Written by: Washington Crossing Advisors
Global stocks rose last year, as did the S&P 500 Index. The market value of global stocks now stands near $106 trillion, and the market value of U.S. companies is roughly $48 trillion.
While both global and domestic stock indices advanced thus far in 2023, it is important to remember the advances come on the back of approximately 20% declines in 2022. Accordingly, as of the time of this writing in early December 2023, equity markets are still below levels achieved in 2021.
Narrow Leadership
The S&P 500 measures the performance of the largest domestic companies in the United States. Increasingly, that performance has been dominated by a handful of global technology giants. From January through November of 2023, for example, the top dozen stocks by size in the S&P 500 contributed over 16% of the S&P 500’s 20% return. By contrast, the average performance among the 1,000 largest U.S. stocks was about 4%. So, while we were pleased to see some positive results from the stock market in 2023, we see that a narrow set of companies drove the advance.
Before we make too much of the success of these dozen companies, we must also tell you that the same companies registered declines of anywhere from 40-65% the prior year. These are huge year-to-year swings for companies that increasingly dominate the success or failure of the leading benchmark for U.S. stocks. These dozen companies are collectively valued at over $15 trillion, with some individual market capitalizations reaching over $3 trillion. Moreover, the returns of the stocks are highly correlated with one another, and they are just about all technology companies.
Such a heavy concentration in so few companies means that the level of diversification in a single equity index is less from what it used to be.
Big Profits
An analysis of the composition of one of the world’s most iconic equity indices would be incomplete if we ignored fundamentals.
Supporting the $40 trillion index are some very profitable businesses. We estimate that the 500 companies’ revenue of over $15 trillion accounts for more than half of the annual output of the entire U.S. economy (currently $27 trillion). The sales of the dozen largest companies in the S&P 500 by market capitalization are about $2 trillion. The size of the largest companies not only holds sway over the performance of the S&P 500 but also accounts for a substantial portion of the total output of the entire economy.
A pickup in profits helped lift the market last year from January through November, just before the writing of this report. Through November, the S&P 500 returned about 21%. Roughly 6% of the return is directly attributable to an increase in forecast S&P 500 per share profits by analysts during the year. Another 2% can be attributed to dividends paid. The remaining 13% resulted from a rise in the price-earnings multiple paid.
But why did the multiple rise, you ask? For most of the year, interest rates rose, so rising multiples are not easily traced to falling interest rates. Instead, it appears that investors’ appetite for risk increased. As a result, the premium charged for taking on risk, especially in large mega-cap companies, fell during the year. In essence, the market concluded that large-cap domestic stocks were attractive because starting valuations seemed reasonable and because hope emerged that an economic “soft landing” could be achieved.
Positioning
As we start 2024, our read of incoming data has been primarily positive. The economy has been expanding, although higher interest rates are beginning to pressure some parts of the economy. In the months ahead, we will be watching what happens to areas such as housing and manufacturing, each struggling with a shortage and an excess of inventory, respectively. Another area of interest is capital investment, which is typically a good indicator of business trends and the profit outlook. Here, we see positive signs.
In the year ahead, challenges for the equity market could emerge from several places. As interest costs, labor, and other inputs rise, profit margins will likely come under pressure. The current margin of 13% is likely to come down to 11% as this process unfolds.
S&P 500 FORWARD 12-MONTH PROFIT MARGIN
Source: Washington Crossing Advisors, LLC | Past performance is not indicative of future results.
Also, we are starting the year with the S&P 500 trading at over 19x forward earnings. This multiple is about 20% higher than our long-run expectation of 15x.
S&P 500 FORWARD 12-MONTH PRICE/EARNINGS (P/E) RATIO
Source: Washington Crossing Advisors, LLC | Past performance is not indicative of future results.
Consequently, we see profit margins and multiples as exerting a headwind for stocks.
On the other hand, some growth in the economy, a modest rate of inflation, ongoing share repurchases, and dividend payments could be enough to offset headwinds over time. The chart below shows how we envision the various long-run drivers of equity market return contributing to our long-run equity market return expectation.
FORWARD-LOOKING FACTORS CONTRIBUTING TO LONG-RUN (10 YEARS) EQUITY MARKET RETURN ASSUMPTIONS
Source: Washington Crossing Advisors, LLC. Assumptions are estimates based on historic performance of the above factors looking back the previous 15 years and an evaluation of the current market environment. These are estimates only and not intended to represent future performance. References to future expected returns and performance do not constitute a promise of performance for any asset class or investment strategy. The forecasts contained herein are for illustrative purposes only and not to be relied on as advice or interpreted as a recommendation to engage in the purchase or sale of any security or financial product. Margin and valuation adjustments assume normalization measured as annualized log return differentials over our forecast horizon.
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