by Professor Jeremy J. Siegel, Senior Economist to WisdomTree and Emeritus Professor of Finance at The Wharton School of the University of Pennsylvania
We continued to see ‘Goldilocks’ data to wrap up 2023 and enter the year-end holiday season. The inflation and Personal Consumption Expenditure (PCE) price index data last Friday were at or below expectations—while real economic indicators like jobless claims continued to show strength and a healthy economy. We had very strong housing starts and durable goods earlier last week which showed no signs of economic weakness. Estimates for the fourth quarter gross domestic product (GDP) growth are being revised higher from the low 1% to the low 2% range. This combination of progress on inflation while the economy stays robust is the best possible combination for the equity markets.
There are two somewhat misleading narratives for the market. First is the chatter around the market pricing in six cuts in interest rates next year while the Federal Reserve (Fed) has only penciled in three cuts in their Dot Plot. I like to remind readers that the Fed funds futures market is not an unbiased estimate of future rates. These futures instruments are used for hedging purposes and, in particular, one of best ways to protect from an economic recession is to position in interest rate cuts so that hedging demand for these assets biases the rates downward. This hedging demand is hard to calculate precisely but I estimate that hedging may add 1-2 rate cuts. So, the real disconnect between what the market expects for next year and the Dot Plot may be more like one added cut instead of three cuts.
There is also a disconnect in believing the market rally is tied to expected rate cuts from the Fed. The important take-away from Powell’s news conference is the flexibility from the Fed. My biggest perceived risk for next year is a Fed that would be too stubborn on the way down because of fears of inflation risk. If the economy stays in the 2.5% to 3% range for real economic growth, the Fed does not need to cut rates materially for stocks to do well. But if the economy slows down considerably, the Fed may be more likely to lower rates than I previously thought.
Reflecting on my calls for this year. Coming into 2023, I was appropriately very bullish for equities expecting a 15% rally; that and more materialized. I was wrong on the Fed and thought they were overly tight and would have to cut rates.
As I look ahead for 2024, I remain very optimistic for equities and expect broader participation beyond the ‘Magnificent 7’ technology stocks. The S&P 500 at 20x price-to-earnings is priced for a 5% real long-term return. This is lower than the historical averages but the equity risk premium—the amount stocks can deliver over inflation protected bonds—remains above 3% which is similar to its very long-term averages. Equity investors had a great dynamic the last decade largely because forward bond returns looked so bleak. Those forward bond returns and yields are now higher but also remain well below their long-term averages.
Small and mid-cap cap stocks in particular have been priced for a recession. The more-flexible Fed lowers the probability of a recession and should lead to a continued catch up in valuations and performance for value and small-cap stocks. This is not to say we will have a drop in growth stocks, just that the value rotation should return.
I wish you a great end to 2023 and happy holidays!
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