Is a Correction Coming?

Dr. JoAnne Feeney, Partner & Portfolio Manager

The rise in the S&P 500 over the past year now exceeds 25% and new records are being set on an almost daily basis. Achieving such heights triggers the inevitable speculation that a correction must be right around the corner. Right? Around the news, or the dining table, you’re likely to hear both the emphatic, “Absolutely!”, as well as the (possibly more sheepish), “No way!” An honest commentator will be more inclined to answer that question with a humble, “We just don’t know.” There are clues, however, to suggest that the recent increase has some solid foundations.

A “correction” is meant to describe a sharp, but temporary, decline in stock indexes, and these are often unconnected to earnings fundamentals of the companies within those indexes. Such corrections can and do happen on a regular basis even though, over years and decades, stock market indexes go higher, not lower, despite those temporary pullbacks. The surge in stock prices over the past 12 months may seem more precarious to some, however, because of the dominance of just a handful of stocks. But when we step back from those and look at the broader market, we see earnings fundamentals at work in a way that supports the recent appreciation. In addition, when we look not just at one year, but at the last ten years, the recent appreciation seems even less surprising.

Over the last year, the S&P 500 has risen nicely, after bottoming in late October:

S&P 500: June 2023 – June 2024

Source: Bloomberg, LLC.

But recall that 2022 saw significant declines in stocks across most sectors as higher interest rates from the Federal Reserve’s inflation fight were announced and then took hold. As the Fed’s rate hikes continued through that year, stocks (particularly high growth stocks) suffered. But for the past several months, investors have recognized that the Fed rate hikes are most likely finished and, indeed, that the Fed would be cutting rates. While it turned out that investors were too optimistic about those rate cuts, the end of rate hikes had at least removed a key headwind for stocks. Widening our lens on the S&P 500’s returns from one year to ten years shows that much of the last year’s appreciation merely reversed the declines triggered by the rate hikes:

S&P 500: 2014-2024

Source: Bloomberg, LLC.

More importantly, perhaps, company earnings prospects improved considerably from 2023 to 2024. And because investors care more about how much a company can deliver in the future, rather than results of the past, better earnings forecasts for 2024 started to drive demand for stocks higher in 2023. And those forecasts have been reinforced by results so far this year. Average earnings for the companies in the S&P 500 in 2023 were roughly the same as those in 2022: a year of no growth, and that is very unusual outside of recessions. But in 2024, analysts expect earnings growth to average 11.3%, and in 2025, earnings are expected to grow over 14%.

Not only are earnings expected to rise because companies are selling more goods and services, but also because profit margins appear to be rising again after two years of declines:

S&P 500 Profit Margins 2013-2023

Source: Bloomberg, LLC.

This year, profit margins are expected to drive six percentage points to earnings growth, while next year, margin expansion should add eight percentage points growth. Profit margin expansion is impressive in the current macroeconomic environment because we continue to hear that companies are facing increasing resistance to price increases from customers. Their ability to deliver bigger margins suggests that productivity could be improving, input cost increases are slowing as supply chains improve, and/or that economies of scale are reducing production costs. That’s a positive for company valuations.

The anticipation of lower interest rates (eventually) and better earnings prospects appear to have driven the market higher. And, yes, the build out of artificial intelligence infrastructure by the likes of Microsoft and others are a big part of that, but the increase in earnings growth occurred across sectors beyond technology, too. This is not to say that some stocks haven’t seen increases at odds with company fundamentals, and for those we would expect investors to get it right eventually. We should always be aware of the potential for corrections, but by seeking stocks with attractive valuations relative to earnings prospects, we expect that longer term results will win out for portfolios.

The foregoing content reflects the opinions of Advisors Capital Management, LLC and is subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or construed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. Past performance may not be indicative of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. Securities investing involves risk, including the potential for loss of principal. There is no assurance that any investment plan or strategy will be successful.