News in Charts: The concentrated resilience of the US equity market

With wage inflation returning rapidly to levels commensurate with a 2% inflation target, Fathom’s Global Outlook, Autumn 2023 singled out the US as the one major economy most likely to avoid a recession – indeed in our central case, it does just that. But, does the equity market reflect that US outperformance? In short, it does, with rich valuations of US stocks indeed reflecting this. The US market commands the highest earnings multiple (forward price-earnings ratio) in the last calendar quarter and that is not just down to positive sentiment. On the contrary, it mainly reflects that even after a bad year, where rising costs were threatening profit margins, corporate earnings remained high by either successfully passing costs onto consumers or by tapping more, better-placed existing or new markets. When the volatility of US corporate earnings remains low, even after an all-in-all challenging year, what investor wouldn’t perceive the risk of throwing money into US equities as low?

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The resilient corporate fundamentals is what helped US equity prices recover after the worst annual performance since the Global Financial Crisis (GFC). Interestingly, the relatively large 2023 drawdown indicates that the recovery did not occur at the onset of 2023 but actually materialised later still. Such resilience was therefore not taken for granted but, as Fathom’s chief economist Andrew Brigden outlined in an earlier recession watch, it had to be seen to prove itself, much like the rest of the economy.

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Rotations in corporate valuations can be tracked via earnings momentum — changes in forecasted future earnings — as well as on the rates at which these earnings are discounted. End-Q1 2023 saw a turning point, with indications being increasingly evident that the hiking cycle, then a year old, had neither curbed consumption or employment, while inflation remained on a downward trajectory. At that point, analysts started upgrading their earnings forecasts while, later still, discount rates indicated a slight fall. The indicative valuations based on these earnings forecasts, now discounted at lower rates, set the tone for a rosier US equity market performance for 2023. The heart of that tone seems likely to carry on beating if the relationship between the cyclically-adjusted price-to-earning (CAPE) ratio and future returns is to be trusted. By indicating cheaper cyclically-adjusted earnings when lower, CAPE points to further price appreciation in the next decade, on average. However, the devil is in the detail and, statistically, relations based on averages do not always materialise. Indeed, there are some points of note in the second chart below. In particular, we can see when lower CAPE was not followed by higher equity returns.

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Are there any weak links in the in 2023 performance? Professional analysts upgraded the long-term earnings forecasts of approximately half of the largest and most robust US companies. What is happening to the rest of corporate America? The truth is that a more comprehensive US sample is unlikely to have that proportion of positive future earnings views – forecasts there would have to be more timid, as companies are far smaller.

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Additionally, the good performance we all seemingly focus on is concentrated to a few companies, which clouds any assessment of the fragility of the 2023 US equity market. So far this year, the S&P 500 has returned around 13% and, for that to be achieved, the proportion of the ‘Magnificent Seven’ — a new set of tech companies replacing the FAANG group, as artificial intelligence (AI) takes the world by storm — had to be increased by 7% (19.5% at the end of 2022 to around 27% now). We have now reached a point where the combined market capitalisation of the ‘Magnificent Seven’ represents around 40% of the remaining 493 stocks. A market that heavily depends on the performance of so very few stocks is a fragile market indeed. It is also a market with heightened fear of ‘bubbles’, where any negative shock is amplified. The spectacular outperformance of a few of late is reminiscent of the ‘dot.com’ bubble at the turn of the millennium. Then, as with now, considerable hype surrounds a handful of tech stocks that rose spectacularly within a short period. The problem was that it was a bubble where some of the stocks saw a dramatic rise, subsequently crashing out completely. We almost saw a repeat of that recently, as the second chart below shows. However, the launch of GPT 4 (at the 1084^th day of the event study chart) has turbo-charged the prospects of the ‘Magnificent Seven’, reversing the trajectory and placing a distinct separation between the ‘dot.com’ bubble and now, at least for the time being…

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Was that a shout out to not only the unparalleled resilience of corporate America but also the versatility and innovative spirit, which positioned it to best integrate AI into a pivotal, indeed transformational, role that would unlock higher trend rates of economic growth. Or, it just happen and then was super-hyped by today’s media? Is there something else brewing in corporate America that is potentially hidden behind the good aggregate performance? In an upcoming In-depth, Fathom examines the corporate sector for signs of trouble. We specifically delve into the world of financially constrained firms and how, when faced with hardship, such troubles may lead to widespread market upheaval.

The views expressed in this article are the views of the author, not necessarily those of Refinitiv Lipper or LSEG.

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