Investment Update Q1 | 2024
Q1 Review and Investor Letter
Stronger than expected profit growth along with investor enthusiasm surrounding the potential of artificial intelligence propelled equity markets during the first quarter of 2024. The S&P 500Ⓡ Index advanced 10% during the period, bringing its 12-month gain to 28%.
Riskier assets including high-beta growth names sharply outperformed during the quarter. Asset flows driven by prospects of sustained, above-trendline growth for well-positioned technology companies attracted investors.
On a sector basis, communication services stocks and technology beat the market, continuing their superior 2023 performance. Rising oil prices boosted energy shares and commodities. Defensive sectors including healthcare and consumer staples underperformed but still posted positive returns for the period.
Style-wise, large growth rose 13% during the quarter, trouncing large value which eked out a 1% gain for the three months ending March 31st.
U.S. markets continue to outperform global indices with the S&P 500Ⓡ’s 10% gain comparing favorably to advances of 4%, 6% and 2% for Europe, Asia/Pacific and Emerging markets, respectively.
Valuation-wise, with the S&P 500Ⓡ closing the quarter at 5230, the market is trading at 20.9 times the current consensus earnings forecast of $250 for 2024 and 19.4 times the CY 2025 forecast of $270. This represents an earnings yield of 5.15% on the CY 2025 forecast versus the current 10-year treasury yield of 4.4%. The implied equity risk premium of only 75 basis points, is well below the historical average, suggesting that equities are less attractive relative to bonds currently.
One offset here is the prospect of accelerating earnings growth which has historically produced solid equity market gains, notwithstanding the modest equity risk premium to bonds. The current consensus calls for nearly double digit earnings growth through the beginning of 2026, a trendline we believe will continue to support stocks in the intermediate- to long-term.
In our view, all this mandates both a research-driven active management approach as well as prudent diversification, both of which have been hallmarks of Roanoke’s strategy for the past four decades.
The Economy
The resilience of the U.S. economy in the face of continuous hikes in interest rates continues to surprise economists and policymakers; the economy and corporate profits continue to perform. Q3 GDP approached 5.0% with the final reading for the Q4 coming in at 3.4%. In January, most economists anticipated a slowdown in the first quarter of 2024 to 1.0%; since then, better than expected consumer spending and a pick-up in government outlays have contributed to stronger growth. As shown below, the Atlanta Fed’s GDPNow tracker points to a 2.5% gain for the first quarter with consensus forecasts for growth rising consistently between January and March.
Stocks rose despite higher than forecast inflation readings which tempered hopes for Fed easing in the near-term. Indeed, at the beginning of the year, bond market prognosticators had expected six rate cuts in 2024 including a 70% probability that the Fed would cut rates to 4.75% - 5.00% at the May 1st meeting. Currently, traders look for just 3 cuts in 2024 with near certainty that the Fed will leave rates unchanged at 5.25% - 5.50% at the May session.
As a result, interest rates have picked up modestly in the face of stronger growth, creating a headwind for bonds. Ten- and thirty-year treasuries fell 2% and 4%, respectively during the quarter. Over the past 12-months, the long bond is down over 11%.
Stronger economic growth has been powered by solid consumer spending, supported by a rosy employment picture. Unemployment remains at multi-decade lows and real wages have accelerated. At the same time, unit labor productivity has risen, though the pace of growth has moderated somewhat recently.
Outlook for Corporate Profits
Corporate profits defied expectations for an earnings recession in 2023 and estimates for both 2024 and 2025 have trended higher over the past several months. S&P 500 earnings for 2023 rose modestly to $223, current expectations anticipate a 12% gain in 2024 to $250 followed by an 8% gain in 2025 and, preliminarily, double-digit growth in 2026 to $270.
Bottom-up analysis supports this expectation for robust growth with the average S&P 500 company expected to deliver a revenue gain of 6% in the coming year with margin expansion producing double-digit improvement in EBITDA. Moreover, some of the largest companies are forecast to grow even faster.
Credit Markets and Inflation
Faster economic growth and sustained strong hiring have tempered expectations for substantive reductions in the Fed Funds rate at least in the near-term. The ten year treasury yield started the year under 3.8% and has crept up to nearly 4.4% currently.
It seems to us that inflation is likely to remain elevated relative to the Fed’s 2.0% target. Core inflation is running a bit hotter than the headline figure with shelter costs rising close to 6.0% in February.
Market Implications
At the beginning of the year, the prospect of more accommodative Fed policy along with moderating inflation and solid earnings growth supported our constructive posture toward equities. With stocks advancing smartly in the Q1, valuations are elevated; at the same time, faster economic growth and a surprisingly robust labor market have dampened expectations for prospective rate cuts.
In our year-end letter, we noted our view that market participants had perhaps overestimated the speed with which the Fed would lower interest rates. We highlighted the risk for margin compression in light of reduced corporate pricing power as inflation moderates; this latter concern has yet to materialize. In fact, margins have exceeded expectations and earnings forecasts have been upgraded.
One additional observation on current market dynamics is the unusually large divergence of performance between styles and even within industries. This market environment makes passive investment strategies particularly imprudent. Roanoke’s style of appropriate diversification, tax-aware portfolio construction and a long-term investment orientation provides important ballast to windward in uncertain times. Our ability to identify winning business models over the long-haul, irrespective of macro considerations, which are currently very much in flux, is particularly impactful today.
As always, if we can clarify or elaborate upon our current thinking, please be in touch. We like hearing from you.