ERPs, which indicate high growth expectations but they tend to have low ERPs. Energy, Utilities and Real Estate appear to have favorable ERP profiles relative to their histories.

Figure 4

Figure 5

Positive Outlook for Equities

Very few investment statement readers in mid-October 2022 would have believed the S&P 500 would rise 50% over the subsequent two years. Yet with receding inflation (down from 9% to 3% in June 2023, 3.2% currently) and a less hawkish Fed, investors could see more of the same in the next two years. With line of sight to $275/$300 of S&P 500 EPS in 2025/2026, a 6,000 S&P 500 price target is defensible. However, unlike the bull market of the last 18 months that witnessed 43%[2]  price appreciation as result of 7% higher earnings growth expectations and a 33% expansion in the P/E, the next leg in the bull cycle will be dominated by earnings growth. In addition, the extremely narrow leadership of the last 18 months—only 56 (11%) of 503 constituents outperformed the index—will give way to broader participation and a return to a historical kind of experience, when 55% (low-high range of 42%-68%) of S&P 500 constituents outperformed the index from 2009-2021.

AI adoption and CPI methodology-driven lower CPI will sustain positive inflation surprises going forward. This will create many investment opportunities, broaden stock market participation, and even help bonds to rally as the 10-year Treasury yield to maturity (YTM) of 4.20% could decline to 3% or below, triggering 10% appreciation and 14% total return. The longer-duration 20-year+ US Treasury ETF (TLT) YTM is 4.53 percent. A 3% YTM on it would yield a 30%+ price in the ETF for a ~35% total return.

Most investors are aware of the impact of passive investing over the last dozen years or so. The dominance of the capitalization-weighted S&P 500 index has undoubtedly benefitted from decisions made to buy the index and not individual stocks as many professionals have done their entire careers. It is inevitable that as expectations for one cohort of stocks become elevated, companies start to disappoint those expectations at the same time as neglected companies, having invested in AI, begin to show margin improvement with or without material revenue growth and their valuations get bid up by investors. That is the recipe for rotation in stock market leadership and there are signs it is beginning.

As reported inflation trends to 2% or lower inflation, lower cost of capital assumptions will help equity valuations, particularly for the undervalued security universe. The risks of “upside” surprises on the economic front would appear muted. The consumer—two-thirds of the economy—faces challenges on the employment front with no full-time employment growth in the last year and strong automation/AI headwinds for growth in the future. This should eventually temper wage inflation concerns.

Corporate capital spending (ex-government tax incentive-inspired legislation driven) is unlikely to roar ahead anytime soon, given regulatory and permitting hurdles, the appeal of share buyback programs, and the pressure on Congress to generate higher tax revenues from the corporate sector. RGDP growth of 1%-2%, receding reported inflation, and AI adoption are likely to improve corporate margins and seem to be the ingredients for a continued favorable investment backdrop. Corporate earnings growing by double digits for a few years and average stock valuations near 16x-17x is a favorable backdrop for a diversified equity portfolio construction. Benchmark index appreciation potential of 5% (15%/3 years) per year after the 50% run over the last 18 months with favored names in a broadening participation market phase should produce appreciation potential several times that of the S&P 500 index.

Thomas C. Stakem, Jr., CFA – Vice President


[2] On a closing price basis, not intraday, the basis for 50% previously
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