April Private Client Letter
/Welcome to a new calendar quarter. With the month of March coming to an end, the S&P 500 posted its fifth consecutive month of gains as corporate earnings remain resilient and the consumer continues to spend money. The index is now higher by about 10% for the first quarter and a staggering 28% since the rally began in late October of last year.
An expansion of the Price/Earnings multiple has largely been the source of this market appreciation as corporate earnings have increased only modestly during this time. Valuations now stand at 21.5x for the S&P, up from 17x just five months ago. Forward earnings expectations are robust to say the least, and a momentum trade has developed in the stock market that has seen investors crowding into a short list of the best-performing stocks.
The cyclically adjusted price-to-earnings ratio, commonly known as CAPE, or the Shiller P/E Ratio, is a valuation measure applied to the S&P 500 and is defined as price divided by the average of ten years of earnings (moving average), adjusted for inflation. This Shiller P/E stood at 34x in March and ranks in the top 1% of history. It is important to note that there has never been a sustained rally starting from a 34x Shiller P/E.
Narrow markets driven by multiple expansion and momentum are particularly difficult to navigate. As equities continue the momentum driven climb higher, the risks of a correction begin to build. Many positive assumptions are now priced into equity prices leaving few sources for upside surprises. Eventually something triggers repositioning or deleveraging among the bigger players and investors experience a rapid unwinding of the rally.
In a recent whitepaper entitled THE GREAT PARADOX OF THE U.S. MARKET!, famed investor Jeremy Grantham observed “Prices reflect near perfection yet today’s world is particularly imperfect and dangerous.” In the paper, Grantham goes on to discuss the current convergence of a number of troubling issues that only a few years ago appeared further out on the horizon. Grantham states, “The stark contrast between apparent embedded enthusiasm and these likely problems seems extreme, illogical, and dangerous.”
Expectations also remain high that the Fed will soon begin cutting interest rates even as the current rate of inflation has not yet dropped to the Fed’s target level of 2%. From our perspective, monetary conditions do not appear particularly restrictive as economic activity proves durable. The final accounting of real 4th quarter GDP growth was revised higher to a rate of 3.4% from a prior estimate of 3.2%. The higher overall number can be attributed to upward revisions to consumer spending on services, along with commercial construction, and government purchases, which more than offset downward revisions to inventories and net exports.
If the rate of growth for the U.S. economy continues at above trend levels, we see little need for the Fed to cut the discount rate – especially as the rate of inflation remains elevated.
While the Conference Board’s Leading Economic Index® (LEI) for the U.S. increased by 0.1 percent in February 2024, it has signaled a pending recession for almost two years. The inversion of the 10-year and 2-year U.S. Treasury notes that began on July 6, 2022, now stands as the longest on record and is more than double the average length of inversion going back to 1976.
Since 1976, there have been six times where the yield curve has inverted for more than 30 days. Each time a recession followed, with the only exception being the 1982 inversion where the economy was already in recession. The average lead time from inversion to recession is 15 months, with a minimum lead time of 10 months and maximum of 18 months. Notably, the S&P 500 Index hit a new all-time high during four out of the five inversion periods where a recession followed (First Trust).
For a little more than a year we have believed the threat of recession was quite real, prompting us to maintain a neutral posture relative to equity weights in our strategies. We also believe the rate of inflation will remain well above the Fed’s target of 2% longer than many investors have been hoping for. And lastly, we see a wide range of exogenous and asymmetric risks that investors appear to be ignoring. Unfortunately, this does little to boost our confidence in the recent record highs.
We have enjoyed a bull market move driven by momentum and the consensus expectation that the Fed is poised to deliver multiple interest rate cuts. While the gains have been impressive, we have grown skeptical over a market that now appears priced for perfection. Alas, knowing exactly when a bull market is about to lose steam and consolidate is impossible. The best we can do is focus on diversified value, avoid actions predicated on the fear of missing out (FOMO), and exercise patience as the story plays out.
We will continue to monitor the economy and markets very closely. Please feel free to contact us directly should you have any questions or concerns.
John E. Chapman
Chief Executive Officer
Chief Investment Strategist
Disclosures:
THIS COMMENTARY HAS BEEN PREPARED BY CLEARWATER CAPITAL PARTNERS. THE OPINIONS VOICED IN THIS MATERIAL ARE FOR GENERAL INFORMATION ONLY AND ARE NOT INTENDED TO PROVIDE OR BE CONSTRUED AS PROVIDING LEGAL, ACCOUNTING, OR SPECIFIC INVESTMENT ADVICE OR RECOMMENDATIONS FOR ANY INDIVIDUAL. ALL ECONOMIC DATA IS DERIVED FROM PUBLIC SOURCES BELIEVED TO BE RELIABLE. TO DETERMINE WHICH INVESTMENTS MAY BE APPROPRIATE FOR YOU, PLEASE CONSULT WITH US PRIOR TO INVESTING. INVESTING INVOLVES RISK WHICH MAY INCLUDE LOSS OF PRINCIPAL. This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities, insurance products, or to adopt any investment strategy. The opinions expressed are as of the date of writing and may change as subsequent conditions vary. The information and opinions contained in this material are derived from proprietary and nonproprietary sources deemed by Clearwater Capital Partners to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. Past performance is no guarantee of future results. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this material is at the sole discretion of the reader. Investment involves risks. International investing involves additional risks, including risks related to foreign currency, limited liquidity, less government regulation and the possibility of substantial volatility due to adverse political, economic or other developments. Index performance is shown for illustrative purposes only. You cannot invest directly in an index. S&P 500 is a registered trademark of Standard & Poor’s Financial Services, a division of S&P Global (“S&P”) DOW JONES, DJ, DJIA and DOW JONES INDUSTRIAL AVERAGE are registered trademarks of Dow Jones Trademark Holdings (“Dow Jones”). The two main risks related to fixed-income investing are interest rate risk and credit risk. Typically, when interest rates rise, there is a corresponding decline in the market value of bonds. Credit risk refers to the possibility that the issuer of the bond will not be able to make principal and interest payments.
