After a rough year in the financial markets in 2022, it was a strong year in 2023. However, according to Barron’s magazine, just a handful of companies "The Magnificent Seven" mega-cap stocks, which refers to Apple, Amazon, Alphabet, Meta, Microsoft, Tesla, and Nvidia were responsible for 76% of the S&P 500's 2023 gain. We believe the financial markets in 2024 will be tougher because the companies listed above account for 30% of the market capitalization of the S&P 500 and are now trading at extended valuations as well as being volatile to own. Moreover, 2024 could see companies delay decisions as business leaders await the results of what will most likely be an ugly presidential election. Despite this, we believe the financial markets can still slowly move higher. In this commentary, we will discuss three reasons why we believe the financial market can move higher in 2024 and why we believe geo-political events will be the biggest risk for the financial markets in the year ahead.
The first reason we believe the financial markets can move higher this year is because of the "Presidential Election Cycle Theory" which was initially put forth by Yale Hirsch, the creator and publisher of the Stock Trader's Almanac. The theory states that presidential administrations try to pump the economy up before elections to increase their chances of getting re-elected. According to a 2021-Dimensional Funds report, the market has been favorable overall in 20 of the 24 election years from 1928 to 2020, only showing negative returns four times. When you further examine the years between elections, however, it becomes apparent that year three (last year) of a president's term is usually the strongest year for the market, followed by year four (this year 2024), then the second, and finally the first, which is usually the weakest. Again, the theory states that when new administrations enter the White House they usually re-prioritize spending in their first two years, and then increase spending and boost the economy before their re-election.
This theory has generally held up well over time. During the current election cycle, the cycle was off during the first two years, as the stock market was strong in the first year, and the second year was very weak; but last year was strong, as the theory predicted. Based on the direction of falling interest rates and a decrease in the rate of inflation growth caused by a slowing economy, we think this year the market will head higher. Even though the economy has been slowing, the market is looking nine months to a year ahead and is assuming that falling interest rates will stimulate economic demand as homes, cars, and other expensive items become easier to finance in a lower interest rate environment. However, we do not see the market doing as well as last year as valuation levels are no longer cheap and the market has already priced in much of the recovery (please see chart below). Indeed, the forward price to earnings ratio is currently at 21, which is a high level and no longer cheap. As a refresher, investors value stocks as a level of earnings. So, if a stock were to earn $1 a share, you could buy the stock for $16 last year, while this year you would have to pay $21 for that same stock. Stocks tend to move higher over time as the underlying earnings of the companies grow, but volatility in the market increases as investors get scared or excited and bid up prices or sell stocks based on the current economic or geo-political news.
In spite of the high valuations of the market, the second reason we think the market will head higher in 2024 is due to the record setting amount of money currently parked in money market funds. As interest rates rose over the last two years, money market funds which were paying less than 1% interest rates became much more popular as they started to pay close to 5% recently. The FRED (Federal Reserve Economic Data) website points out that money market funds currently hold close to $6 trillion, which is a record amount according to Barron’s Magazine and 29% more than levels just before COVID (December 25, 2023). Historically, the amount of money in money market funds increases during times of recession or economic weakness as seen by the grey vertical lines on the chart on the next page which represent recessions. Money market funds peaked during the Tech Crisis, Financial Crisis, and at the onset of COVID. As those crises slowly passed the money that accumulated in the money market funds was withdrawn to buy stocks and other assets as the financial markets slowly improved. Likewise, as the economy slowly improves as interest rates fall, the interest rates paid 4 on money market funds will decrease and those assets will likely again be redeployed into stocks, bonds and other assets with higher returns.
The third reason why we believe the market will move higher this year is that earnings estimates for the 500 largest companies in the United States are expected to rise steadily as we progress into this year. (see chart on next page) The reason for the rise in earnings is because interest rates are expected to fall, which will act to stimulate the consumption of cars and other big-ticket items, which in turn will drive earnings higher for a wide range of companies that produce these products.
Moreover, earnings should also rise because as interest rates in the Unites States fall, the value of the U.S. dollar versus other large currencies will fall. Indeed, the value of the U.S. dollar fell -5% from November 1st, 2023 to December 29, 2023 according to FactSet Research as interest rates in the U.S. fell and interest rates in other countries remained steady, which made the U.S. dollar less desirable. Although a falling dollar sounds bad, it actually helps the earnings of U.S. corporations because the average revenue of America’s largest 500 firms get about half 5 of their earnings overseas. So, when the dollar falls, those earnings overseas are repatriated back to the United States at higher levels. The decline of 5% of the U.S. dollar in the last two months of last year will translate in 2.5% higher earnings growth this year (5% multiplied by 50% of an average company’s earnings which occur overseas).
Stronger earnings this year are also being anticipated by the cardboard box makers. It is also interesting to point out that even though cardboard production was down last year due to a slowing economy, PPI Pulp & Paper Week, a weekly trade publication of the cardboard industry, that points out the largest US cardboard makers including Packing Corp of America and Westrock increased their prices by 9% in December in anticipation of higher demand for manufactured products in 2024.
While we all hope for a strong 2024, we believe the biggest risk the financial markets face in 2024 could be geo-political. In Europe, open conflicts in Ukraine due to the Russian invasion look increasingly like Russia may prevail as well as new conflicts may arise at any time in Kosovo, Armenia, and Moldova. Russia appears to be trying to require the territory of the old 6 Soviet Union, and countries that have not joined NATO (North Atlantic Treaty Organization) look vulnerable. Moreover, the Western sanctions against Russia have not slowed down the Russian military economy as much as was hoped. Despite having an economy smaller than California, Russia is out producing the West in terms of tanks, planes, ammunition, and artillery (although of inferior quality). According to Nicholas Drummond, a defense consultant, German companies could produce 400 tanks a year at the height of the Cold War, but now could only build 50 tanks per year. In comparison, Russia can fix, repair, or build between 100-150 tanks per month. In addition, Russian battlefield tactics have gotten better. Russia fields many advanced jamming capabilities and have deployed these systems across their dug in positions which can block GPS (Global Position System) signals of missiles, bombs, and drones making those weapons far less effective. In addition, Reuters reports that after Putin’s December 2023 decree, the Russian Army will number 1.32 million soldiers and 2.2 million in their military, by far the largest in Europe.
On the other hand, European allies have not only drained their stockpiles of weapons to help Ukraine but also now find themselves in dangerously low levels of inventory. A leaked report published in the Wall Street Journal (Dec 2023) reported that Germany (which keeps its official numbers secret) would run out of ammunition within days or even hours in the event of a war. We continue to see reports that although the Western military equipment is very good, the lack of spare parts and ammunition are hindering their success. Furthermore, at the current industrial base, it will take years to correct the current situation. For example, the NASAMS (National Advanced Surface to-Air Missile System), produced in Norway, is capable of launching 72 missiles all at once. When first deployed in Ukraine in 2022, it recorded a 100% success rate shooting down cruise missiles and drones. It is even used to defend the airspace 7 around the White House. However, to order one will take over two years before delivery. Our fear is that Putin may see a window of opportunity by the current weakness in European defenses as a chance to retake some of the former states of the former Soviet Union. Our fears are not alone, General Petraeus, former head of U.S. forces in Iraq, and former CIA director, said in an interview on CNN (1-8-24) that Putin “won’t stop there” if he wins in Ukraine.
In the Middle East, we see a possibility of a wider conflict. A wider conflict will lead to higher oil prices, will slow economic growth, and add to inflation. In 2024, we believe Israel will finish defeating Hamas. The bigger issue is Hamas financial backer, Iran. As we wrote last year, Israel has stated that they will never allow Iran to obtain nuclear weapons. Two of the 8 biggest war exercises Israel has ever done were last year over the Mediterranean Sea, in which Israel practiced bombing Iran nuclear facilities. Unfortunately, last November the International Atomic Energy Agency (IAEA) said Iran could produce enough material for ten nuclear weapons with delivery systems within one year. That announcement was only one month after Hamas attacked Israel. Meanwhile, Iranian backed groups Hezbollah and Houthis continue to cause problems with Hezbollah firing rockets into Israel and the Houthis using missiles, drones, and ship drones to attack ships in the Red Sea.
Turning to Asia, we see continued problems with North Korea and a further decoupling with China. At the end of last year, we saw a ramp of North Korean rhetoric. Most of this we believe is for domestic North Korean party politics. The biggest change is that North Korea is no longer willing to give up nuclear weapons for aid. Moreover, they have added a constitutional amendment mandating continued development to WMD (weapons of mass destruction) and vowed to increase their nuclear arsenal.
Our relationship with China has also become more contentious. Under President Xi, China has become more authoritarian and increasingly no longer sees the United States as a partner but as a competitor. China’s economy is slowing and its over reliance on debt is showing cracks. Reuters reports China’s debt-to-GDP is a whopping 280%, (economists consider anything over 100% to be a problem, the U.S. also has a debt-to-GDP over 100%), with the bulk of China’s liabilities held by local government financial vehicles. CNBC reports that China’s property market has been in a crisis since 2020 with real estate giants such as Evergrande and Country Garden struggling to repay debts and their cash flows are drying up due to falling home sales. When domestic economies look bad, governments sometimes turn to foreign affairs to divert attention away from failed domestic policies. China could do this with Taiwan. China has stated that they will retake the island of Taiwan, by force if necessary, and anyone who gets in their way will suffer painfully. The problem here is that the U.S. has a treaty to defend Taiwan, which could put America into direct conflict with China.
In conclusion, our base case is that the financial markets will move higher in 2024 assuming that inflation will continue to fall, and assuming that the Federal Reserve will begin to lower interest rates in the mid to second half of the year. Currently, the futures market is expecting three rate cuts for 2024. These interest rate cuts will help to spur the economy, drain funds out of money market accounts as investors look for higher returns, and be critical to help drive earnings growth for 2024. At the same time, we believe policy makers will have to prevent the current geo-political problems from getting worse so that the economy can run its course. As a result, we continue to favor large capitalization, brand name equities who are providing goods and services that consumers and business need on a daily basis and who are returning cash back to investors as the best risk adjusted returns for the year ahead.
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