It was a memorable year for investors with exposure to American stocks. You did not have to be very smart to make a lot of money in 2023. US stocks barometer S&P 500 Index closed at 4,769, up 24.7% for the year. Nasdaq 100, the tech-heavy benchmark, was up 54.2% last year. It was a bumpy but spectacular rally that most investors did not buy into until the very end when they frantically helped themselves, sending the market nearly 16% higher in the last nine weeks.
The surge was a stark contrast to 2022 when S&P 500 was down 19% following a 28.7% rise in 2021, an 18.4% increase in 2020 and a 31.5% jump in 2019. If you had invested US$1,000 ($1,320) in an S&P 500 ETF five years ago, you would have more than doubled your money before reinvesting dividends. The period includes a horrendous 2022, a pandemic-induced recession in 2020 when the market briefly plunged 35%, as well as the fastest interest rate hike cycle in history.
Compare the S&P 500’s 102% total returns since 2019 to the Straits Times Index (STI) which was almost flat during the same five-year period and the FTSE Bursa Malaysia KLCI Index which was down 13.4%. During the past five years, Japan’s Nikkei 225 gained 71% and the Stoxx Europe 600 was up 39.6%. The US dollar’s strength since 2019 made the S&P 500’s gains even juicier.
Yet, past performance is no guarantee of future returns. So, how will US stocks do in 2024? The S&P 500 is currently trading at 19 times this year’s estimated earnings — just above its five-year average of 18.8 times and its 10-year average of 17.6 times. Most Wall Street strategists’ S&P 500 price targets are around 5,100 for 2024 or 7% higher than the index’s close at the end of 2023. Consensus earnings estimates for the current year are now around US$250, or up 12% over last year, and US$280 for 2025, up 8.5% over the current year’s earnings.
Pessimists believe that at this point in the cycle, the S&P 500 should be trading at around 17.6 times expected earnings for the next 12 months or at its 10-year average. Those earnings multiples would put the index about 8% below where it is now. Optimists, for their part, argue that the US recovery is well underway, margin improvements have yet to be factored in and the tailwinds of generative AI will deliver higher productivity growth, all of which will lead to stronger earnings. London’s Capital Economics believes the S&P index could reach 5,500 by the end of this year once investors factor in upwards earnings revisions.
See also: 2023 demonstrated the importance of US equity exposure for Asia's investors
All about margins
Powering S&P 500 earnings are increasing profit margins and robust share buybacks. Listed US firms bought back over US$1 trillion worth of their own shares in 2022 and the pace of repurchases shows no signs of abating. Profit margins are another overlooked tailwind. Top homebuilders Lennar Corp, DR Horton and PulteGroup reported record margins amid higher interest rates that dampened demand. Here is how they do it: During the pandemic, supply chain disruptions sent raw material prices soaring. Prices of lumber, a key home building component, rose from US$550 per thousand feet pre-Covid to US$1,700 in May 2021, pushing new home prices skywards. Lumber prices have since fallen to below where they were at the start of the pandemic even as home prices have risen. Homebuilders refuse to cut prices even as material costs decline. The fall in other costs far outweighs any increase in labour costs. That gives top US home builders gross margins of around 26% compared to 20% pre-Covid.
Prices of everything went up during pandemic lockdowns due to supply chain bottlenecks and raw material shortages. Now, as they fall back to pre-Covid levels or lower, margins are on the mend. The only way margins can go down is if firms slash prices of whatever they make which will lead to rate cuts as runaway inflation turns into deflation. Central bankers fear deflation almost as much as they fear inflation.
See also: This isn't your father's S&P 500. Don't worry about valuations
Apple Inc, the iPhone maker, has grown its gross margins from 38% five years ago to 45.2% currently. Despite its growing services business, Apple is a hardware company. The narrative around Apple has been that it is aggressively buying back shares which pushes up its earnings per share. That in turn helps boost its stock price. But look no further than its expanding margins to see how Apple has remade itself. Apple is not only sourcing cheaper components and raw materials, it is making more of its components itself, like its own silicon. Burger chain McDonald’s has grown its gross margins from 50.8% pre-pandemic to 57% currently.
Another way to look at EPS growth is through the dramatic transformation in the composition of US earnings. America is a services-based economy. Over 75% of the US economy is now services, 19% is manufacturing while agriculture and everything else is the rest. During the 2020–2021 pandemic lockdown, Americans consumed less services and more goods. They bought more laptops, smartphones, refrigerators and sofas online. They could not fly on planes, stay in hotels or go to restaurants, concerts or theme parks. Over the last two years, it has been revenge travel, hotels bursting at the seams, sold-out Taylor Swift concerts and jam-packed theme parks and restaurants. That process is now reversing — again. Revenge travel is so last year. Sold-out concerts sound like 2022 and 2023. Americans are quietly reverting to buying more goods than services.
Here is why that matters: The stock market is not the economy. The composition of where the S&P earnings and revenues come from does not mirror the US gross domestic product or GDP. American economy may be 75% services but just 35% of S&P’s earnings come from services. Most of the remaining 65% of the profits come from industrial firms. With the onshoring boom as corporate America brings back more manufacturing home from China and elsewhere, services share of the total pie will continue to decline while the share of industries will grow, indeed, even more so as the US goes from paying more for services to buying more goods over the next few years. Onshoring also boosts capital expenditure that US firms have deferred since the start of the pandemic. Chipmaker Intel Inc is spending US$100 billion on US plants with help from the US Chips Act. Its stock was up 88% last year.
The revival in the global economy will be another tailwind for US earnings. The US has been the engine pulling along low-performing economies like Europe, developing Asia and Latin America. Now, recovering Europe and Asia are doing their part even as the US starts to slow. American companies are global by nature. Over 40% of S&P 500 total earnings come from outside the US. As economies around the world rebound, so will global corporate earnings. That will help S&P’s overall earnings. The better China’s or Europe’s or the economies of the rest of Asia do, the better growth there will be in the earnings of the S&P 500. And, oh, the strong US dollar had weighed on S&P’s earnings for years. Now a weaker dollar is putting winds in the sails of American firms’ earnings.
Normally, during a downturn and with rising rates, corporate cash flow plummets. As interest rates rose over the past year, US corporate cash flow actually touched a record high of US$3.4 trillion in the July-September quarter. Companies with growing hoards of net cash on their balance sheet — or all of the large capitalisation tech firms — are now earning a good yield on their cash. Apple, Microsoft and Google’s owner Alphabet, which earned less than 1% on their US$75 to US$100 billion net cash, can now earn 5% on short-term money market instruments and 4.5% on long-term Treasury bills.
Over the past three decades, America has built the most innovative, flexible and efficient companies on earth. California’s Silicon Valley is home to the most vibrant venture capital ecosystem and the most valuable tech start-ups on earth. Of the 1,400 or so unicorns, or private firms with a value of over US$1 billion, 58% are American. Of the world’s top 20 listed firms by market capitalisation, 18 are American. Disruptive technology, like generative AI, is boosting productivity and the biggest beneficiaries of the new productivity boom are not European or Chinese firms but lean and mean American ones.
Here is how American capitalism works: When things go bad, companies fire more people than they need to, cut costs more aggressively than they have to, and embrace new technology faster than they want to, which is the way they are backing AI right now. So, when things turn — and they always do because downturns or rate hikes don’t last forever — earnings rebound with a vengeance, triggering a bounce back in stocks.
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In contrast, companies in Europe and Asia are often reluctant to fire staff just because they see a slowdown looming, often drag their feet on painful corporate restructuring and are unwilling to jump into untried and untested emerging technology because they do not see immediate paybacks. That leads to more efficient and future-proof firms led by CEOs who care about shareholders in the US and more bloated ones overseas. Demographics is another tailwind. Japan has an ageing population as does much of Europe and China’s demographics have started to turn for the worse. Among the larger economies, only the US and India are likely to reap the benefits of a demographic dividend.
America may not have Europe’s cathedrals, castles, classic paintings like the Mona Lisa, Dubai’s skyline or Singapore’s infrastructure but it has built trillion-dollar tech behemoths at the cutting edge of innovation. “Apple is our Colosseum, Microsoft our Taj Mahal, Google our Sistine Chapel, Amazon our Notre Dame [and] Nvidia our Eiffel Tower,” financial blogger Ben Carlson, recently wrote.
Buy now or hoard cash?
Make no mistake, there is plenty that can go wrong this year as investors turn to a new 2024 playbook. Fed’s aggressiveness over the last two years and a delay in cuts could lead to a shallow recession. Meanwhile, geopolitical concerns — the Middle East, Ukraine and Taiwan— are still lurking. Yet markets are a discounting mechanism. Over the past year, they have climbed a huge wall of worry. The thing about scaling high walls is that once you are on the other side you are less wary of heights. Expect some rotation away from the tech giants to mid-cap and small-cap stocks as investors move from money market funds which hold about US$5.9 trillion in assets to raise their exposure in stocks again.
Have stocks gone too far, too fast lately? Probably. But that is no reason to be on the sidelines holding cash this year. Investors make money not by timing the market but by their time in the market. Last year, US$1.3 trillion flowed into US money market funds from equities and savings accounts that paid almost nothing as money market yields rose to 5.2%. Cash was the king as the Fed raised rates for 21 months. Now, as it cuts and markets touch new highs, the flight-to-safety trade is unwinding. The switchback will provide new tailwinds for stock investors.
Assif Shameen is a technology and business writer based in North America
