By Gerrit Smit, manager of the Stonehage Fleming Global Best Ideas Equity fund
Stockmarket performance until recently has been concentrated in a small number of predominantly technology-driven stocks. While performance has since started to broaden to a wider universe of neglected companies, investors must brace for an uncertain outlook over the second half of the year.
Returns over time are mainly driven by earnings expectations, so expect the focus to remain on operational business results and the outlook from company management. With valuations relatively high, any disappointment will get severely punished.
In our view, these are the key issues that are going to determine the stock market outlook in the second half of 2024.
The US election
Even with Joe Biden now out of the race, a potential second term under new Democratic leadership is expected to deliver few surprises and a stable economy. But with a 60% expected winning odds ratio (according to the US PredictIT index), the market must consider the implications of a Trump victory.
This could be a tale of two halves. A Trump administration is expected to bring economic stimulus with lower taxes and less regulation. This may assist in keeping the US economy from falling into recession and support the stock market.
But more protectionism and tariffs will affect inflation to the upside and keep interest rates higher for even longer, negatively affecting the consumer and prolonging uncertainties for, in particular, the building industry.
The US economy
There are signs the US economy is slowing. Employment data is starting to soften, with new employment and wage growth numbers slowly dropping, and the unemployment ratio increasing above 4%. Some PMI Indices indicate contraction and there are signs the US consumer is getting weaker.
Against this, the Conference Board index of 10 leading economic indicators have turned upwards and we believe with careful management a ‘soft landing’ scenario can prevail.
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This scenario will help inflation and interest rates to continue their downward trend and support the share prices of those companies that can continue delivering good earnings growth. This is expected to be the case for sectors like technology and healthcare, while some industrials, financials, discretionary and staples companies could also deliver well. More cyclical type of businesses under industrials, commodities and auto will find it difficult to keep growing.
Earnings results
Overall S&P 500 index earnings are currently growing at 2%. This is largely skewed towards technology and communications, specifically those companies participating in the digital revolution.
While these are expected to maintain earnings momentum in the second half of the year, we expect results to broaden out on a low base for some other sectors, with health care and consumer discretionary the main beneficiaries.
More broadly, the consensus expectation for S&P 500 12-month forward index earnings is currently accelerating at a two-year record level of 13%. This reflects growing confidence in operational performances of US companies. Should this trend continue, it would support the stock market for the rest of this year.
Valuations
The S&P 500 forward P/E ratio at a 21 multiple is over a quarter above average. This perceived excess valuation contributes to the risk of a negative reaction should a business disappoint on earnings. Yet we would argue that valuations are relatively fair.
Share prices closely follow analyst bottom-up valuations over time. The S&P 500 valuation is currently growing at a strong 23% following the accelerating earnings picture and an improving backdrop of lower interest rates. The current index upside is up 10%, slightly below the 10-year average upside of 12%.
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In terms of specific-stock valuations, some fear the perceived high earnings valuations of many technology related businesses. We believe this should be put in context of their earnings outlook, and rather consider their PEG valuation ratios (expected compounded growth divided into the P/E ratio).
As examples, Microsoft is currently valued at a 2.7 PEG ratio, and Alphabet at a 1.9 PEG ratio. This compares to the MSCI World’s 2.6 and the S&P 500’s 2.5 respective PEG ratios. Relative to these indices, these stocks do not appear that expensive.
Stock ownership
Not to be ignored, the level of specific-stock ownership especially among very active managers (including hedge funds) has become a focal point for potential share volatility. Crowded ownership can potentially turn into additional underperformance should such a business disappoint operationally or in its outlook. Some technology related businesses currently fall in this category.
The phase of the US economic cycle is more important for stock market performance than the election outcome. The market currently has high expectations for operational delivery, as reflected in both earnings expectations and valuations.
The economy is in a late rather than an early cycle revival. Investors, therefore, must caution against any exuberance and rather err on the conservative side in considering existing holdings and new candidates for their portfolio.
All these favour quality growth as an investment style and astute investors may find good new buying opportunities in a potentially volatile market.
