The Bull Market Climbs a Wall of Worry

Wall Street proverb, anonymous, 1950s

Sir John Templeton

For many in the investment business, the question we are asked most frequently is, “Where is the market going?” Or phrased another way, “What do you think about the stock market?” One would think this is a very appropriate question to direct to investment professionals, who spend a very large percentage of their waking hours analyzing companies, industries, sectors of the stock market, the stock market itself, and quantitative indicators. When asked this question, many investment professionals give responses that sound knowledgeable regarding the direction of the market. They do so either because they actually believe they can accurately forecast the short-term action of the market, or because it might be embarrassing to admit that they don’t know.

At Bradley, Foster & Sargent, Inc., however, we are not embarrassed to admit that we do not know where the stock market is headed over the short term. We also freely admit that we don’t know in which direction gold, bitcoin, or the dollar are headed. And we find ourselves in good company in this regard, as iconic investors such as Warren Buffett, Peter Lynch, and John Templeton all believe it is impossible to predict the direction of the market in the short term with any degree of regularity. We do believe, however, that we can forecast with some degree of accuracy the total return of the U.S. stock market over the long term (30 or more years), as there is a great deal of empirical data to draw on over the past 200 years. Books such as Stocks for the Long Run by Jeremy Siegel provide a treasure trove of information about the historical returns of the U.S. stock market, as well as several other international stock markets. For example, the compound annual total return of the S&P 500 since its inception in 1926 is approximately 10% per annum, and unless grave changes are made to this experiment in democratic capitalism called America, it is likely that the long-term annual growth rate of the best companies in the U.S. stock market will be in the range of 10%.

But back to short-term forecasts. A year ago, the consensus among most professional investors, analysts, and economists was that the Federal Reserve’s determination to curb inflation in 2023 through the continuation of its program of raising the Fed funds rates would probably cause a recession and result in a decline in the prices of both stocks and bonds. This prediction appeared eminently reasonable, and we subscribed to this forecast as well, advising our clients that 2023 might be a rough year.

Well, as is so often the case in the stock market, the consensus was wrong. Investors believed that inflation would be difficult to bring down without draconian steps taken by the Federal Reserve. The Federal Reserve did, in fact, raise the Fed funds rate four times between February and July last year — the fastest series of rate hikes in 40 years. In doing so, the Fed brought the Fed funds rate to 5.25% to 5.50% — up from close to zero in mid-2021. But no recession materialized. In fact, real GDP in the U.S. grew an estimated 2.4% in 2023. One of the main reasons for this was the huge fiscal spending programs that emanated from Washington, which led to an increase in federal debt of $2.2 trillion in fiscal 2023. Due to this flood of money, the consumer fared reasonably well, as the spending added to the surpluses that had built up in their checking accounts from the $6 trillion from the U.S. government during the Covid pandemic.

With the consensus forecasts about a recession in 2023 being wrong, the projections for negative returns in the stock market in 2023 were wildly off as well. The chart below shows the performance of the S&P 500 Index and the Dow Jones Industrial Index in 2023:

As Sir John Templeton said in the quote at the start of this commentary, the stock market perversely often seems to advance during times of pessimism and skepticism, and tends to falter and even decline when there are no clouds on the horizon. Before diving into the many things that investors had to worry about last year and are still anxious about in 2024, it is helpful to describe why the market behaves as it does when investors are skeptical. Fundamentally, a bull market is a process rather than an event, as Austin Pryor explained many years ago in his newsletter, Sound Mind Investing. At the end of a bear market, there are few sellers of stocks at the margin. This was apparently the case at the end of 2022, after the S&P 500 Index had dropped -18.1% and the NASDAQ Composite was down over -32.5%. Most investors who had wanted to sell stocks had already done so. Thus, even a small number of buyers at the margin can begin a new bull market if there are comparatively few sellers. As prices rise, most skeptics continue to doubt; hence the “wall of worry.” But a few see better times ahead. As doubters incrementally convert to believers (buyers), prices continue to rise. A trend is established, and momentum investors jump on board. Prices rise further, reassuring still more skeptics, who buy stocks. And finally, when all the worriers are converted, the bull market is over. Why? Because everyone who wanted to buy stocks has already done so. There are now few new buyers at the margin, and the process is ready to unwind, as believers become skeptics (sellers) again at the margin, and stocks decline. And so the cycle continues ….

This “Wall of Worry” analysis deals primarily with investor psychology and the supply and demand for shares at the margin. This concept is important for investors to understand. It is also important to mention, however, that if investors’ dire forecasts actually turn out to be accurate, prices may indeed fall rapidly. If, for example, the administration in Washington had not unleashed the fiscal floodgates with trillions of dollars of spending, the U.S. economy probably would have experienced a recession in 2023 with lower corporate earnings, and there would have been a continuation of the 2022 bear market. And, if the U.S. economy does not experience a “soft landing” but rather enters a recession in 2024, triggered by the contraction in money supply (M2) over the past year and higher interest rates, it is quite likely that this “Wall of Worry” bull market will come to an end.

There was a lot to worry about in 2023, and most of these issues have not been resolved. In fact, if anything, there are even more things to worry about this year. There are dark clouds in every direction on the horizon. To make it easy, we have placed them into three categories: economic, political, and geopolitical, as follows:

• With unemployment in the U.S. below 4%, inflation may remain sticky, with the CPI staying above 3% during 2024.

• Sticky inflation could lead the Federal Reserve to maintain higher interest rates for longer; i.e., fewer than the three Fed funds rate cuts currently forecast. This, combined with the contraction in M2, might well cause a shallow recession rather than a “soft landing.”

• This recession would lead to lower corporate earnings in 2024; consensus 2024 operating earnings for the S&P 500 of $245 could end up flat at $225 or even lower for the year.

• The enormous fiscal deficit of $2+ trillion, and the total Federal debt of $34 trillion, could keep interest rates elevated as the U.S. Treasury scrambles to fund it. The yield on the 10-year U.S. Treasury note might well go back above 5%.

• With a slowing economy and flat corporate earnings, investors could become uncomfortable valuing the S&P 500 at a P/E ratio of 19.5. Accordingly, the market’s P/E ratio might fall to its historic average (when inflation is at 3%) of 17.5, leading to the S&P 500 trading around 4,000 — a drop of approximately 16% from its current level of 4,775.

• America has become a polarized nation with deep cultural and political divisions exacerbated by social media. This has increasingly led to acrimonious and inflammatory political debate with emotionally charged accusations by leading political figures. This could give rise to social and political turmoil during and after the coming elections.
• For the first time in American history, the two leading presidential contenders are 80-year-olds, each dealing with worrisome personal issues. The former President has been indicted four times and might even be sentenced to jail time before the election in November. The current President appears to be suffering from cognitive decline, which is often on display in public appearances. Investors worry about how the election will play out and whether the results of the election will benefit the nation over the next four years.

• The nation’s immigration laws are a nightmare. Over six million people have crossed illegally into the country since 2021 with many of the migrants ending up in the country’s largest cities, taxing their resources. Is the U.S. still a nation governed by laws?

• Russia invaded Ukraine 23 months ago. Each side appears to want to continue the war until total victory is achieved. It seems unlikely that either side will accomplish this. How can a diplomatic solution be achieved without emboldening Putin’s aggressive plans in Eastern Europe? Could things spiral out of control in Eastern Europe?

• Hamas attacked Israel over three months ago. The war in Gaza will likely last many months. In the meantime, regional conflicts are simmering with Hezbollah in southern Lebanon, the Houthis in Yemen attacking shipping in the Red Sea, and Iranian-backed militia attacking U.S. troops in Syria and Iraq. Will total war engulf the Middle East?

• China has increased its aggression toward Taiwan, routinely sending airplanes and ships into Taiwan’s sovereign airspace and waters. President Xi of China reportedly told President Biden during their recent meeting in San Francisco that China’s “reunification” with Taiwan is inevitable. A Chinese blockade of Taiwan or even an invasion would be disastrous for all parties concerned.

One would have thought that investor anxiety over these different issues would have caused the 2022 bear market to persist into 2023. Instead, there was a robust bull market in 2023, and many think that it will continue in 2024. Why? One of the reasons is that investors are still very skeptical. In 2023, while equity ETFs pulled in $388 billion, money market vehicles attracted $1.1 trillion of new money. That is a lot of dry powder saved up by anxious investors. As outlined above, there are indeed many things to worry about. But historically, this has always been the case. The stock market generally turns in positive returns in years with presidential elections. Weighing all the evidence, we are cautiously optimistic about the bull market continuing to climb the “Wall of Worry” in 2024, as long as one of the geopolitical scenarios above doesn’t lead to the U.S. engaging in armed conflict. But as stated earlier, forecasting the near-term direction of the markets is often a fool’s errand. We believe it is more prudent to establish a long-term allocation with a significant commitment to equities but with the understanding that there will be bumps along the way.