Market Commentary - Second Quarter 2024

Big Picture Review

The first quarter of 2024 was a record-setting one for the markets. The Dow Jones Industrial Average, the S&P 500 Index and Nasdaq Composite all hit all-time highs during the first three months of the year in response to positive economic signals and stronger earnings momentum. The headwinds derived from ongoing geopolitical events including ongoing violence in the Middle East and the continued Ukrainian embargo were not enough to tame the animal spirits. While the yield on the key benchmark U.S. Treasury 10-year note remained stubbornly above 4% for most of the quarter, investors were encouraged by the hope that the Federal Reserve would begin its rate cut policy during the first half of the year. Traders and consumers alike are hoping that the battle against inflation is nearing its ending phase.

Fed Chairman Jerome Powell and his colleagues have put inflation fighting at the forefront of their efforts since early 2022. The Fed has a dual mandate given to them by Congress: achieve full employment and maintain a stable level of prices. Textbooks can be written about what exactly “full employment” and “stable level” truly mean but suffice it to say that the Fed has not been able to complete both directives simultaneously for some time. The unemployment rate had fallen to 3.6% by the middle of 2022 and stood only a few tenths of a percentage points away from a multi-decade low, but the inflation rate as measured by the consumer price index had soared to over 9% on an annual basis at that time. Thus, one could argue that “full employment” was reached or remarkably close to it, but the economy remained quite distant from a “stable level” of cost of goods.

Where does the economy stand today? Unemployment in March was 3.8% with nonfarm payrolls rising 303,000 with the total blowing away all economic estimates. The strength of the labor market has been surprising to the markets and economists alike. Pandemic era fiscal spending by the federal and state governments was the source of household financial worthiness for a while, but those programs have long ended. Clearly, the economic engine has been humming along nicely with businesses getting back on their feet and consumer confidence rising over the past few years.

The Fed’s preferred measure of inflation is the personal consumption expenditure (PCE) deflator rather than the consumer price index. The PCE expenditure weights change as people substitute away from some goods and services, which makes sense because people in general prefer to spend less than spend more. The PCE also includes a more comprehensive coverage of categories including durable and nondurable goods and services, spending on behalf of households by third parties (e.g., health care insurance providers who purchase prescription drugs on behalf of patients), household purchases of used goods and purchases of goods and services by U.S. residents in foreign countries. Shelter costs can comprise nearly twice the weight in the CPI versus the PCE and vice versa for health care related spending. A massive study was conducted beginning in 1996 comparing the two indices with the Fed switching from referencing CPI to PCE in its communications starting around 2000.

February’s PCE data showed that the indicator rose 0.33% month-over-month resulting in an annualized increase of 2.5%. Excluding food and energy, the so-called core PCE rose 0.26% month-over-month or 2.8% on a year-over-year basis. There is also a “supercore” that many economists are tracking which are core services excluding housing rents and focuses on the stickiest part of the inflation conundrum. Think medical services like root canals and hip or knee replacements which do not go “on sale” or car repair costs which seem to always be rising as technology under the hood becomes more complex. On a year-over-year basis, the supercore grew 3.3% versus a 3.5% annualized rate in January. When one annualizes the prior three months of data, that indicator is growing at a 4.5% pace which suggests that it is slowing but still not close to the 2% preferred target the Fed is looking for. Personal income for the month rose 0.3% compared to the prior month while spending (not the deflator mentioned above) was 0.4% higher for February meaning consumers dipped into savings to maintain their lifestyle reflected in the personal savings rate dipping to 3.6% from 4.1% in the first month of the year.

Cooling inflation is unambiguously good news for the Fed. The question is if it has cooled enough. During the press conference following the March Federal Open Market Committee meeting which saw no change in the benchmark interest rate, Powell stated: “We do not expect that it will be appropriate to lower our policy rate until we have greater confidence that inflation is moving sustainably down toward 2 percent. Given the strength of the economy and progress on inflation so far, we have time to let the incoming data guide our decisions on policy.” Thus, it will take time to reach that “greater confidence” threshold.

What will we be watching to determine how close we are for the Fed to reduce rates? Keeping an eye on the health of the labor market is crucial. People with paychecks tend to spend them. If we see unemployment rise, wage pressures are likely to cool. The monthly Jobs Openings and Labor Turnover Survey is one indicator which shows the trend in the number of positions available and if people are voluntarily leaving positions for new roles. Weekly initial unemployment and continuing claims are a timelier indicator of job strength than the monthly payroll report. Personal spending has become more concentrated due to those at the upper end of the income spectrum. So, tracking if this situation continues and how those at the other end of the spectrum are faring, will be important. While the markets and economists focus on the rate of change in inflation, most consumers think of inflation in level terms. For example, even though the price of a gallon of milk may only increase 2.5% one month down from a 3.5% pace the prior month, shoppers at the supermarket remain shocked that it is $4 when it was only $3.30 some years ago! One last indicator we will keep an eye on is good old jawboning. This is an age-old method by which Fed members can influence the direction of rates merely by commenting. If the president of the Atlanta Fed says rates may come down soon, the market is likely to react. Similarly, if the president of the St. Louis Fed says inflation is not yet under control, the markets will react to that as well. Sometimes investors have to read between the lines, but the recipe is often simply paying attention.

We are only three months into a busy 2024 calendar filled with quintessential events. Paris will host the XXXIII Summer Olympiad in a few months. Numerous national elections are still to take place around the globe including right here in the U.S. in what is shaping up to be a rematch of the 2000 election. We strongly encourage clients to focus on the Fed rather than the ballot box as history has shown that staying invested reaps financial rewards regardless of one’s political persuasion. The recent earthquake in Taiwan brings back frightful images of the devastation that rocked Japan in 2011 and reminds all that Mother Nature can and will provide exogenous shocks outside of humankind’s plans. We will continue to monitor and report as usual so stay tuned.

Market Analysis & Outlook

The first quarter of the year continued the momentum started in the fourth quarter of 2023. Investors had dialed back their severe recession expectations and were anticipating a more accommodative Fed as the year progressed. That helped fuel 22 new record closes for the S&P 500. There were no new closing highs in 2023 and only one in 2022 which happened on the very first trading day of that year. The index was up 10.6% including dividends during the first three months of the year with all eleven sectors gaining in February and March. The index finished March at a closing high, up 3.2% for the month in total return. The Dow Jones Industrial Average had a 6.1% first quarter total return and the Nasdaq Composite was up 9.3%.

What was significant about the rise during the first quarter was that breadth widened. Last year, the focus of traders was on the “Magnificent Seven” stocks which dominated the S&P and powered returns higher. Welp, that total has now shrunk from seven to a “Gang of Four” as three members have started 2024 with relatively mediocre to eye-catching underperforming returns and provided quick proof of the Warren Buffett quote we emphasized last quarter: “The dumbest reason in the world to buy a stock is because it’s going up.” Year-todate, in the S&P there have been 369 companies which have moved higher (with 199 up at least 10%) while 134 have fallen. That breadth has improved with 402 issues gaining (an average of 6.3% each) in March, up from 322 issues rising in February. This trend was also evident in midcap and small cap indices. Another sign of increasing inclusion is the fact that the equal-weighted S&P 500 has been up 25.8% from November of last year through the end of March compared to the oft-mentioned capitalization index which is up by just a bit more at 26.1%. For all of 2023, there was a huge gap between the two methodologies emphasizing the narrowness of the tech-fueled rally.

How can this be with Tesla figuratively breaking down on the side of the road and Apple seemingly turning rotten on the tree branch? Because the market is made up of more than just seven stocks. The Seven were down an average of 45% in 2022 before they made their Lazarus-like recovery last year. This suggests that having a diversified portfolio is prudent to protect wealth. Since no one can predict the future, investments across a broad spectrum of industries and geographies will help balance those sectors that zig against those that zag as they do every year. And when earnings for the majority of names in the group are poised to do well, it helps all. In our view, that has really been the fuel behind the rise in the indices and helped the S&P clinch its best first-quarter performance since 2019. According to Bloomberg estimates, the first quarter of 2024 for the S&P 500 should be up about 2.9% compared to the first quarter of 2023. That would denote the third consecutive quarter of earnings growth. That would mark a welcome turnaround from the three straight negative comparisons that started in the fourth quarter of 2022 through the second quarter of 2023 when earnings fell 5.0%. If the analysts are right, the second and third quarters of 2024 will exhibit over 8% yearover-year growth only to be followed by a mouth-watering 12.9% figure by the final quarter of the year.

The theoretical valuation of stocks depends on three main factors. The first, and most important, are earnings, or, more specially, cash flows. While related, earnings and cash flows do have differences that come down to timing of inflows, tax deferrals, noncash charges and other items. But if we assume they are roughly equal, more valuable firms should generate rising streams of cash that can be distributed to shareholders after operating expenses and paying debt holders. The second factor deals with interest rates. There is the general level of rates that is mostly set by the Federal Reserve and then there is another spread attributed to the specificrisk that security poses. We will dig into the general level of rates more below but suffice it to say that a biotech company will have a higher risk-profile than a food manufacturer because its cash flows are more volatile. The third variable is inflation. This wild card has been largely held under 3.5% since the early 1990’s only to relatively recently see levels shoot higher in response to the global pandemic.

Therefore, since markets discount future events into today’s prices, seeing a strong trend of earnings growth over the next several quarters is viewed as good news. We specifically wrote about this last quarter: “Having a growing earnings stream across a breadth of industries will be a key component to a strong year for stocks.” The market is also keeping its fingers crossed that the Fed will indeed lower rates. We borrowed the chart below from our friends at Schwab. It shows that market history has been somewhat noncommittal following the final Fed rate hike. The sample size is not large at only 14 observations and the political, economic and cultural environment of the earliest data point in 1929 is vastly different from what was happening in 2018 nearly 100 years later. With that in mind, investors would be challenged not to draw some clear conclusions subsequent to the first rate cut. Both six months and one year following that event, the S&P was positive 79% and 86% of the time, respectively. That is why there is always such a focus on the Fed and why events like international conflicts on foreign soil and even national elections may garner headlines, but they do not move markets like the Fed does.

At the start of the year, the market was expecting the Fed to cut rates six times. A rising tide lifts all boats and repeated cuts would provide a strong tailwind for potential gains. However, there was a wrench thrown in the market’s plans—the economy may not need a boost from the Fed after all. Contrary to the views of many traders, the Fed’s role is not simply to make sure the market goes higher. In the eyes of the Fed, if the markets sell off in the process of achieving their dual mandate, so be it. Of course, in reality the Fed would not be totally blasé and wants to see a strong market because of its influence on the wealth effect of households (thereby providing a hedge to periods of less than full employment). With unemployment only a half a percent from a multi-decade low, more job openings than unemployed seekers and corporate balance sheets in solid condition with earnings rising, there is no hurry to change the status quo. The Fed last hiked rates on July 26, 2023, and has been holding steady ever since.

The markets can be in limbo for some time. The one thing the Fed absolutely cannot do is begin to raise rates again and expect everyone to stay calm. That is what happened in the 1970s in response to the runaway inflation during that period, and it is what colors the Fed’s decision to this day. The markets would lose confidence in Chairman Powell and his colleagues and set the stage for a potential repeat of 2022 when the S&P was down on a price-only basis 19.4% and the Nasdaq crushed by 33.1%. Nobody wants to see that again. By delaying any cut, the Fed runs the risk that the economy will slow too much leading to a recession. So far, there have not been any signs that that is occurring which gives them room to wait. What the market needs now is patience.

As a bottom-up stock picker, our focus is on the companies in our portfolios and their ability to gain market share, solidify their balance sheet and invest in value-adding opportunities. The backdrop of interest rates and inflation will always play a role in that evaluation, but our focus on the cash flows is what empowers us to remain patient as well. From quarter-to-quarter those flows are not going to be super sensitive to whether the federal funds rate is 5.50% or 5.00%. With a diversified portfolio, our names are going to take part in an economy which may be in transition but remains relatively attractive versus other developed nations. So far this year, we have had 11 companies increase their dividend payouts, which helps offset inflationary pressures and provides a positive signal that management is functioning well operationally. When things get more expensive, it always helps to get paid more. Unless the environment drastically changes, we are hoping to match the 30+ firms which raised their distributions last year.

We will continue to monitor our holdings and search for bright ideas to add. As usual, the key is being able to distinguish catching a falling knife from finding ignored “fifty cent dollars.” Nobody is perfect in this business so minimizing risk is an important part of portfolio management. There are times when wonderful companies go through rough patches, but that does not make them worthless. Similarly, broken firms have value if unlocked, underlying asset growth potential gets a needed spark from a change in management or innovative product introduction. Given the strong returns we have had over the last five quarters, pullbacks cannot be unexpected and even welcome to prevent too much froth from building up. Having the trust of clients to steer their funds into the best investments is appreciated and something we cherish. We look forward to the challenges which are certain to come during the remainder of the year.

If you would like to schedule a meeting with SGK, please contact Lisa Martin at 703-777-8826 or lisa@sgkwealthadvisors.com

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