Market Commentary - Third Quarter 2024

Big Picture Review

The first half of 2024 saw GDP remain moderate, buoyed by robust consumer spending and continued business investments in technology and infrastructure. However, concerns over the housing market continued as mortgage rates remained elevated, which dampened buyer enthusiasm. Unemployment rates continued to hover near historically low levels, indicating a tight labor market. Wage growth, while moderate, contributed to consumer confidence and spending power. The Federal Reserve's approach to monetary policy during the quarter was mostly unchanged as they left their benchmark interest rate untouched following their most recent meeting in the early half of June. Throughout the quarter, the Fed continued its gradual tapering of asset purchases initiated in previous quarters, signaling a cautious approach towards normalization.

The global economic picture, as usual, will be driven by the actions of monetary policy and how they interact with fiscal measures. For the first time in a considerable period, we began to see central banks begin to loosen policy through interest rate declines. On June 5, the Bank of Canada became the first G7 central bank to approve a cut, reducing its benchmark rate a quarter-point to 4.75%. It was the first reduction in four years. Governor Tiff Macklem said the timing of the next cut would depend on whether inflation continued its downward trajectory. A day later, the European Central Bank (ECB) cut its key rate also by a quarter-point. The benchmark moved from 4.00% to 3.75% during a council meeting in Frankfurt. ECB President Christine Lagarde commented, “We will keep policy rates sufficiently restrictive for as long as necessary. We are not committing to a particular rate path. Are we today moving into a dialing-back phase? I wouldn’t volunteer that.” Though neither central bank would commit to near-term cuts, futures markets are predicting that further declines are coming. While these are the first two “major” central banks instituting rate cuts, monetary officials in smaller countries have already begun. Sweden, Switzerland, Hungary and the Czech Republic have all started down that path.

The Bank of England (BoE) kept its main interest rate unchanged at a 16-year high of 5.25% on June 20 ahead of its July 4 election. Two members of their policy committee voted to support a cut to 5.00% but were outvoted by seven of their colleagues. BoE Governor Andrew Bailey said in a statement, “We need to be sure that inflation will stay low and that’s why we’ve decided to hold rates at 5.25% for now.” Though the futures markets believe a rate cut is not expected until September or November, a growing number of market watchers believe a move could be coming in August given that the decision to keep rates on hold was “finely balanced” for some BoE members. The ECB began tightening credit four months after the U.S. Federal Reserve did in March 2022. Now, they have started lowering rates before the Fed. The BoE seems close to pulling the trigger on cuts. What are Chairman Powell and his colleagues thinking?

In minutes of the latest Fed meeting released in early July, Fed officials stressed that they needed more evidence that inflation was under control before adjusting policy toward easing. Nonetheless, the “vast majority” of officials saw economic growth “gradually cooling.” Staff noted that risks were skewed to the downside because “more-persistent inflation could result in tighter financial conditions than in the staff’s baseline projection.” Many of the upside risks to inflation related mostly to geopolitical tensions and supply chains, some of which have not yet been unsnarled post-pandemic. The overall tone of the minutes could be considered “dovish” suggesting that Fed officials were on the lookout for more reasons to cut rates than to keep them steady. In the Fed’s preferred inflation measure—the personal consumption expenditure index—the core reading showed the 12-month rate of inflation eased to 2.6% in May, down from 2.8% in April. That was the lowest reading since March 2021 and is inching closer to the 2% target. The latest reading from the consumer price index also tilted heavily towards disinflation.

The labor market will be a key input to how wages grow and households spend in the coming months. As we wrote about recently in our weekly newsletter, the latest Jobs Openings and Labor Turnover Survey from the Bureau of Labor Statistics suggests that the labor market is slowing somewhat. The number of available positions rose to 8.14 million from a downwardly revised 7.92 million (from 8.06 million) in the prior reading. While vacancies rose, the number of vacancies per unemployed worker held at 1.2x, which is close to the prepandemic level. In 2022, this ratio was 2.0x giving job seekers the upper hand in negotiating signing bonuses and pay raises. However, today, the quits rate, which measures people who voluntarily leave their position, held at 2.2x, the lowest since 2020. A lower quits rate suggests that employees are more reluctant to go looking for greener pastures and could help put a lid on pay increases.

According to the Department of Labor, in June nonfarm payrolls grew by 206,000, which was above the consensus estimate but included a revision downward to the two prior months by 111,000. In a survey of households, the unemployment rate rose to 4.1% in June from May as more job seekers entered the pool of available workers. The rise in the unemployment rate puts the three-month average at 4.0%, which is approximately 0.43 percentage points above the lowest three-month average reading over the past 12 months. Why is that important? Because an economic indicator called the Sahm Rule states that if the average rises 0.50 percentage points above its low point from the previous 12 months, a recession is already underway. So, the economy could already be contracting even though the effects have not yet become widespread. Why this particular indicator will prove predictive during this not-so-normal post-pandemic period while numerous others have failed to do so remains to be seen.

Importantly, average hourly earnings rose 3.9% in June on an annualized basis, in-line with expectations and a notch lower than the 4.1% in May. That is key because wages are an unambiguously important fuel for consumers in terms of spending and seeing that ease somewhat will be viewed as good news by the Fed in its desire to fulfill its mandate on stable prices.

Looking forward, the interplay between economic data, inflation trends, and Fed policy decisions will continue to shape the trajectory of the U.S. economy in the quarters ahead, against a backdrop of global uncertainties and domestic challenges.

Market Analysis & Outlook

Similar to the first quarter, the Dow Jones Industrial Average, the S&P 500 Index and Nasdaq Composite all hit all-time highs during the second period of the year emphasizing investors bullish sentiment and hopes of a Fed rate cut. For the first half of the year, the S&P 500 returned 15.3% including dividends and totaled 31 new record highs. Over the past twelve months, the S&P has generated a total return of 24.6%. For the Dow, the second quarter was down 1.3% including dividends but did manage to return 4.8% year-to-date. The Nasdaq Composite benefited from a handful of large cap technology names helping it to surge to an 18.6% total return for the first six months of 2024. The second quarter’s 8.5% was strong but still fell a bit short of the first quarter’s 9.3% expansion.

Yet, for all the record-setting gains, investment returns have been supported mostly for an increasingly narrow group of names. The S&P 500 is a market-weighted index. This means that a firm with a larger market cap will contribute more to the return in the index. Apple Inc. has a market cap over $3 trillion. Etsy Inc. has a market cap of $6 billion. Both are in the S&P 500, but the sheer size of Apple means that a 1% move in that stock will have a much greater impact on the overall index than a similar change in Etsy. If Apple and Etsy and the other 498 names were weighted equally, it would result in an equal-weighted index. For the first half of 2024, such an index rose a respectable but much less robust 5.1% compared to the market-weighted version. In fact, during the second quarter, the equal-weighted index was down 2.6%. According to Dow Jones Market Data, the average stock within the S&P 500 is up 4.1% compared to the broader market. That is the largest underperformance since 1990. The S&P Midcap 400 was down 1.6% in June and 3.5% during the second quarter. The Russell 2000, which measures small cap stocks, was down 3.3% in the second quarter after a 5.2% gain in the first quarter.

What is the cause of this bifurcation? A handful of stocks have captured the public’s attention and greedily vacuumed investor buy orders. We wrote last quarter of the “Magnificent Seven” stocks and how some of them had lost upward momentum compared to the rest of the market. Nonetheless, the Mag 7 has registered a total return of 37% year-to-date. One stock alone—Nvidia—has accounted for nearly one-third of the S&P 500’s total return. Add Microsoft, Amazon, Meta Platforms and Eli Lilly and approximately 55% of the market’s return came from just those five names. The Market Intelligence Desk at Nasdaq.com wrote this in their first half executive summary: “Currently, three companies have a market cap above $3T (trillion) and combined comprise more than a 20% weighting in the S&P 500. At the height of the dotcom era in 1999, the top three members of the S&P 500 had less than a 10% weighting. The top 25 members of the S&P 500 currently have roughly the same market cap as the rest of the index combined. The top 10 have a combined index weighting of ~35% versus a high of ~27% in the dotcom era.”

As money managers, one of the most important jobs we are responsible for is controlling risk. If an asset manager told their clients: “We’re going to invest in five stocks and go with that.,” there would be reasonable claims of malfeasance especially if they are a fiduciary. That is why it is so hard to beat the market. According to Morningstar, in the first half of 2024, only 18.2% of actively-managed mutual funds and exchange-traded funds that use the S&P 500 as a benchmark have outperformed it. This compares to 19.2% in the first half of 2023 and 19.8% for all of last year. In the past decade, that number has averaged 27.1%. The growth of passively-managed funds and ETFs helps contribute to this as more money is funneled into machine-driven algorithms that enforce already entrenched algorithms. Users of social media know this well—if all one screens for are pictures of kittens on Instagram and TikTok, one will get a lot of cute kitten pics. Another challenging aspect is the fact that global correlations have risen. The average correlation between the S&P 500 and the world’s top markets like the U.K., France, Japan, Hong Kong and the like has risen from 0.24 in the 1970s to 0.70 in the early 2020s.

This period of a handful of stocks dominating the market is neither historically unique nor perpetual. In the early 20th century, railroads were the dominant industry until autos and airplanes became the dominant form of transportation. Today, the nation’s largest railroads have a combined market cap of nearly $400 billion, one third the size of Facebook owner Meta Platforms. Auto companies like General Motors and Ford ruled the mid20th century until they were cut down to size by Japanese innovators. Exxon Mobil and its ilk roared after import oil prices squeezed economic growth to a trickle in the 1970s and 1980s. Today, energy has shrunk to the fourth smallest sector in the index. The message is that money will go to its best and most efficient use in free markets, and today’s champions over time have a greater than average chance of becoming tomorrow’s chumps. Spoiler alert! Skip to the next paragraph if you have not seen 1960 classic namesake movie, The Magnificent Seven. Four of them are killed by the end.

That is not to say that these companies will disappear overnight, and averages will exhibit more breadth by next week. As investment advisors, we understand that trees do not grow to the skies and taking into account risk is an important input especially after some of the gains we have seen in these names. The point is that bull cycles are often defined by a small group of leaders that often leave other index members in the dust. The question is when will that end? Nobody knows. If an investor jumped out of Nvidia at the end of 2022 looking at a 50% loss, a lot of subsequent upside would have been missed. Similarly, if an investor dived into Exxon Mobil at the start of 1981 after the 46% return achieved in 1980, he or she would have lost nearly a quarter of that investment that year when the economy went into a recession. Hindsight is always 20/20. Unfortunately, the stock market does not hand out mulligans, which is why having an appropriately balanced, well diversified portfolio has been our mantra because it protects wealth while also participating in upside growth.

We define a stock’s value as a function of interest rates and future earnings (or cash flows to be more precise). While the debate over the path of interest rates continues, expectations are already formed for company results in the next few quarters. The technology and tech-adjacent communications sectors have the strongest price momentum, but the upcoming quarters will show waning earnings dominance. The lofty relative multiples will be another headwind for these groups. According to Bloomberg research, only four of the eleven sectors are likely to see earnings per share growth acceleration over the next year—health care, energy, materials and consumer staples. Revision breath, which measures a sector’s constituents’ change in year-ahead earnings estimates over the past three months, favors energy utilities and materials. For the markets to continue their stellar first half of the year growth, there must be more participation from non-tech sectors. Believe it or not, the economy is more than iPhones, social media pages and artificial intelligence semiconductor chips. The industries with the highest employment in this country are in elementary and secondary schools, full-service restaurants and general medicine and hospitals. Certainly, all those industries benefit from technological advances, but, at their core, are solidified by different drivers than the latest software download.

We will continue to monitor the markets and the macroeconomic events which will have long-term implications. A question we always get around the fall every four years relates to the presidential election. Here is an important quote we are emphasizing from Schwab’s legislative and regulatory affairs expert Michael Townsend:

“But probably the biggest thing that I get asked by clients, and probably you’re going to be asked over the next six months, is, you know, how much does the market really care about the election outcome? And I think the answer to that is not really a lot. And one of the things I like to show, this is a chart that looks at the S&P 500 performance in all of the election years going back to 1928. And what you see is that there are only four years in which the S&P 500 has been down for the year in an election year—1932, 1940, 2000, and 2008. Really important, though, to remind investors what was going on in those years. 1932, great depression. 1940, Europe is falling apart, and we’re headed towards World War II. 2000, tech bubble burst. 2008, great financial crisis. The four years, presidential election years in which the S&P 500 was down, it was down for reasons having absolutely nothing to do with the fact that it was an election year. So, a good reminder that it continues to be outside of the election events, economic and job information, geopolitical issues, and all that that affects the market, not the fact that it’s an election year.

And I’ll end with this. This is kind of my important message for investors at this time, and certainly for advisors right now, and that is that this is going to be an emotional election. We are going to have strong emotions from over the next five months, potentially going to have extremely strong emotions from clients on November 6th, the day after the election. And of course, as we all know, mixing emotion and investment decisions is not a good thing. This is a fun chart that I show clients, and, you know, its premise is kind of goofy, I freely admit that. But basically, what it says is if you had $10,000 in 1961, and you invested it only when a Republican was in the White House, you would have about $102,000 today. If you invested it only when a Democrat was in the White House, you would have more than $500,000. But of course, if you stayed invested the whole time without, regardless of who was in the White House, you would have about $5.1 million. So I think that’s a really important takeaway, that, you know, trying to invest around elections, or who is in the White House, and what they might do or might say, is just not is a good idea.”

There will be certain public policies which will have direct effects on particular industries or sectors. But that’s always the case regardless of who is in the White House or what party controls Congress. So, we encourage our readers to vote if eligible, but don’t fret on the outcome in terms of the financial markets because it is time in the markets and not timing the markets which is the main takeaway.

For our investors, a powerful incentive to stay invested relates to the continued cash flow received from dividends. Through the first half of the year, the SGK Core has had 20 companies increase their dividend payout. This is positive for a number of reasons. First, dividends are a real return on investment. Stock prices fluctuate day-to-day. A great month can be followed by an underperforming one, but dividends do not change once declared. Second, firms are loath to reduce the amount paid. It is not unprecedented to lower the payout but, for the most part, companies do not want to send a poor signal to investors that they are making less money than in a previous period. Thus, even in a tough market, investors get paid to wait for operations to improve. Third, with the majority of dividends paid in cash, the payout is a solid hedge against inflation. When items cost more, it is great to get paid more. Last year, we had 30+ firms increase their distributions, and this year is tracking very closely to 2023, so we are confident that there will be more raises to come.

The second half of the year is likely to have unforeseen and impactful events, like every year. The heart of hurricane season in the U.S., continued violent clashes overseas and the election in November all await. While they can present some daunting headlines, there can be unique opportunities that develop in the face of such challenges. Back-to-school sales are not going to be affected by election results, but they will play a major role for our holdings in WalMart and Visa. Whether or not the situation in the Middle East ends soon is not really going to affect the drug pipeline of Johnson & Johnson or Pfizer. Profitability, strong balance sheets and solid returns on equity and cash flows will continue to be the hallmarks of our fundamental analysis. We are thankful for the trust clients have given us to manage their financial affairs and fulfil our fiduciary duty. We look forward to what the global markets and economies will unveil in the months ahead.

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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