US Strategy Weekly: The Underpinnings of Targets

How much potential or risk there is in stock prices is best explained by current and forecasted fundamentals, in our opinion. Momentum and sentiment can drive stock prices over the short-to-intermediate term, but over the longer term, earnings growth, or lack thereof, always underlies the trend of the equity market. For this reason, we sought to understand the underpinnings of the many S&P 500 forecasts of 5100 or 5700 for this year.

There are two simple components to any S&P forecast: the appropriate PE multiple and the earnings estimate. However, it is never that simple because both can be moving targets. As we noted in our 2024 outlook, our valuation model is a PE forecasting model derived from our expectations for inflation and interest rates. Our assumptions for 2024 are that inflation will ease to 2.75%, short-term interest rates will fall to 4.25%, and Treasury bond yields stay relatively stable at 3.6%. These are optimistic forecasts in our view; however, they fall well within the range of consensus forecasts. With these estimates, our valuation model indicates that the average PE for this year should be 18.5 times and the maximum PE multiple could be 21 times. A 21 PE multiple would be a possibility if inflation falls to 2% or less, since this would imply earnings growth is more “real.” In short, the model provides a broad range of possibilities.

When we take a multiple of 18.5 times and apply it to our 2024 earnings estimate of $234.00, a 10% increase from S&P Dow Jones 2023 estimate of $213.55, the result is an SPX target of 4330 for this year. If we use a maximum PE multiple of 21, we get an SPX target of 4914.

If we assume our earnings forecast is too pessimistic and use the IBES consensus estimate of $243.98 for this year, we get an SPX target of 4514 with an 18.5 multiple. To get to an SPX target of 5123, we need to use a maximum PE of 21 times and the IBES 2024 earnings estimate. This is a good explanation of why several strategists are using a 5000+ target for this year.

However, for those looking for even higher SPX targets, the forecaster must use not only a maximum PE of 21 times, but also the IBES 2025 earnings forecast of $274.59. This combination equates to a target of SPX 5766. In short, this exercise explains how one gets to an SPX target of 5100 or 5700, but it also reveals how much risk there is to these targets.

First, both targets assume stocks will reach and maintain a maximum PE which is likely only if inflation falls to 2% or less later this year. Second, an SPX 5100 forecast assumes that the IBES consensus earnings estimate for this year is correct. The risk here is that consensus earnings forecasts tend to peak early in the year, start to decline in March and then during each reporting season thereafter. This declining trend is rarely absent unless the economy is coming out of a recession. Analysts tend to be too pessimistic after a recession; and as a result, consensus earnings estimates are usually too low and increase during each quarterly earnings season.

Nonetheless, an SPX target of 5700 discounts not only a perfect year of low inflation but all the optimistic earnings growth expected over the next 24 months. There are many risks to these assumptions, the most obvious being that the economy may slow, revenues will decelerate, and earnings growth could disappoint. The first few days of 2024 have already been an adjustment to the overly optimistic view that there will be multiple interest rate cuts beginning in early 2024. And after analyzing the basis of the bullish targets for 2024 it becomes clear that every earnings season, every inflation report, and every FOMC meeting will be very important to substantiate the bullish forecasts for this year.

Employment Data

The 216,000 increase in payrolls in December was stronger than expected, but the unemployment rate was unchanged at 3.7%. Note that the unemployment rate for those with less than a high school degree has been rising and was 6% in December. Clearly, the lower-income worker was experiencing a more difficult job market at the end of the year. The household survey showed roughly a 1.5 million increase in people no longer counted in the labor force in December; meanwhile, there was a 460,000 increase in the number of people not included in the workforce but who indicated they want a job. Job growth was 1.75% in December, which is above the long-term average of 1.7%. However, job growth in the household survey was 1.18% and this was below the 1.5% long-term average for the first time since March 2021. In short, there were some signs of stress in the jobs data. See page 3.

Economic Data

The ISM manufacturing index improved slightly from 46.7 to 47.4 in December; however, the services index fell from 52.7 to 50.6. Since 50 is the breakeven level, the December services survey was indicating only modest economic activity. Perhaps more importantly, the services survey saw the employment index fall from 50.7 to 43.3 in December, the lowest reading since July 2020 and a sign that job growth has slowed or is declining in the service sector. The employment index in the manufacturing survey has been below 50 (neutral) since September. See page 4.

When we look at a variety of components in the ISM manufacturing index, it is obvious that most have been below 50 for most of 2023, a sign of weak economic activity. In the services survey, the overall trend was above 50 but slowly decelerating. The drop in the employment index may be a bad omen for 2024. See page 5.

The small business optimism index improved slightly in December, rising 1.3 points to 91.9. However, this reading was still the 24^th consecutive month below the long-term average of 98 and a sign of recession. In December, businesses indicated they were generally unhappy with the level of their inventories and indicated a reluctance to increase capital expenditure. Hiring plans also continued to decline. On a hopeful note, plans to raise prices appear to have peaked for most entrepreneurs. See page 6.

Technical Update The breakouts in all four of the popular indices were perpendicular and dramatic at the end of 2023, but only the Dow Jones Industrial Average managed to record an all-time high. The S&P 500 is most interesting since it has been fractionally away from recording a new high but is yet to better its January 3, 2022 high of 4796.56. The Russell 2000, after beating the key 2000 resistance, has now dropped below this level, which neutralizes the breakout seen at the end of the year. See page 9. The 25-day up/down volume oscillator is at 1.76 and neutral this week after being in overbought territory of 3.0 or higher for 22 of 25 consecutive trading days ending January 5. This indicator needed to remain in overbought territory for a minimum of five consecutive trading sessions to confirm the recent uptrend as “significant.” This is positive, however, weakness in the early part of a new year is often a warning sign of fading demand for equities. In sum, 2024 is apt to be a volatile and unpredictable year.

Gail Dudack

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