2024 market outlook: stocks are stories, bonds are math

Stock market stories

Overall, 2023 turned out to be a good year for stocks. The S&P 500 Index is up over 20.0% through December 1, with the largest portion of the return coming from forward price-to-earnings (P/E) multiple expansion. The S&P 500 Index started the year with a forward P/E of 16.7x and by December stood at 18.8x, which created nearly 13.0% of the total return. Future earnings estimates have also risen over the course of the year from $231 to $244, or about a 6.0% contribution to the total return. The dividend yield on the S&P 500 Index has made up the remainder at about 1.5%.¹

We didn’t see the significant valuation rerating nor the more optimistic view on earnings growth into 2024 given the deteriorating macroeconomic backdrop; however, we advocated an overweight in U.S. large- and mid-cap stocks relative to international equities and preferred the quality factor, which has held up well. 

It’s important to note that the significant appreciation in equities this year came without much fundamental support from earnings. In fact, earnings growth was difficult to find in 2023. S&P 500 Index earnings only grew by 0.6% year over year. Overseas, the picture was even gloomier, with MSCI EAFE Index earnings falling by 0.9% and MSCI Emerging Markets Index earnings falling by 1.2%.¹  

In our view, markets rose this year in part due to the expectation that 2024 earnings growth will be meaningfully better. In fact, forward-looking estimates from the analyst community suggest earnings growth for the S&P 500 Index will come in at 11.7%, MSCI EAFE Index at 6.3%, and MSCI Emerging Markets Index at 14.4%.¹ This sounds optimistic to us given the still-elevated cost of capital, less fiscal support from here, and the continued lagged effect of tighter monetary policy. 

Because of the optimism already baked in on stocks from both earnings estimates and valuations, the “math” on equities isn’t especially compelling to us today. In fact, we see the risk/reward as less favorable for stocks going into 2024 than we did coming into 2023 when valuations were lower and earnings estimates were more reasonable. Another issue for the S&P 500 Index heading into 2024 is the significant concentration risk—and valuation risk—within the highest market capitalization companies, with the top 10 stocks in the S&P 500 Index having contributed 76% of the total return year to date.¹  

While we continue to emphasize U.S. large-cap stocks due to their higher-quality attributes, such as strong balance sheets, high return on equity, and greater profitability, we’re mitigating that risk by diversifying into mid-cap equities, which are trading at the steepest discount to their large-cap counterparts since the late 1990s.²

Overall, we’re modestly underweight in stocks relative to bonds heading into 2024 as we believe fixed income will likely begin looking more competitive to equities on a risk-adjusted basis.

Math test

The bond market told a very different story than stocks over the course of the year as there was more value created, not less. The yield on the Bloomberg U.S. Aggregate Bond Index started the year at 4.68% then went as high as 5.74% before landing at 4.91% in December. High-quality bonds were on sale over the year as the 10-year U.S. Treasury yield rose from 3.88% to as high as 4.99% before coming back down in December to 4.22%. Though yields for high-quality areas of the fixed-income market have recently fallen, they remain above anything seen for much of the past decade.

With that said, riskier high-yield bonds became more expensive over the year on a relative basis. U.S. high-yield spreads started the year at 4.69% before falling to 3.74% in December, suggesting meaningful tightening of credit spreads compared with U.S. Treasury bonds.

Leading economic indicators (LEIs) implied an economic slowdown in 2023; however, we saw choppiness instead, with a Q3 consumer resurgence from savings and a resilient labor market causing riskier parts of the fixed-income market to rally.

Another curveball this year was a backup in Treasury yields that didn’t rhyme much with history. The last rate hike from the U.S. Federal Reserve (Fed) continues to look like it was at the July meeting. Historically speaking, the 10-year Treasury yield tends to peak for the cycle before the federal funds rate does, then either falls or trades sideways as the Fed is on hold. This time, we saw a significant backup in Treasury yields after what is likely to be the last rate hike. In our view, the backup in higher-quality bond yields represents an attractive entry point.

Overall, we continue to emphasize higher-quality bonds over credit heading into 2024. This includes mortgage-backed securities, municipals, investment-grade corporate bonds, and even government bonds at a neutral weight. The parts of the bond market we continue to underweight are non-U.S. government bonds (as we prefer Treasuries), emerging-market debt, and U.S. high-yield bonds. In our view, high-quality bonds offer value as they trade at a discount to par, offer attractive yields compared to history, and stand to benefit as inflation and global growth decelerate. We see lower-quality parts of the bond market as expensive and would patiently wait for a more attractive valuation entry point.

The waiting is the hardest part

This has been one of the longest late-cycle periods in history with the yield curve being inverted and LEIs being negative on a year-over-year basis for roughly a year and a half without a recession. The questions we have to grapple with are classic: Is this time different?  Will economic cycles rhyme with those in the past? 

In our view, this late-cycle period has simply been extended due to the massive pandemic-era fiscal stimulus of 2020/2021. As that stimulus finally becomes depleted—and as the lagged impact of Fed tightening starts to bite—we see a contraction unfolding into 2024. It’s hard to imagine that this time will be different with the Fed flipping from the easiest monetary policy to the most restrictive in a matter of years.

Considering this view, we expect bonds to play an increasingly important role in portfolios and we would continue to lean into higher-quality parts of the equity markets. Meanwhile, we would de-emphasize highly cyclical and unprofitable businesses, which are more likely to feel the impact of a decelerating growth environment and a higher cost of capital. Over the course of the year, we may see a valuation rerating and we’ll be looking to get our shopping list out. Volatility often creates opportunity, and if equity markets see downside moves in the face of a correction, the math may once again look compelling.

1 FactSet, as of 12/1/23. 2 FactSet, as of 11/30/23, based on the forward P/E ratio of the S&P MidCap 400 Index vs. the S&P 500 Index.