When I predicted corrections for 2018, 2020 and 2022, I was called "permabear" by commenters and a few analysts. I wonder what they will call me now that I see the potential for a euphoric top to the stock market in the next five or six quarters? My guess is that quite a few folks question that we are not in euphoria now.

The only interruption to the happy dance will be angst in the banking sector tied to commercial real estate and misplaced fear about a recession that wasn't. The angst though will lead to a flood of liquidity into risk assets. How euphoric do I think 2024 could get? To put a number on it, I see the S&P 500 (SPX) reaching 5720 in 2024. That will be a on its way to 6000 in H1 2025.

Key takeaways

• Rising earnings, increasing buybacks, flattening inflation and rising liquidity will lead to higher valuations and higher prices for stocks
• There will be a banking hiccup that releases liquidity, but there won't be a recession unless there is an international shock
• Inflation is falling, America is at full employment, most folks got a raise and Covid isn't scaring anyone right now resulting in improving consumer sentiment
• AI will help mitigate a quarter million Baby Boomers retiring each month the next 6 years and improve corporate margins
• Large caps will set new index highs, but micro, small and mid caps select stocks are poised to be the biggest winners

"But stocks fall after a big up year"

That is not actually true. Since 1950, in 51% of years following a 15% up year, stocks rallied at least another 10% according to Bloomberg.

It's interesting that of the 14 years that returned over 10%, nine of them actually returned over 15%. And, of the positive years, nearly half were over 15%. That means the odds of another big up year are not that bad.

Sentiment is bad. Or is it?

There are conflicting signals on sentiment. On the one hand, investor sentiment surveys are saying we are very bullish on stocks. And, that is despite investors pulling about $200 billion out of stock funds this year. Weird, right?

Common wisdom is that extreme optimism and greed by investors is a contrarian signal. In general, I agree that it is. But, extreme can get pretty extreme and technical signals say there is a bit more to go to the upside short term into the January effect.

I do think there will be a standard 5-10% correction in stocks sometime in the first half of 2024. I also think that is a pause that refreshes.

I like to look at consumer sentiment and it looks to have bottomed a year ago. There is a pretty defined rebound in consumer sentiment happening.

We might see some spending sluggishness over the winter. That is not unusual. But, with folks not afraid of Covid anymore, the nation at essentially full employment, many folks having gotten raises and inflation falling, I think consumer spending will do well come summer and beyond.

Given I don't see a recession coming without a global shock, revenues should continue to drift up. What makes the chart above more compelling is that share buybacks are set to accelerate again in 2024 after pulling back in 2023.

AI driven earnings will surprise to the upside

We just went through a nearly two year period of essentially no earnings growth. Earnings are already looking to improve. I think by more than analyst projections.

I expect AI to drive widening margins as more companies adopt AI solutions. Read that as increasing revenue without adding as much labor as the past few years.

Sectors like healthcare and industrial stand to see huge margin expansion. At the subindustry level we will see anything that used machines to manufacture or computers to complete tasks gaining efficiencies with the deployment of AI. In addition, it spurs a whole wave of capex.

The discussion of whether AI take our jobs is for another day, but in the short run, I don't see unemployment problems with around a quarter million Baby Boomers retiring per month through 2030.
For 2024 I see S&P 500 earnings in the $260-70 range.

Liquidity impacts investment sentiment

According to Federal Reserve Chair Jerome Powell and other Fed members (JPow & The Fed Presidents maybe a band name), the economy moves with long and variable lags to monetary stimulus.
But, we also know that stocks respond much quicker to sudden wads of cash thrown into the financial system. Investors see the liquidity coming and start to buy risk assets from stocks to real estate to Bitcoin (BTC-USD).

As liquidity flows into the financial system we see waves (sure, Elliott if you prefer) of successive buying until the liquidity is used up preceding an actual contraction. The reverse is also true.

We saw how fast bailouts pumped up stocks up after the Financial Crisis and took off in spurts after further quantitative easing. There are plenty of charts that show the high correlation of the Federal Reserve balance sheet and the returns on stocks. Here's a one from Bank of America (BAC) I really like as it also poses a question for us to answer.

This chart includes the Federal Reserve, the Bank of Japan and European Central Bank. Remember that they've all talked about being "coordinated" since the Financial Crisis.

The S&P 500 chart looks similar, but a bit less pronounced in the past year. Why? The Magnificent 7 and the AI rally.

That begs a question: what is that outlier Nasdaq 100 (NDX) rally while liquidity has been sinking lately?
There's two answers. The first is the AI rally. The second answer is: it's the liquidity stupid. Apollo provides this chart:

The most recent rally is clearly AI driven, but it also supposes that more liquidity is coming to markets. If the markets are wrong about either thing, then stocks will likely fall in 2024, for at least a while, until of course, more liquidity happens and AI waddles up the slope of enlightenment (adoption).

Banks Need More Liquidity

First off, let's remember who the Federal Reserve really works for - it's owners, the big banks. My thought is it does not take more than a few phone calls from banks to increase liquidity. Why would they call?
There is a looming commercial real estate meltdown that threatens default rates similar to the Financial Crisis. A working paper from the National Bureau of Economic Research argues that 14% of the $2.7 trillion of commercial real estate loans held at banks are at risk of default. That is led by 44% of office CREs having higher loan value than property value.

That's a potential nearly $400 billion hole about to be blown into bank balance sheets. I have heard and read various estimates of this number up to a trillion dollars, with most being estimates in the $400 billion to $600 billion range.

Importantly, that doesn't include the loans held at non-bank where about 55% of the CRE debt is.

Last year, banks had a similar problem and 3 big failures occurred at about the same time: SVB, Sovereign and First Republic. Those three banks had about a half trillion of assets.

What should the takeaways be here?

The first things is that there is NOT likely to be a major banking crisis. It will be more like some indigestion and heartburn. Investors could very well treat it like an end of the world event for a month or two though. They like doing that.

The half trillion or so of at-risk CRE debt is spread across a lot of banks and non- banks. It is a pretty well diversified market. That means while there is likely an insolvency or two or three, it will not be a systematic collapse.

But, that hole in bank balance sheets, still needs to be filled and the Federal Reserve will be the one to do it. They'll do it three ways:

• Lower interest rates which reduces bank losses on investments and improves their borrow short, lend long business margins.
• Reduce or end QT (quantitative tightening) to reduce the tightening impact on on the monetary system.
• Fund a Special Facility (don't call it QE) to help bank balance sheets. This will come with strings attached to the most at risk banks.

Most pundits are talking about recessions and glide paths to the Fed loosening. I reject that. I was firmly in Camp Soft Landing since early 2022 when I projected that inflation would come down firmly in 2023. I don't see a recession coming and I'm a permabear don't forget.

I also believe when the Fed loosens, it will be fast and hard. Government, and big bank owned quasi-government, don't like a good crisis to go to waste - even if it's conjured.

When the liquidity increases, stocks will go up because that's what more liquidity causes. See section above again if necessary.

U.S. Treasuries need liquidity too

We know that the U.S. Treasury market has been tightening up in recent quarters. That has largely been by design from the Federal Reserve's QT program. But, it has also been because China is a net seller of U.S. Treasuries lately.

While there are a lot of moving parts to a $26 trillion market, it is enough to say that there needs to be liquidity. The Fed ending QT is one way to improve liquidity. The Special Facility for banks will also result in most of that money ending up in U.S. Treasuries and then loaned against.

I included this section for context because it will matter more at some point in the future. I think way out there a few years, maybe 2026 when the "basis trade" winds down if new SEC regs take effect as planned (lots to unpack there, but not today).

By adding liquidity in 2024, the Federal Reserve is killing two birds with one stone and maybe one down the road. It is not only helping banks and Janet Yellen's U.S. Treasury market today, but might be setting up for an even bigger gift to banks at the expense of a few big "basis trade" firms as the world continues to dollarize and Bitcoinize (articles coming, follow along for weekly Macro Dashes pieces in 2024).

Money on the sidelines

Money markets have climbed to over $6 trillion in the past year. That is more than a trillion dollars more than "normal" in money market accounts if we consider post Covid normal.

What happens as interest rates fall? I think some of that money finds its way back into stocks. What if around $3 trillion is the actual "normal" amount that we would expect in money market accounts?

Either way, there's a lot of money on the sidelines likely to find its way into stocks and real estate in the next year or two or three or five.

Interestingly, the rise in money markets lowered total household net worth as stocks rose by far more than those eye popping 4% and 5% bank yields.

Let that be yet another less to not let emotions drive your financial decisions.

Multiple Expansion

With positive earnings surprises, more liquidity and full employment, I see valuations expanding. That is despite being a permabear who regularly warned against high valuations in 2021 into 2022.

As you see, valuations have come back a bit from the highs. With earnings rising and liquidity set to go from expecting easing to actual easing, I think the valuation ratios expand back towards 3rd standard deviation range in the next year or so.

So, to apply some math for my 5720 projection, I am simply applying a 22 P/E to earnings of $260. I would not be surprised if we make a run at 6000 by January 2025.

The euphoria has just begun

To sum things up, I expect a robust January Effect and a good Q1 on whole.

Sometime in Q2 or Q3 there will be some market indigestion from angst over what headlines are calling a commercial real estate crisis. We know that it is really just a run-of-the-mill half trillion dollar problem to be papered over.

Once the Fed loosens, I expect the Dionysian dancing to really begin.

Overall, the combination of falling inflation, full employment and AI doing some of the heavy lifting is a better macro environment than a year ago.

Could there be political and geopolitical hiccups or worse? Sure. But who can forecast that besides Ian Bremmer and George Friedman?

Indexers into the SPDR S&P 500 ETF (SPY) and Vanguard S&P 500 ETF (VOO) they will be happy. I do not think they will be as happy as people who invest into certain micro, small and mid cap ETFs or select stocks. Those categories typically do better in a loosening cycle than large caps.

And, for what it is worth, there are better large cap ETFs than SPY and VOO. But, that's a topic for another article. Though, here's a hint:

Notice that the markets haven't really gone up in 2 years. Stocks are where they were 2 years ago. If we don't have an event driven crash, then we probably only get a pullback that launches markets to even higher highs.

So, what should you do as an investor?

First off, buy the dips. It's a great dance.

Second, pick better ETFs than SPY and VOO.

Author

Kirk Spano 

CEO/CIO — Fundamental Trends

Kirk is an Accredited Investment Advisor and founder of Fundamental Trends and Bluemound Asset Management LLC. Kirk has been highly successful in helping DIY investors make sense of the investment world, and profit in stocks, ETFs and crypto.