Summary
- I’m predicting a potential euphoric top in the stock market within the next five or six quarters.
- The banking sector may experience angst due to commercial real estate
concerns, but this will lead to a flood of liquidity into risk assets. - AI-driven earnings are likely to surprise to the upside, with sectors like healthcare and industrial seeing significant margin expansion.
- There is over a trillion dollars in money markets not normally there that can find its way into stocks and real estate.
- The S&P 500 should set multiple new all-time highs in the next 18 months, but the biggest winners might be in small and mid caps.
Deagreez
When I predicted corrections for 2018, 2020 and 2022, I was called “permabear” by commenters and a few analysts. I wonder what they will call me now that I see the potential for a euphoric top to the stock market in the next five or six quarters? My guess is that quite a few folks question that we are not in euphoria now.
The only interruption to the happy dance will be angst in the banking sector tied to commercial real estate and misplaced fear about a recession that wasn’t. The angst though will lead to a flood of liquidity into risk assets.
How euphoric do I think 2024 could get? To put a number on it, I see the S&P 500 (SPX) reaching 5720 in 2024. That will be a target on its way to 6000 in H1 2025.
“But Stocks Fall After A Big Up Year!”
That is not actually true.
Since 1950, in 51% of years following a 15% up year, stocks rallied at least another 10% according to Bloomberg.
| The S&P 500 has returned 15% or greater 28 times since 1950. Here’s what happened next. | Frequency In Years | % |
| S&P 500 has positive return | 20x | 71% |
| S&P 500 has negative return | 8x | 29% |
| S&P 500 returns over 10% | 14x | 50% |
| S&P 500 returns over 15% | 9x | 32% |
It’s interesting that of the 14 years that returned over 10%, nine of them actually returned over 15%. And, of the positive years, nearly half were over 15%. That means the odds of another big up year are not that bad.
Sentiment Is Bad – Or Is It?
There are conflicting signals on sentiment. On the one hand, investor sentiment surveys are saying we are very bullish on stocks. And, that is despite investors pulling about $200 billion out of stock funds this year. Weird, right?
Fear & Greed Index (CNN)
Common wisdom is that extreme optimism and greed by investors is a contrarian signal. In general, I agree that it is. But, extreme can get pretty extreme and technical signals say there is a bit more to go to the upside short term into the January effect.
I do think there will be a standard 5-10% correction in stocks sometime in the first half of 2024. I also think that is a pause that refreshes.
I like to look at consumer sentiment and it looks to have bottomed a year ago. There is a pretty defined rebound in consumer sentiment happening.
Michigan Consumer Sentiment (U of Michigan)
We might see some spending sluggishness over the winter. That is not unusual. But, with folks not afraid of Covid anymore, the nation at essentially full employment, many folks having gotten raises and inflation falling, I think consumer spending will do well come summer and beyond.
Revenue/Share (Yardeni)
Given I don’t see a recession coming without a global shock, revenues should continue to drift up. What makes the chart above more compelling is that share buybacks are set to accelerate again in 2024 after pulling back in 2023.
AI Driven Earnings Will Surprise To The Upside
We just went through a nearly two year period of essentially no earnings growth. Earnings are already looking to improve. I think by more than analyst projections.
Earnings Outlook ( Yardeni)
I expect AI to drive widening margins as more companies adopt AI solutions. Read that as increasing revenue without adding as much labor as the past few years.
Sectors like healthcare and industrial stand to see huge margin expansion. At the subindustry level we will see anything that used machines to manufacture or computers to complete tasks gaining efficiencies with the deployment of AI. In addition, it spurs a whole wave of capex.
Ai Hype Cycle (Gartner)
The discussion of whether AI take our jobs is for another day, but in the short run, I don’t see unemployment problems with around a quarter million Baby Boomers retiring per month through 2030.
For 2024 I see S&P 500 earnings in the $260-70 range.
Liquidity Impacts Investment Sentiment
According to Federal Reserve Chair Jerome Powell and other Fed members (JPow & The Fed Presidents maybe a band name), the economy moves with long and variable lags to monetary stimulus.
But, we also know that stocks respond much quicker to sudden wads of cash thrown into the financial system. Investors see the liquidity coming and start to buy risk assets from stocks to real estate to Bitcoin (BTC-USD).
As liquidity flows into the financial system we see waves (sure, Elliott if you prefer) of successive buying until the liquidity is used up preceding an actual contraction. The reverse is also true.
We saw how fast bailouts pumped up stocks after the Financial Crisis and took off in spurts after further quantitative easing. There are plenty of charts that show the high correlation of the Federal Reserve balance sheet and the returns on stocks. Here’s one from Bank of America (BAC) I really like as it also poses a question for us to answer.
Central Banks & Stocks (Bank Of America)
This chart includes the Federal Reserve, the Bank of Japan and European Central Bank. Remember that they’ve all talked about being “coordinated” since the Financial Crisis.
The S&P 500 chart looks similar, but a bit less pronounced in the past year. Why? The Magnificent 7 and the AI rally.
That begs a question: what is that outlier Nasdaq 100 (NDX) rally while liquidity has been sinking lately?
There’s two answers. The first is the AI rally.
The second answer is: it’s the liquidity stupid.
Apollo provides this chart:
SPY Performance & Net QE (Apollo Global Asset Mgt)
The most recent rally is clearly AI driven, but it also supposes that more liquidity is coming to markets. If the markets are wrong about either thing, then stocks will likely fall in 2024, for at least a while, until of course, more liquidity happens and AI waddles up the slope of enlightenment (adoption).
Banks Need More Liquidity
The Federal Reserve is designed to support the monetary interests of the nation. However, the 12 regional Federal Reserve banks are owned by the member banks at a passive level and receive dividends from the regional Fed banks. That creates at least the appearance of potential conflict of interest (I’m not trying to feed conspiracy theories here, rather, I am acknowledging the complex structure of the banking system).
The Federal Reserve has always shown “flexible” ideas about how to do their job, which is guided by their dual mandate. The dual mandate is even flexible in that it does not acknowledge that there are really three mandates.
Per the Richmond Fed: “Since 1977, the Federal Reserve has operated under a mandate from Congress to “promote effectively the goals of maximum employment, stable prices, and moderate long term interest rates” — what is now commonly referred to as the Fed’s “dual mandate.” The idea that the Fed should pursue multiple goals can be traced back to at least the 1940s, however, with shifting emphasis on which objective should be paramount. That such a mandate may, at times, create tensions for monetary policy has long been recognised as well.”
With its flexibility, the Fed uses its tools, rate and balance sheet manipulation primarily, to keep the banking system stable and able to lend at what the Fed considers appropriate levels. When economic growth slows, the Fed will try to stimulate banks to lend. When banks are pressured, they will try to alleviate that pressure consistent with the Fed’s goals.
In my opinion, the Fed will ultimately do what is good for banks, even if it comes with a long or variable lag.
For 2024 and 2025, there is a looming commercial real estate meltdown that threatens default rates similar to the Financial Crisis. A working paper from the National Bureau of Economic Research argues that 14% of the $2.7 trillion of commercial real estate loans held at banks are at risk of default. That is led by 44% of office CREs having higher loan value than property value.
That’s a potential nearly $400 billion hole about to be blown into bank balance sheets. I have heard and read various estimates of this number up to a trillion dollars, with most being estimates in the $400 billion to $600 billion range.
Importantly, that doesn’t include the loans held at non-bank where about 55% of the CRE debt is.
CRE Not A Crisis (Cohen And Steers)
Last year, banks had a similar problem and 3 big failures occurred at about the same time: SVB, Sovereign and First Republic. Those three banks had about a half trillion of assets.
What should the takeaways be here?
The first things is that there is NOT likely to be a major banking crisis. It will be more like some indigestion and heartburn. Investors could very well treat it like an end of the world event for a month or two though. They like doing that.
The half trillion or so of at-risk CRE debt is spread across a lot of banks and non-banks. It is a pretty well diversified market. That means while there is likely an insolvency or two or three, it will not be a systematic collapse.
Bank Exposure CRE Debt (Cohen And Steers)
But, that hole in bank balance sheets still needs to be filled and the Federal Reserve will be the one to do it. They’ll do it three ways:
- Lower interest rates which reduce bank losses on investments and improves their borrow short, lend long business margins.
- Reduce or end QT (quantitative tightening) to reduce the tightening impact on the monetary system.
- Fund a Special Facility (don’t call it QE) to help bank balance sheets. This will come with strings attached to the most at risk banks.
Most pundits are talking about recessions and glide paths to the Fed loosening. I reject that. I was firmly in Camp Soft Landing since early 2022 when I projected that inflation would come down firmly in 2023. I don’t see a recession coming and I’m a permabear don’t forget.
I also believe when the Fed loosens, it will be fast and hard. Government, and big bank owned quasi-government, don’t like a good crisis to go to waste – even if it’s conjured.
When the liquidity increases, stocks will go up because that’s what more liquidity causes. See section above again if necessary.
U.S. Treasuries Need Liquidity Too
We know that the U.S. Treasury market has been tightening up in recent quarters. That has largely been by design from the Federal Reserve’s QT program. But, it has also been because China is a net seller of U.S. Treasuries lately.
China UST Holdings (Dept of Treasury, CEIC)
While there are a lot of moving parts to a $26 trillion market, it is enough to say that there needs to be liquidity. The Fed ending QT is one way to improve liquidity. The Special Facility for banks will also result in most of that money ending up in U.S. Treasuries and then loaned against.
I included this section for context because it will matter more at some point in the future. I think way out there a few years, maybe 2026 when the “basis trade” winds down if new SEC regulations take effect as planned (lots to unpack there, but not today).
By adding liquidity in 2024, the Federal Reserve is killing two birds with one stone and maybe one down the road. It is not only helping banks and Janet Yellen’s U.S. Treasury market today, but might be setting up for an even bigger gift to banks at the expense of a few big “basis trade” firms as the world continues to dollarize and Bitcoinize (articles coming, follow along for weekly Macro Dashes pieces in 2024).
Money On The Sidelines
Money markets have climbed to over $6 trillion in the past year. That is more than a trillion dollars more than “normal” in money market accounts if we consider post Covid normal.
Money Markets Surged (FRED)
What happens as interest rates fall? I think some of that money finds its way back into stocks. What if around $3 trillion is the actual “normal” amount that we would expect in money market accounts?
Either way, there’s a lot of money on the sidelines likely to find its way into stocks and real estate in the next year or two or three or five.
Interestingly, the rise in money markets lowered total household net worth as stocks rose by far more than those eye popping 4% and 5% bank yields.
Let that be yet another lesson to not let emotions drive your financial decisions.
Multiple Expansion
With positive earnings surprises, more liquidity and full employment, I see valuations expanding. That is despite being a permabear who regularly warned against high valuations in 2021 into 2022.
As you see, valuations have come back a bit from the highs. With earnings rising and liquidity set to go from expecting easing to actual easing, I think the valuation ratios expand back towards the 3rd standard deviation range in the next year or so.
So, to apply some math for my 5720 projection, I am simply applying a 22 P/E to earnings of $260. I would not be surprised if we make a run at 6000 by January 2025.
Threats To Euphoria
Clearly there is always a wall of worry. Usually, it can be climbed. Occasionally, as with my warnings of past corrections the wall comes down or at least needs some repairs before climbing. This time is no different in that there are risks that will need to be scaled. Chief among those risks are these in my opinion:
- The Federal Reserve has bad timing and execution. I think this is common wisdom here, especially since most have less faith in the Fed than I do. Waiting too long to loosen could cause a domino effect economically causing the banking mini-crisis that I see to become a major one. Easing too soon could reignite inflation for a while. While I expect Goldilocks, maybe she ditches us.
- Global economic disruptions, particularly in China or Europe, could derail the global economic system much like Covid did in 2020. While I do not see a large risk of a global recession triggered by a big player, it certainly could happen. China for instance could use economics, think supply disruptions or capital risks, to impact the U.S. election.
- Geopolitical disruptions, particularly in the Middle East or with Russia, carry significant risk. Both have war right now and war has gotten out of hand with unfortunate regulatory for humanity. An expanding war in the Middle East or in Europe could disrupt the entire global economy in addition to the horrors of war.
- Politics are always a slow moving disruption until it becomes sudden. The rise of the far right in many places in the world, including the United States, is potentially more disruptive than the rise of the far left during the Communist and Socialist peaks of the 1960s and 1970s. The disruption of law in America, supposedly the leader in rule of law, could disrupt a move to rule of law that has been creeping along since World War II.
Those are just a few risks that stand out. There are far more, including what Donald Rumsfeld called “unknown, unknowns” or as we now call them thanks to Nouriel Rubini, “Black Swans.”
The Euphoria Has Just Begun
To sum things up, I expect a robust January Effect and a good Q1 on whole.
Sometime in Q2 or Q3 there will be some market indigestion from angst over what headlines are calling a commercial real estate crisis. We know that it is really just a run-of-the-mill half trillion dollar problem to be papered over.
Once the Fed loosens, I expect the Dionysian dancing to really begin.
Overall, the combination of falling inflation, full employment and AI doing some of the heavy lifting is a better macro environment than a year ago.
Could there be political and geopolitical hiccups or worse? Sure. But who can forecast that besides Ian Bremmer and George Friedman?
Indexers into the SPDR S&P 500 ETF (NYSEARCA:SPY) and Vanguard S&P 500 ETF (NYSEARCA:VOO) will be happy. I do not think they will be as happy as people who invest into certain micro, small and mid cap ETFs or select stocks. Those categories typically do better in a loosening cycle than large caps.
And, for what it is worth, there are better large cap ETFs than SPY and VOO. But, that’s a topic for another article. Though, here’s a hint:
VOO SPY SPGP QQQ Since 2016 (Kirk Spano via TradingView)
Notice that the markets haven’t really gone up in 2 years. Stocks are where they were 2 years ago. If we don’t have an event driven crash, then we probably only get a pullback that launches markets to even higher highs.
So, what should you do as an investor?
First off, buy the dips. It’s a great dance.
Second, pick better ETFs than SPY and VOO.
As always, keep an eye out for unknown unknowns.
Author
Kirk Spano
CEO/CIO — Fundamental Trends
Kirk is an Accredited Investment Advisor and founder of Fundamental Trends and Bluemound Asset Management LLC. Kirk has been highly successful in helping DIY investors make sense of the investment world, and profit in stocks, ETFs and crypto.