Eighteen months ago, the market outlook was dire. A recession seemed inevitable as inflation hit multi-decade highs, and spiking interest rates led to the worst year for stocks since 2008.
Fast-forward to early 2024, and the script has been flipped. Investors are pricing in a best-case outcome where earnings rise and inflation returns to normal in a continued economic expansion.
“All signs also point to a ‘Goldilocks’ scenario of resilient growth, low inflation, and easier policy being on the table,” wrote Solita Marcelli, the investment chief Americas at UBS Global Wealth Management, in a February 13 note.
The Goldilocks theory is fool’s gold
However, many market strategists are skeptical that solid economic growth and strong earnings can coexist with inflation that’s low enough to lead the Federal Reserve to reduce interest rates.
“We’ve just not been big believers in the current Goldilocks narrative,” said Sameer Samana, a senior global market strategist at Wells Fargo Investment Institute (WFII), in a recent interview. “We just don’t believe that you’re going to get all those things simultaneously.”
The six other market veterans Business Insider spoke with for this story largely concurred with Samana. Investors won’t be able to have their cake and eat it too, as one investment chief put it last week — meaning that either corporate profits or interest rate cuts are bound to disappoint.
“It’s a tough needle to thread,” said Steve Sosnick, the chief strategist at Interactive Brokers. “It really involves a lot of things going just right simultaneously. It’s not even just the Goldilocks economy — it’s sort of the Goldilocks everything.”
Unless everything goes according to plan in the economy, US stocks could get a haircut soon.
“The idea that we’re just going to get immediate, continued, unrelenting good news — inflation doing nothing but slow, profits doing nothing but rise, interest rates doing nothing but fall — that’s too much to ask,” said Steven Wieting, Citi Global Wealth’s chief investment strategist. “And I wouldn’t be surprised if we had a setback right now.”
Stretched valuations may cause stocks to stall
Even if stocks successfully walk the tightrope in a just-right economy, the market’s most bullish investment firms still don’t see a clear road map for further gains. The S&P 500 is already on the doorstep of the most ambitious year-end targets that strategists set heading into 2024.
Samana, whose firm boosted its S&P 500 target range last month to account for the massive rally to close 2023, warned that the index will be stuck in quicksand for the rest of the year.
“We’ve spent much of the last few weeks flirting with the upper end — even above the upper end,” Samana said. “And that pretty much pulls forward almost all the returns, in our minds, for 2024.”
Crit Thomas, a global market strategist at Touchstone Investments, has the same concern.
“I’m not bearish on the market, but it does seem like it’s pulled some of the future away and put it into the past,” Thomas said. He later added: “We’re not afraid of the market, but it’s hard to get too excited — at least in large-cap land.”
Pricey valuations are another reason the market has gotten ahead of itself, said Chris Galipeau, a senior market strategist at the Franklin Templeton Institute. He noted that the S&P 500’s 21x forward earnings multiple is well above its long-term average of 16.8x.
“When you take into context the order of magnitude of the recent move from the October lows, the S&P is up north of 20% — which annualizes at about 105% — and that pace is probably unsustainable,” Galipeau said. “And so at 21x earnings, there’s very little margin for error here.”
Fourth-quarter earnings mostly met measured expectations, as did forward guidance. But to maintain their hard-earned gains, stocks must continue to execute at a high level this year.
“Everything came through solid, which is good enough,” Sosnick said of Q4 earnings. “But I think we’ve also had a situation — as pointed out by that forward P/E — that there’s a lot of good news priced in and not a lot of room for error.”
Solid earnings may be masking the market’s warts, said Liz Ann Sonders, the chief investment strategist at Schwab. She noted that although the growth-focused Nasdaq Composite hasn’t had a 3% drawdown yet this year, its average component has experienced a 20% correction.
“If you only looked at the index level, you’d say, ‘Yeah, things look great,’” Sonders said. “But under the surface, there’s been a lot more churn and weakness distribution. So I think that may be telling a more accurate story than what you would pick up by just looking at the index.”
The market may be top-heavy and expensively valued, but that doesn’t mean stocks will sink anytime soon. Clark Bellin, the chief investment officer at Bellwether Wealth, said he’s less worried about valuations broadly and is more interested in seeing which sectors look cheap.
“There’s some things that may be artificially inflated,” Bellin said. “There’s other sleepy parts of the market that don’t make the news all the time, but there’s still some nice opportunities in. You may not see these huge pops in these particular sectors, but you’re still going to have some good growth.”
Inflation is on the right track, but don’t count on rate cuts yet
Stocks got crushed after news broke in mid-February that inflation topped estimates last month, which puts the part of the Goldilocks thesis regarding interest rate cuts in jeopardy.
Strategists expect the Fed to disappoint investors by lowering rates later than hoped. Before the year, the market was pricing in five to seven rate cuts, which was double the projection from the US central bank. If price growth persists, Samana said there’s a chance rates won’t fall at all.
Markets are now pricing in four cuts by year’s end, though they may still be overly optimistic.
“I don’t think the Fed feels any pressure to cut rates,” Galipeau said after the inflation report. “As we saw in the data in the CPI earlier this morning, the market got way ahead of itself.”
Sosnick agreed, quipping that investors won’t get the “immaculate disinflation” they were wishing for. Still, he believes that inflation is under control and is unlikely to surge higher.
8 top places to invest
The consensus among strategists is that stock-pickers should look for high-quality companies.
Firms with healthy balance sheets and plenty of cash on hand due to a strong free-cash-flow yield and high returns on equity and invested capital are worth prioritizing in this environment, according to Samana, Galipeau, and Sonders.
“This is not a time where you want to go down in quality,” Sonders said.
That focus on quality steers Samana toward large caps, but Wieting and Thomas believe mid-cap companies offer more bang per buck. Wieting highlighted cybersecurity stocks as having increasingly attractive valuations due to rapid earnings growth.
The Citi Global Wealth strategy chief said another industry to target is healthcare, specifically healthcare equipment. Healthcare companies have lagged again in 2024 after disappointing last year, though Wieting believes the defensive sector is overdue for a rebound.
Bellin from Bellwether Wealth said he isn’t sweating much about the economy since wages are rising and consumer spending is stable, though he favors defensive stocks like those in the consumer staples sector since they’re getting little love compared to companies tied to AI.
“Everybody wants to talk about artificial intelligence,” Bellin said. “They don’t want to talk about toilet paper.”
Firms that make household products might not be as flashy as AI, but they make products that consumers need in any economy. Bellin cited Clorox (CLX) as an example of a stock that fits this mold.
“We just bought some in the consumer staples area that people are going to continue to buy,” Bellin said. “They’ve got nice healthy parts — they’re just not fun to talk about; they’re boring. I think boring could be a place to be.”
