🔒 Wall Street's forecasting dilemma: Market outperforms again

Wall Street strategists have repeatedly underestimated the US stock market since the pandemic, leading to a scramble to adjust projections later in the year. The dominance of a few large-cap growth companies, coupled with a stronger-than-expected economy, has challenged traditional forecasting models. Despite the market’s high valuations, fundamentals remain robust, suggesting that upward revisions may continue, and a reckoning is not imminent as strategists brace for further adjustments.

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By Jonathan Levin

Since the pandemic, Wall Street strategists have repeatedly underestimated the performance of the US stock market in their annual projections, leading to a mad dash to boost their outlooks in the back end of the year. ___STEADY_PAYWALL___ The flurry of upward revisions can look something like a “short squeeze,” which is a situation where traders are forced to cover bearish bets in quick succession, often reinforcing a security’s upward momentum. In that sense, this year has already seen the biggest short squeeze among strategists in a decade, and seasonal trends suggest it’s poised to continue in coming months.

In general, such price targets have always had a spotty record, but this market has proved particularly difficult for strategists to process. First, the outperformance of large-cap growth companies has broken traditional models meant to translate macroeconomic conditions and interest rates into fair values for the S&P 500 Index. Just five companies — Nvidia Corp., Apple Inc., Microsoft Corp., Alphabet Inc. and Amazon.com Inc. — explain almost half the benchmark’s performance since early 2020, which means that macro models are insufficient if they fail to account for their idiosyncratic stories, including the artificial intelligence theme. Though some stocks have benefitted from rising price-earnings multiples, it’s mostly been the underlying surge in revenues and profits that have powered them higher. At a minimum, every strategist should be having lunch with a Nvidia analyst a few times a quarter.

Second, economists and strategists have consistently misjudged the strength of the economy. At the start of 2023, the median estimate showed economists surveyed by Bloomberg thought the US would barely muddle through the year. Instead, it grew 2.5% and lookspoised to do so again this year. Much of the forecast error was probably an over-reliance on old rules of thumb, including the idea that Federal Reserve interest-rate increases typically lead to economic downturns. That may be true in “normal” economic cycles, but not after a pandemic when employers are hoarding labor, consumers are desperate to get back into restaurants and concerts and the typical homeowner has a 3% mortgage rate and is swimming in home equity. Economists may have also underestimated the macroeconomic impacts of capital expenditures from the AI arms race along with President Joe Biden’s industrial policies.

And yet the average strategist surveyed by Bloomberg still sees the S&P 500, which closed last week at 5,648, falling about 3% to end the year at 5,469 (median: 5,600; range: 4,200-6,000).

That’s perplexing because many pieces of that 2023-2024 story remain broadly intact, supported by real-time data. The Federal Reserve Bank of Atlanta’s GDPNow model suggests the economy is currently growing at a 2.5% annualized rate. About 81% of S&P 500 companies have beaten Wall Street estimates in the current earnings season, including consumer bellwethers Target Corp. and Walmart Inc. And longer-term borrowing costs have begun to plummet in advance of expected Fed rate cuts likely to begin in September. Initial jobless claims show layoffs aren’t getting out of hand, and the recent slump in AI chipmaker Nvidia (known to some as the most important stock on the planet) has been more about company-specific production snags, rather than the long-term promise of AI.

Meanwhile, the market’s supporting cast looks to be hitting its stride. Excluding the top five stocks, earnings growth for members of the S&P 500 is projected to accelerate through 2025.

Of course, the S&P 500 is trading at 21.3 times blended forward earning, which is on the high side of history. That shouldn’t be handwaved away even if it’s largely a reflection of the index’s changing composition. Yet high valuations reinforced by fundamentals and great stories can stay high for sustained periods of time. And with another strategist short squeeze seemingly in the offing this autumn and winter, it’s much harder to imagine that a reckoning is close at hand.

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