The US stock market rally extended during the first three months of 2024. The S&P 500 is up 30% since the October lows and 10.6% for the quarter, reaching April with twenty-two newly minted all-time highs. International equities trailed the US but were positive, up 5.7% and 2.1% for developed and emerging markets, respectively. Fixed income markets pulled back 0.8% as yields moved higher during the quarter.

US equities have been an exceptional market for investors. The following chart compares the S&P 500 annualized returns as of quarter-end to the index’s historical averages since 1936.

Source: JRM Investment Counsel, Morningstar Direct

The dark blue bars represent the current period returns as of quarter-end. The returns in gray represent the average of all rolling period returns since April 1st, 1936. For example, the 10-year historical average of 11.3% is the average of all 10-year returns, starting with 4/1/1936 through 3/31/1946, then 4/1/1937 through 3/31/1947, and so on.

Performance over the past year was driven mostly by market sentiment, with the index posting an impressive 29.9% return. Over short time periods, markets can swing dramatically. The data set supporting the bar chart above includes one-year returns ranging from -49.5% to 56.4%, yet produced an average return of 12.3%. Sequence of returns matter, especially for clients taking distributions from their portfolios in retirement or for other purposes.

Returns for the last 12-months have been outstanding, but negative returns in 2022 were a drag on 2-year results, leaving the index return of 9.5% below the historical average of 11.3%. Returns for the trailing five and ten year periods were 15.1% and 13.0%, respectively, considerably above historical averages.

Although the current 20-year return is below average, it is notable that despite multiple wars, the tech bubble, Great Recession, Covid pandemic and numerous other crises, the average 20-year return across all time horizons for the S&P 500 was 11.2%.

No two market cycles are identical, but as investors, it’s hard to look at the statistics and be pessimistic. Over long periods of time, a diversified portfolio of equities has been a phenomenal strategy for compounding wealth.

The chart below shows the average 10-year return for the S&P 500 Index (11.3% as shown by the light blue line) compared to rolling period returns (i.e. as of the most recent quarter-end, the 10-year annualized return was 13%) since 1936.

Source: JRM Investment Counsel, Morningstar Direct

Rolling period returns allow us to analyze return data over different market cycles and environments. Equity market performance, even when evaluating longer time horizons, rarely stays near its average. The most recent rolling periods have trended above average, but historically, 10-year returns for the index have fluctuated between both exceptional and sub-optimal results.

Over time, performance tends to gravitate towards the underlying fundamentals of corporate earnings and historical valuation multiples (such as the Price-to-Earnings (P/E) Ratio). Valuations are currently elevated, and last year, despite 6.5% sales growth across S&P 500 companies, cost pressures squeezed profit margins to a negligible 0.4% earnings per share growth.

Broadly speaking, economic expansions support periods of earnings growth while economic contractions cause earnings to stagnate or decline. Since 2000, S&P 500 earnings per share growth and market returns have closely tracked each other at an annualized rate of 7-8% (assuming reinvested dividends). For the most recent 10-year period, however, the market is up an annualized 13%, outpacing earnings per share growth of 7.8%.

The difference between 10-year returns and earnings per share growth is reflected in today’s P/E Ratio. The P/E Ratio is a multiple of how much investors are willing to pay for each dollar of earnings. In the short term, P/E ratios can be volatile, fluctuating with investor sentiment, but over the long-term, they offer insight into the market’s growth potential.

Currently at 21x forward earnings, the S&P 500’s P/E ratio is more than one standard deviation above the 30-year average of 16.6x. The market has priced in optimism regarding forward earnings, disinflation, economic growth, and favorable Fed policy.

Despite revising inflation and GDP growth upwards and reducing its unemployment rate forecasts at the March meeting, the Fed maintained its projection for three rate cuts in 2024. During the post-meeting press conference, Fed Chairman Powell acknowledged a recent pickup in inflation, but downplayed its significance, attributing increases to seasonality and the “bumpy road” to 2%.

The chart below shows the current FOMC (Fed) forecasts for GDP, unemployment, inflation and forward interest rates compared to market expectations. It’s a chart we’ve referenced in past letters, so you may recognize it.

The Fed forms its policy decisions as data evolves. Early in the year, Fed comments led to an easing bias, contributing to improved financial conditions and a shift towards risk in capital markets. Currently its base case includes 2% real GDP growth, 4% unemployment and 2% inflation by 2026.

The shaded gray area on the chart above shows the wide range of interest rate expectations since the December Fed meeting. Expectations continue to edge higher as CPI rose from 3.1% in January to 3.5% in March. The futures market subsequently tempered expectations from the beginning of the year, reducing the number of expected rate cuts in 2024 from six to two as of April 12th.

The Fed does not want to ease financial conditions prematurely and cause inflation to reaccelerate further or stall in the 3% range. In this scenario, the three rate cuts projected for 2024 could easily become two, or one, or zero for the year.

The Fed is running an unprecedented experiment to unwind 15 years of ultra-low interest rates and a complex $7 trillion bond buying spree, while global economies grapple with the aftereffects of the pandemic and … arguably … monetary policy missteps. Rates could remain above long-run projections, at least until there is more clarity regarding the long and variable lag effect of restrictive monetary policy.

At the end of the day, the Fed adheres to their dual mandate for price stability and maximum employment. Their ultimate goal is to reach the neutral interest rate, where monetary policy neither contracts nor stimulates the economy. The Fed’s official stance suggests both a soft landing and a prolonged, gradual path towards neutral.

If the base case of a gradual slowdown in both inflation and economic growth occurs, a gradual decline in interest rates would make sense. While this trajectory may evolve, the prospect of several years with declining rates would bode well for most asset classes. We don’t know how this “goldilocks” scenario will play out, and we don’t know when rate cuts will commence, but spoiler alert, neither does the Fed.

The following chart shows US equity and fixed income returns 12-months before and 24-months after the end of each Fed hiking cycle. On the lefthand side, the equity market is represented by the S&P 500. The righthand side shows the same analysis for the US 10-year Treasury. The current cycle for both is notated in red.

The takeaway from these charts is mostly positive. US equities performed well during four of the last six cycles. Fixed income performance has been more stable, with all represented post-Fed hiking periods resulting in positive returns.

Every cycle is different, and there are many factors that could impact forward returns. This is why diversification is so important. Our expectations may be modest relative to the past 10-year period, but we remain optimistic and fully invested. Equity investing is a long-term commitment, not a short-term game. Our strategies are focused on profitable companies trading at reasonable valuations, and we remain globally diversified.

Tax efficiency is a core tenet of our investing principles. You can expect us to be mindful of your real aftertax portfolio return and we will never unnecessarily interrupt compounding. Interest rates and fixed income yields are attractive, which for moderate risk investors, is enormously useful for mitigating equity volatility.

We are grateful for your trust and confidence. Please let us know if you have questions, would like to discuss your financial plan or review your investment portfolio.


The JRM Investment Counsel Team
Jack, Phil and Lauren