2023 has ended on a very positive note. While 2024 is widely expected to be just as good, if not better, some heavy question marks are hanging over the markets. The economic outlook has brightened, but is still uncertain; meanwhile, politics and geopolitics could add even more uncertainty to the overall picture. Against this backdrop, stocks are in overbought territory, complacency is high, expectations for the Fed’s cuts are quite overstretched, and earnings projections seem to be very optimistic. Thus, investors are strongly advised to closely watch for warning signs, following economic data, earnings reports, and market indicators.
A Difficult Year Ended With a Cheer
The S&P 500 (SPX) index logged an impressive 24% rally in 2023 – its best year since 2004 – while adding over $8 trillion to its overall capitalization and coming within a whisker of its all-time high. Throughout the year, the market’s performance was strongly influenced by earnings surprises, as well as several important events such as the regional banking crisis, the “chip war” with China, the ongoing war in Ukraine, and the Middle East conflict. However, the inflation worries and the Federal Reserve’s policy direction were central to the market’s sentiment and risk perception.
During most of the year, gains were largely concentrated within a handful of mega caps, with the rest of the market hanging in limbo. However, this changed towards the end of the year, with the rally broadening to include stocks from all sectors, shapes, and sizes. This change of heart came on the back of the increasingly common perception that the U.S. is slated for the “Goldilocks scenario,” where inflation comes down while the economy continues humming along, albeit slowing down a little. Of course, this scenario provides a very positive backdrop for all stocks, with the earlier laggards expected to catch up with the winners as the rising tide lifts (almost) all boats. Besides, a robust economy would support earnings, which have just started to rebound in some sectors. If the rosy scenario plays out, many more companies will see their bottom lines thicken.
If this picture looks a little too perfect to you, you are not alone. In 1979, Warren Buffett said “You pay a very high price in the stock market for a cheery consensus,” and it still holds true today. While the positive expectations may prove correct or even too modest, things may roll downhill, too. So, let us try and discern which factors may spoil the stock-market party in 2024.
Scarily Cheery Consensus
The most immediate risk to the rally’s continued endurance is the profit-taking. Of course, this would be a normal step in the flow of the markets after any period of significant increases. However, this time, the markets are especially vulnerable to a considerable correction, for several reasons.
First, the U.S. stocks are now trading firmly in the overbought territory, as the widely followed technical gauge called “relative strength index” or RSI, which measures the strength of a stock’s price action, has increased above the threshold signifying overbought conditions. While the RSI is not at its extreme at the moment it is worth watching closely, as it can hint at an immediate stock-market direction change when taken in the context of other indicators. When the RSI reaches the extremely overbought level, it may signal an increased risk of a strong correction when volatility strikes.
Second, speaking of stock market volatility, it is currently virtually nonexistent according to the CBOE Volatility Index. The index, better known as the VIX or “the fear gauge,” is calculated using S&P 500 (SPX) options to reflect the implied volatility over the coming 30 days. In December, VIX dropped to its lowest levels since January 2020, hinting at an extreme tranquility in the markets. However, this level of investor complacency at a time when there are still many dangers lurking around could also pose a warning sign.
Third, the investor sentiment is flashing “extreme greed” at the moment. In the span of just a little over two months, from the end-October to the end-December 2023, the market sentiment shifted from very bearish to extremely bullish. The CNN Business’ iconic Fear & Greed Index, widely used as a contrarian indicator, switched its display from “fear” to “greed” in mid-November, and has been powering up since, reaching extreme levels in December.
Of course, none of this implies an impending crash, but after a stellar 2023, this year investors should tread carefully, weighing contrarian data against the market lull.
What if the Fed Changes Its Mind?
As the inflation rate tumbled down from its June 2022 peak of 9.1% to 3.1% in November 2023, the markets have become increasingly convinced that the Fed has won its battle to quell price increases. Policymakers apparently came to the same conclusion at their latest meeting in December, signaling an impending pivot in 2024, with the policy outlook penciling in a total of 0.75% in rate cuts this year.
Notably, almost half of the SPX’s annual increase was reached in the last nine weeks of the year, when the easing was already clearly on the cards. If the economic data points coming in during the next few weeks strengthen this assumption, then barring any unexpected events, the stock markets can continue their gains. Thus, investors are already getting jittery about the next inflation report due mid-January, as according to the Cleveland Fed’s estimates, December’s CPI has inched up from November, as if trying to prove that the fight is not over just yet.
According to CME Group Inc.’s (CME) widely used FedWatch tool, which measures market expectations for the Federal Reserve’s policy changes, investors are now pricing in an 85% chance of a rate cut in March 2024. In addition, derivatives traders are expecting much deeper interest rate cuts than what the Fed has signaled, pricing in a total of 1.5% reduction in 2024.
Herein lie two problems. First, investors may get restless waiting for the Federal Reserve to start cutting rates, especially if some data points coming out between now and March detract from the easing case, which could lead to sell-offs. Second, the amount of cuts expected by the markets befit a considerable economic slowdown, not the currently expected Goldilocks scenario, which leaves the markets prone to disappointment.
Meanwhile, some strategists predict that the U.S. economy may experience a dip in the beginning of 2024, basing their forecast on the contracting manufacturing activity, slower-than-expected rebound in consumer sentiment, and other factors. If the economy weakens substantially, this might prompt larger and faster rate cuts, but I strongly doubt that in this case they will be cheered by the markets.
Damned if You Do and Damned if You Don’t
The S&P 500 earnings-per-share (EPS) have been falling on a year-on-year basis since Q3 2022, with the earnings recession ending in Q3 2023. Analysts expect another small year-over-year EPS increase in the last quarter of last year, which would bring the total 2023 EPS growth to a tiny, but still positive, change of +0.6%. As for this year, the outlook is considerably brighter, with the expected rebound of earnings growth to double-digit figures and the expansion of net profit margins. Moreover, all S&P 500 sectors without exception are expected to produce strong EPS growth this year.
These lofty expectations pose a high bar for companies to clear this year; even a small mishap could produce a sell-off out of discouragement. That is also true regarding the Federal Reserve’s strong easing pivot, as well as the continued robustness of the economy.
Wall Streeters love the saying “buy the rumor, sell the news” – which means that the high expectations may be baked into stock prices already. In other words, the markets have already bought on the rumors of the Fed easing even before the central bank had signaled the pivot. If the Fed delivers according to expectations, traders may well “sell the news”, taking profits. If the policymakers do not announce cuts in March, a strong sell-off of disappointment is on the cards. As for the earnings, the situation is even more difficult, since the companies are expected to exceed analyst projections, while simply producing an in-line number usually leads to declines.
The Takeaway
Stocks are moved by fundamentals, sentiment, rumors, expectations, and a myriad of other factors. It always pays to watch out for economic and market signals, especially when complacency is high, and exuberance prevails.
In the end, great companies will outperform over the long haul. As for the short term, watch out for signs of trouble, but do not panic. Even if the markets unexpectedly crash, that will just mean that stocks will offer more value at lower prices. A great financier Nathan Rothschild said in 1815: “Buy when there’s blood in the streets and sell to the sound of trumpets.” Let’s hope that 2024 will bring a strong rally with it, but if it does not, there will be ample chances to buy.
