by Hubert Marleau, Market Economist, Palos Management
The S&P 500 hovered around the 5000 mark all week, registering new record highs day by day, yet it got no respect from the naysayers. They claim that the rally is too narrow, has run up too fast and blown valuations, while the Fed is too restrictive. Really? I dispute their negative chatter. My line of thinking is quite different from theirs.
First, the main reason why the Federal reserve is not itching to cut rates too early is because it knows that the current surge in productivity allows inflation to fall with limited cost in the labour market.
Second, it is not totally true that the market run-up is without breath and width. Financials, health care and industrials have also fared very well along with the technology sector. Weakness was concentrated in the energy sector and utilities.
Third, earnings are doing a lot better than they appear. After making adjustments for anomalies, S&P 500 earnings per shares are up about 4.5% from last year. At the forward P/E of 28.3 currently, the MegaCaps may look costly, but they are still cheaper than during the pandemic and not that expensive relative to their strong profit growth. Meanwhile, knowledge-based industries are on a sugar high because they have the unusual characteristic of not being subjected to diminishing returns like production-based industries whose returns tend toward the cost of capital as competition increases. As much as 60% of the latter's cash flow from operations is re-invested in capex and R&D.
Productivity is Making a Roaring Comeback
Over the past 5 years through Q4/2023, productivity rose, on average, 1.5% per year. It would have been much higher if the trend had not been obstructed by the pandemic. Over the next 6 years, Yardeni Research predicts that yearly gains will be at least 2.5%, and perhaps as high as 3.5%. This forecast may prove to be conservative. In the past, productivity growth booms, it reached levels as high as 4.0%.
The Market Outlook
Without the MegaCaps, the S&P 500 is 17.5 times forward earnings. This is an earning yield of 5.71%, which is a respectable 350 bps above the present expectation for inflation in one year’s time. Nonetheless, a tactical correction is very possible because speculators may decide to take some trading profits. In this connection, investors should consider buying dips in stocks that they like. Why? I maintain the view that the S&P 500 will nudge toward 5400 in 2024 and further along to 5900 in 2025. Take note that all-time highs are usually followed by more all-time highs.
P.S. I’m on a cruise ship for the next month. There will be fewer letters (unedited plus short and sweet.)
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