Q3 2024 Commentary

We ended the last quarter mulling a conundrum that has confronted us repeatedly over the last eight years.

Economic data was encouraging and corporate earnings were rising – both positive developments for equity prices. At the same time, however, strength in equity markets had brought prices to historically unsustainable multiples.

In these situations, we must ask the question: what are stocks worth?

In a strong economic environment with strong corporate earnings growth, owners of corporate equity have the greatest claim to the fruits of that growth.  On the surface, equities is where investors want to be.

But there is a cost to accessing that corporate ownership. As that cost increases, risks increase that the benefits will not offset the price (at least not in a timely fashion).

By virtually any valuation measure, the last thirty years has been the most expensive market period in history.  Prices have been justified, in part, by incredible advances in information technology, automation, and medicine. Some stretches have been aided by historically low interest rates, massive government stimulus or both. 

Despite all of the realized potential of technological advancements and the gifts of monetary and fiscal tailwinds, the earnings growth of S&P 500 stocks has averaged around 7% over those thirty years – only about 1% higher than the average over the previous thirty years.  Expensive capital investments and intense global competition have had a way of containing earnings growth.

To start the quarter, the S&P 500 is trading at a P/E multiple of 28. The median “justified” multiple (future low prices/prior peak earnings) of the last thirty years has been 18. If an 18 times earnings multiple is appropriate for a 7% growth environment, what sort of earnings environment do we need to justify multiples that are more than 50% higher? 

The math can be approached in a number of ways. In a generous interpretation, today’s multiples imply that earnings growth will be above 8% per year in perpetuity. That would be a nearly 20% increase from the historical rate of earnings growth. If we are looking at shorter time horizons (10-15 years), a P/E multiple of 28 implies earnings growth greater than 10% per year over that stretch.  For reference, that would match the strongest decade of earnings growth in U.S. history (outside of recession rebounds).

Today’s prices are either extremely optimistic about future earnings growth or they imply acceptance of significantly below average market returns going forward. From forward earnings estimates and investor expectations, we know that this is largely a function of the former.   

We are optimists in the sense that we believe that market incentives drive corporations to provide value to their shareholders, and that, over time, regardless of the obstacles, enterprises can provide strong returns on capital.  But that optimism does not include naively paying fair value on a bet that the best decade in earnings history lies ahead. The only two times in history that markets have agreed to make that bet (in 1998 and 2021), investors have eventually faced notable losses.

We have already seen these multiples once this year, near the close of the last quarter.  Markets continued their hot streak into mid-July, but then quickly corrected nearly 10%. The rapid reversal was reflective of the risks inherent in markets, which are amplified at high valuations. 

Despite the high valuations and the pullback, we were relatively optimistic early in the quarter.  Markets looked overvalued, but the valuation dispersion amongst stocks was historic, and we believed that out-of-favor stocks had plenty of room to rise. There was also the risk, however, that markets would “catch down” to out of favor stocks. Between the early-quarter correction and the late-quarter rally to new highs, we saw a bit of both.

The convergence was beneficial to our Time Overlay strategies, but it has also left us less optimistic about the market environment going into the fourth quarter.

We are entering the quarter with stocks slightly more expensive than they were three months ago. The historic valuation dispersions still exist, but they have narrowed. We have responded by reducing equity exposure throughout the quarter, with Time Overlay strategies currently targeting equity allocations below 35%. 

There is no guarantee that markets will hit a ceiling at these valuations (as they did earlier this year). In fact, given the historical propensity of expensive/euphoric markets to become even more overvalued (we hit price/peak earnings multiples of 30 and 35 in 2021 and 2000, respectively), we were somewhat surprised by the timing of the pullback in Q3.

There are legitimate fundamental narratives at work that drove markets to new highs this quarter, and could continue to do so in the fourth quarter and into next year. The most significant developments have been a reversal in Fed policy and record corporate earnings.

The Fed was able to cut rates by 50 basis-points in September. It was the first rate cut since they slashed the benchmark rate to zero in March of 2020.  The Fed was able to make the rate cut because of recent progress in inflation data, but they were also pressured to cut because of emerging uncertainty in employment data.  In our most recent commentary, we pointed to that emerging weakness in labor markets as a possible concern, worrying that the Fed’s first rate cut may not be one of convenience, but of necessity. September’s labor data showed some improvement, making the Fed look more cautious than panicked, but employment numbers will be worth monitoring closely.

Record earnings warrant record stock prices, but they are not, in themselves, an all-clear for equity markets, particularly at these valuations.  Any emerging weakness in the earnings growth outlook could begin a devaluation process, which is the pattern seen in past bubbles, as price multiples fell before markets did. This will make forward guidance worthy of additional scrutiny in the quarters ahead.

Beyond signs of softening in the labor market, there is little else fundamentally standing in the way of this market. If corporate earnings remain solid and markets become comfortable with the “soft landing” narrative, expensive markets can remain expensive for some time. If markets continue to rise unabated, we will likely take the opportunity to further increase our cash allocations.

Even if there are no disruptions to fundamentals, markets do face some seasonal risks. October has historically seen heightened volatility in election years. Any significant moves ahead of the election (or shortly thereafter) are likely to be temporary.  If dislocations are large enough, we are prepared to take advantage of opportunities that the market presents, but we will not be positioning based on speculative election outcomes