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How sustainable is this year’s equity rally?

Much of this year’s strong performance has been driven by valuation expansion rather than improving fundamentals. A soft landing — and stronger earnings growth — could justify the improvement in investor sentiment.

Recent performance driven by multiple expansion chart illustrationEquity markets have delivered for investors this year, with most indexes serving up double-digit returns thus far. U.S. large-cap performance has been particularly notable, topping 20% through the end of July. Widespread recession expectations coming into 2023 had created a subdued investor mood. As a result, strong equity market returns have been a welcome surprise for many investors, as better than expected economic data and optimism for future earnings potential have provided a lift.

It’s important to put the equity rally in perspective and understand what has driven performance over the past year. As shown above, equity returns over that time frame have been almost entirely driven by an increase in valuations, rather than outsized earnings growth. Put differently, it’s been an improvement in sentiment rather than stronger underlying fundamentals. An increase in price/earnings multiples can be justified if that expansion occurs in anticipation of a coming surge in earnings growth that ultimately materializes. Still, over the longer-term, valuations tend to revert toward their long-term average, making fundamental factors (earnings growth and dividends) the primary drivers of equity returns over a market cycle and beyond. As the chart also illustrates, performance over the past three decades has been almost entirely driven by those fundamental factors, standing in stark contrast to the past year.

What does this mean for investors? For valuation-driven rallies to be sustained, stronger fundamentals need to follow in the form of stronger earnings, a reduction in the discount rate, or both. With the Fed still committed to tight policy, an improvement in the earnings growth in the coming quarters appears to be the necessary catalyst.

Past performance does not guarantee future results. All investments include risk and have the potential for loss as well as gain.

Data sources for peer group comparisons, returns, and standard statistical data are provided by the sources referenced and are based on data obtained from recognized statistical services or other sources believed to be reliable. However, some or all of the information has not been verified prior to the analysis, and we do not make any representations as to its accuracy or completeness. Any analysis nonfactual in nature constitutes only current opinions, which are subject to change. Benchmarks or indices are included for information purposes only to reflect the current market environment; no index is a directly tradable investment. There may be instances when consultant opinions regarding any fundamental or quantitative analysis may not agree.

Plante Moran Financial Advisors (PMFA) publishes this update to convey general information about market conditions and not for the purpose of providing investment advice. Investment in any of the companies or sectors mentioned herein may not be appropriate for you. You should consult a representative from PMFA for investment advice regarding your own situation.

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