Stocks Are Stretched After a Roaring First Half - but the Rally Isn't Over Yet

The first half of 2024 was remarkably favorable for U.S. equity investors, with the S&P 500 rising 14.5%, excluding dividends. As investors look to the second half, the focus shifts to second-quarter earnings reports, leaving several questions unanswered.

‍

Optimists point to strong revisions in forward 12-month earnings-per-share (EPS) estimates as a positive indicator for stock prices. Conversely, pessimists highlight that macroeconomic reports have generally fallen short of expectations, suggesting a potential period of earnings disappointments and negative guidance. Furthermore, elevated valuations could pose a challenge for stock prices.

‍

Which perspective is correct? Here's a preview of the upcoming earnings season.

‍

A Strong Bottom-Up Outlook

To start with the positive news, FactSet reports that S&P 500 forward 12-month EPS revisions are strongly positive, signaling bullish fundamental momentum. Wall Street analysts anticipate above-average EPS growth of 11.2% for 2024 and 12.7% for 2025.

‍

A K-Shaped Recovery

However, Peter Atwater, author of “The Confidence Map,” argues that the U.S. economy is experiencing a “K-shaped” recovery. The affluent have seen substantial gains, creating an extraordinary wealth effect that benefits luxury sectors, such as fashion, travel, cars, and real estate, propelling companies like LVMH to new heights.

‍

Meanwhile, those at the lower end have been left behind as financial assets soared, and rising interest rates have increased their financial burden. Since 2021, food prices have risen over 20%, auto loan rates have nearly doubled, and U.S. banks now charge over 25% on most credit card balances.

‍

This results in a bifurcated economy: the wealthy continue to spend lavishly, while the less affluent struggle to make ends meet.

‍

The Transcript has documented anecdotal evidence of this K-shaped recovery from earnings calls:

• Darren Rebelez, CEO of Casey’s General Stores, noted consistent buying behavior among upper-income consumers.
• Mark Lashier, CEO of Phillips 66, described a bifurcated economy where the affluent feel good about their financial situation, but the working class faces tough choices daily due to higher living costs.
• James Quincey, CEO of Coca-Cola, observed that lower-income individuals are under pressure from inflation, affecting spending patterns in various sectors.

‍

Consumer-driven companies have responded by focusing on volume growth through price reductions. McDonald’s has reintroduced its $5 menu, and General Mills has increased couponing efforts to drive volume growth.

‍

Top-Down Perspective

From a macroeconomic viewpoint, the Citigroup Economic Surprise Index (ESI), which tracks whether economic releases exceed or fall short of expectations, has weakened to levels last seen in 2022. This signals a slowing economic growth outlook, contradicting the optimistic bottom-up earnings expectations from Wall Street analysts. However, the ESI’s correlation with bond yields suggests that lower yields could boost stock prices.

‍

The Federal Reserve is expected to respond to lower inflation pressures with two quarter-point rate cuts this year, likely at the September and December meetings.

‍

Elevated Valuation

Another concern for equity prices is valuation. The S&P 500’s forward price-to-earnings (P/E) ratio is 21.0, above its five-year average of 19.2 and ten-year average of 17.8. These elevated levels indicate potential overvaluation, especially for investors following the Rule of 20, which suggests the market is overvalued if the sum of the P/E multiple and inflation rate exceeds 20.

‍

Interestingly, my monthly screen for leveraged-buyout (LBO) candidates revealed some surprising findings. In late May, no stocks in the S&P 1500 fit the criteria for an LBO with no money down, and only 22 stocks could be bought with 30% down. However, the latest update identified three stocks that could be purchased with no money down and 25 stocks with 30% down or less. This discrepancy is likely due to valuation differences between large-cap technology stocks and smaller-cap stocks, indicating emerging deep value among small- and mid-cap stocks.

‍

As the second-quarter earnings season approaches, investors face numerous challenges. Strong bottom-up EPS estimate revisions contrast with weak top-down economic releases. Additionally, elevated forward P/E valuations may act as a headwind for stock prices.

‍

I interpret these conditions as indicative of a midcycle expansion. Fundamental momentum, reflected in positive EPS expectations, drives the short-term trend. While valuation is crucial in the long term, it has limited short-term impact. As long as fundamental momentum remains positive, U.S. stocks can continue to rise.

‍