Contracting Equity Risk Premium

As we enter first quarter earnings season (banks will start off the reporting season), we can look back fondly on Q1 24. When the fourth quarter reporting period ended, the earnings growth rate finished up 4.3% (revised from -1.4% on January 26). The S&P 500 finished up 9.4% for the first quarter 2024. Not a bad start to a year that many economists had predicted would produce a hard landing leading to recession.

So where does the first quarter earnings growth rate stand today? It is at 2.9%. Certainly not a recessionary reading and likely to be revised up. Why the relative earning strength you might ask? The main reason is economic strength. The economy hasn’t followed form with the history of tightening cycles. Despite the Fed raising rates eleven times between March 2022 and July of 2023, the economy defied predictions and continued to grow. Remarkably, the economy is even showing signs of strengthening. One could stake a claim on that assertion by pointing to the S&P 500 closing at a record high at the end of the first quarter while interest rates were going up. The U.S. post-COVID recovery leads the world and domestic markets have significantly outperformed those of Europe, China, or most other developed economies. Current predictions call for the Fed to lower interest rates two times in 2024 with a slight chance that we see a quarter point reduction by mid-summer.

The timeline, though, keeps getting pushed out. One can argue that the economy would continue to grow, at a modest pace, even if the Fed kept their current level of 5.00% to 5.25% through the remainder of the year. Since the stock market has priced in one to three quarter point cuts, price increases could pause while earnings continue to grow. Since some companies are trading at relative historical premiums, we could see a contraction in the market weighted price earnings multiple.

A couple of thoughts, 1) Not all companies are trading at rich multiples. Relative out performance in the technology, communications and healthcare sectors (crowded trades) has created relative value in underperforming sectors. The S&P equal weight index trades at a significant discount to the S&P market weighted index. European equities are trading at a near historical discount to U.S. equities. 2) Higher interest rates are terrific for fixed income investors and savers. Earning 4.5+% in a money market is a welcome relief from the 0% regime leading into 2022. We always preach the gospel of long term investing and compounding for the simple reason that it works.

Although we’re not oblivious to the challenges ahead, there’s lots to look forward to in the advent of artificial intelligence. We think it can and will be transformative. All aspects of the economy are impacted, from drug discovery to climate modeling to the re-engineering our industrial economy. Rather than second guess the market or it’s near term price movements, we instead will take advantage of higher rates while they last and, if available, better price points to add to the existing positions and establish new ones.

To wrap up, as we maneuver through the market's ups and downs, we remain steadfast in our investment strategy, envisioning a future defined by mutual success. Should you have any questions, please don't hesitate to reach out.

Regards,

Ken and Michelle

1. Briefing.com, April 5, 2024

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