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EXCERPT FROM CLIENT LETTER April 2024  (see full letter above for tables, charts, and full commentary)

FROM THE DESK OF BOB CENTRELLA, CFA                                                                     April 8, 2024

We just returned from a short “spur of the moment” trip to Italy a few weeks ago and I still have food and wine depression. Rome was buzzing before Easter and if this was any indication, travel this summer will be strong, especially to Italia. On a fun note, we went to a new area just below Rome called the Castelli Romani and tasted some interesting wines. You must read on to get to my Italian wine tips and a food idea!

The market had a great start to 2024 and the first quarter is in the books. The strong Q1 bodes well for the rest of 2024 based on history.  More on that later. Presently we see inflation moderating, employment holding steady and the economy continuing to grow as the possibility of a never-achieved “soft-landing” remains in the cards. We entered 2024 after a strong year for stocks led by the coming Artificial Intelligence (AI) revolution and MegaCap growth stocks or the “trillionaire’s club” of Apple, Amazon, Alphabet, Meta, Microsoft and Nvidia. These stocks plus Tesla constituted the “Magnificent 7” (stupid name imo) which provided the bulk of last year’s 26% gain in the S&P 500.  In Q1-24, large growth again paced stocks in the first quarter although we did finally get some participation from the rest of the market . The S&P 500 price gain was 10.2%, eclipsing many strategists targets for the full year.  This was only the 4th time this millennium it gained more than 8% in the first quarter. This was despite bond yields rising, with the 10-Yr UST yield climbing from 3.89% at the end of 2023 to 4.21% leading to a loss of -1.0% for the Barclays Bond Agg Index.  

KEY TAKEAWAYS AND LOOKING AHEAD

We entered  2024 with the consensus expecting a soft-landing to be engineered by the Fed for the economy, with up to 6 rate cuts during the year. Personally, I was looking for 3 rate cuts, but even that is now suspect. Here are some takeaways from the quarter and what to expect ahead.

 

1.  Remember that 2024 is an election year. The average annual return in an election year since the 1920’s is 11.2%.  So, theoretically we don’t have much to go. But… history suggest more gains to come. Since 1950, the market has gained over 8% in the first quarter 16 times. Of those 16 times, only once, 1987’s crash, did the index lose ground the rest of the year. In fact, for the other 15 times, the index gained an average of 9.7% more during the subsequent 3 quarters.  So, going back 75 years, that’s a 94% chance of more gains to come.
2.  Inflation remains stubborn and has averaged around 3% the last 2 months. The Fed target remains 2% but with oil prices rising now above $90 and other commodities rallying, further drops in inflation will be hard to come by.
3.  The Fed is on hold and not ready to decrease rates. Fed Chair Powell recently said that the Fed would lower rates at some point, but would continue to be data dependent. The latest Fed estimates had forecasted 3 rate decreases but recent reports such as strong employment and inflation above 3% may put those on hold. Plus given the election year, the Fed’s window to decrease rates probably closes around September.  
4.  Corporate profit reports are coming over the rest of April. The next few weeks will be influential on stocks as companies report Q1 earnings and give guidance.  Estimates call for 3% earnings gain overall in Q1. As the year progresses, quarterly comps should get easier. Earnings gains are projected to be 9.4%. 8.5% and 17.5% for the following 3 quarters for a total increase of 10.9% for 2024. The Mag-7 stocks provided almost all the earnings growth in 2023 for the S&P 500. Can the rest of the market provide earnings growth?
5.  Stocks are still valued above average. The S&P 500 currently trades at a forward PE ratio of 20.5x EPS compared to the 5-yr average of 19.1x and the 10-yr average of 17.7x.  Earnings growth will be key now that PE multiples are above average. Higher earnings growth can move the market higher, but if lower than expected…
6.  Bond yields remain above 5% out to a year and above 4% beyond out to 30 years. The yield curve has been inverted now a record 639 days and counting. On average it is usually ½ of that. What gives? The inversion reflects concerns about the long-term economic outlook with a recession predicted within 1-2 years. If the Fed only cuts rates 2-3 times this year, the inversion will persist. Is this the new normal? Short rates need to drop 1% all else being stable for the inversion to start normalizing.
7.  Geopolitical risks seem to be increasing in the Israel/Hamas war and the Ukraine/Russia war wages on. There is concern that the conflict can spread further in the Mideast. What’s the next geopolitical event to occur?   
8.  It’s “Sell in May and Go Away” season.  It’s coming up on a seasonally slow period for stocks. Is a market correction in the cards? Stocks have been on a tear since November having risen 29% at as of March 31st since they bottomed from the 11% correction that started in August ‘23. At some point we are likely to get tested this year. With the election looming, the market skittish about inflation and interest rates, valuations above average, and geopolitical risks rising I would not be surprised to see a period of weakness occur. So what should you do with stocks, is it sell and hibernate time? Here’s a look at the S&P for the last year.

If we do get a correction, I would expect any weakness to be a normal -5% to -7% pause over a few months which would be short-lived and eventually met with buying. This would more likely be if the Fed signals they won’t be cutting rates by June, or things worsen in the Mid-East. And if the Fed does lower rates, don’t fight the Fed! Buy stocks.  So, we advise holding on, raising a little extra cash and looking for good opportunities. 

SUMMARY AND CONCLUSION

Coming into 2024 my base case forecast was for a nice up year for stocks and a collect-the-coupon year for bonds. Here are my scenarios I presented 3 months ago with current updates:

*  My highest probability and base case remains that the Fed pulls off a soft landing and we do not have a recession. I do see market volatility with up and down months remaining and a possible correction of 5% or more.  I don’t see the Fed lowering rates until after June as it continues to be data dependent. Investors have adjusted their expectations (to where I was) to 3 rate cuts at most given stubborn above average inflation and a solid labor market. I was forecasting stock returns of 10%-13% coinciding with S&P earnings growth. The S&P 500 target at that level would be 5300 – 5450.  As an update, I am moving my target to 12% to 16% return and 5400 – 5600. I believe earnings growth could be a little better assuming economic growth is around 2.5%. For Bonds, I was forecasting returns in the 4%-5% range for the Bond aggregate.  I now see that return for bonds in the 1–2-year maturity range. I think the bond aggregate may return only 1% to 3%. I assign an 85% probability to this base scenario with returns in the 10% to 16% range for the year.
*  My bear case scenario is that the Fed can’t cut rates because inflation lingers and drives us to a mild recession where the Fed must then eventually lower rates. Corporate profits could decline 5% or more and stocks drop 10%+ until rebounding late in the year after the election but still remain in the red. I assign a 15% probability of this case or a more bearish scenario than my base case.
*  My best-case scenario of 5-6 rate cuts is highly unlikely at this point, so I am removing it.  I had only given it a 15-20% probability.  

In sum, I think equities outperform bonds, but ST bonds should be held for income and protection in balanced accounts and should produce positive returns. I continue to favor a diversified large cap equity portfolio with some exposure to mid, small, and international stocks as well. Stock-picking will be key. 

Bob
  
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Bob Centrella, CFA
Managing Partner
Forza Investment Advisory, LLC

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