Don’t Call Me Bearish… It’s Just Math

It may be a little early to make a stock market forecast for the end of 2024.

After all, we still have more than six weeks of market action left in 2023.

So today’s essay feels a little like putting up the Christmas decorations right after Halloween. We’re jumping over the festivities right in front of us.

But, as my lovely wife said as she watched me carry dozens of boxes of ornaments, lights, and nutcrackers up from the basement two weeks ago, “What’s the harm?”

Of course, our focus here in Market Minute is on the short term. We’re traders. We look for opportunities that are likely to play out over the coming days and weeks.

It does help, though, to keep a longer-term picture in mind. After all, if we think stock prices will be higher by the end of next year, we’re more likely to want to be a buyer of dips rather than a seller of rallies.

Vice versa if we think the stock market will be lower. And for 2024, I expect it to be more of a vice-versa year.

In other words, my forecast for 2024 is bearish. My year-end target for the S&P 500 is 4080. That’s about 10% below where the index closed on Friday.

It’s not because the economy is going to roll over and die. Or because interest rates will be sharply higher. And it’s not because World War III will break out. Forget about any of the things the ordinary bears are worried about.

It’s because of the math.

The math simply does not justify the S&P 500 trading at a higher level. Let me explain…

The consensus earnings estimate for the S&P 500 for 2024 is about $240. For most of my adult lifetime, the index has traded somewhere between 15-20 times its forward earnings estimate. That gives us a target range for the S&P of 3600 on the low end (15 times the $240 estimate) and 4800 (20 times $240).

And with short-term interest rates at 5%, it is unreasonable to expect the S&P 500 to trade at 20 times earnings.

Think of it this way…

If we buy a business for 20 times its annual earnings, it will take 20 years to recover our original investment. That’s an earnings yield of 5% (20 years times 5% equals 100%).

Alternatively, we can put our money in a money market fund and make 5% each year without the volatility and systemic risk of the stock market.

Any rational investor is going to opt for the money market fund in this scenario.

So stock prices need to fall until the earnings yield on the S&P 500 is large enough to compensate investors for the added risk of being in the stock market. Either that, or short-term interest rates need to fall until a 5% earnings yield on the S&P 500 looks like a deal.

Since the Fed has repeatedly said interest rates will be “higher for longer,” it seems unlikely rates will fall much in 2024. So, we have to expect lower stock prices.

With short-term rates at 5%, I’ve calculated a “fair” earnings yield for the S&P to be 6%.

There’s a variety of reasons for this. Most of them are boring mathematical functions that are much too dry to list in an e-letter. Suffice it to say that the 1% difference in yield is enough to fairly compensate investors for the risk of being in the stock market versus the perceived safety of a money market fund.

To get a 6% earnings yield on the $240 forward earnings expectation for the S&P 500, the index will need to trade for slightly less than 17 times earnings (100% divided by 6% equals 16.7).

And $240 earnings times 17 gives us the price target of 4080 on the S&P.

So that’s my year-end forecast for 2024. It’s about 10% below the current level on the S&P 500.

I guess you can call me bearish for next year.

But it’s not because of the plethora of reasons most bears will point to. Or because of some inherent bias to the short side.

It’s just math.

Best regards and good trading,

Jeff Clark

How are you preparing to trade in 2024?

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