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In January, most economists were convinced that stubborn inflation and rising interest rates would lead to an imminent recession, and Wall Street’s top minds were feeling bearish about 2023.
But Fundstrat Global Advisors co-founder Tom Lee was optimistic. The veteran market watcher, who previously served as JPMorgan’s chief equity strategist, argued that the S&P 500 was set to soar nearly 25% to between 4,750 and 4,800 by year-end.
It was an out-of-consensus call, given that forecasters surveyed by Bloomberg had a median year-end target of just over 4,000 for the blue chip index. But Lee believed that the Fed’s interest rate hikes would be able to tame inflation without sparking a job-killing recession—the vaunted economic “soft landing” that, historically, has been hard to come by.
Now, that call is looking pretty prescient. The labor market has proved its resilience this year; inflation has steadily dropped from its 2022 four-decade high; and the economy continues to grow. As a result, the S&P 500 is up over 23% year-to-date, just a few percentage points away from Lee’s year-end target.
After this monumental rise in stocks, which saw the Dow Jones Industrial Average hit a record high this week, some investors are beginning to wonder if there are any gains left to be had.
“The recent rally in the market has investors pricing in the perfect soft landing for the economy, without the pain of a recession,“ David Donabedian, chief investment officer of CIBC Private Wealth US, said Friday. “This may not be realistic, however.”
Donabedian warned that even if it’s “all systems go” for markets in the near term, there are “lingering concerns about valuations and ultimately a scenario that may be too rosy.”
Lee, ever the bull, disagrees. And he has a recommendation for investors: look to smaller companies for outperformance next year.
“In the next twelve months it seems like small caps can be up 50%,” he told CNBC Friday, arguing the Russell 2000 index, which tracks U.S. stocks with an average market capitalization of just $2.8 billion, could rise from 1,996 to 3,000 by year-end.
How small cap stocks could outperform in 2024
Next year will be all about fading inflation and interest rate cuts, according to Lee, and that should benefit the small-cap stocks that have been hit the hardest by rising borrowing costs. Small caps tend to have higher leverage, which means the Fed’s interest-rate hikes over the past 18 months have dramatically affected their bottom line.
As a result, the Russell 2000 is up just over 14% this year, compared to the S&P 500’s roughly 23% rise. But if inflation continues to fade in 2024, leading the Fed to cut interest rates as is now widely forecast, that could be a boon for small caps. And Lee is convinced inflation has already been tamed.
“I think inflation is easily going to hit the 2% core target sometime next year, and sort of stay there,” he said.
He noted that consumers’ inflation expectations, a good predictor of actual inflation, are falling. Americans’ one-year inflation outlook sank to just 3.1% in the University of Michigan’s December consumer sentiment survey released last week, a marked drop from the 4.5% in November and the lowest level since early 2021.
Lee also argued that 60% of core inflation—a metric that excludes more volatile food and energy prices—comes from housing, cars, and car services, categories that are no longer seeing huge price jumps.
“Housing and cars alone account for 1.74 percentage points of the excess inflation. We’re at 1.6% of excess [inflation]. So literally those two things account for all the inflation,” he noted.
To his point, U.S. home prices rose just 4.7% year-over-year in November, while rent prices fell 2.1% from a year ago, according to Redfin data. New vehicle prices have also fallen for three consecutive months, according to Cox Automotive. And used car prices dropped 5.8% from a year ago in November, according to the Manheim Used Vehicle Value Index.
As long as housing inflation “stabilizes” at 6% and car prices continue to fall, Lee believes inflation will drop to the Fed’s 2% target and “stay there” in 2024.
For investors, this means small caps that will benefit most from interest rate cuts present opportunity, especially given how cheap they are compared to larger peers. Lee noted that small-cap stocks are a particularly good buy relative to the value of the assets on their balance sheets, called book value.
“On a price to book basis, [small caps] are trading at where they were in 1999, relative to the S&P. And that was the start of a 12 year outperformance cycle,” Lee said.
