First Quarter 2024 – Don’t Put All Your Eggs In the Shiny Basket

Market Recap

The first three months of 2024 were good for US stocks, in particular.  The S&P 500 index of large US companies advanced 10.6%, though it has been volatile and has given back some of those gains in the weeks following the end of the first quarter.  Developed international stocks were up 5.8% (MSCI-EAFE Index) and Emerging Market stocks were up 2.4% (MSCI EM Index).  Bonds were mixed for the quarter, with the Bloomberg US Aggregate Bond Index declining 0.8%, while high-yield bonds (ICE BofA High Yield Index) were up nearly 1.5% in the quarter. 

Investment Outlook and Portfolio Positioning

The primary story of the first quarter of 2024 is the surprising strength of the US economy.  A year ago, it was nearly universally accepted that we would be facing an economic slow-down by this time, and likely a shallow recession.  All of the economic indicators converged to paint a forecast that seemed bulletproof.  However, the sheer magnitude of the pandemic related stimulus programs has helped cushion the impact of higher borrowing rates and the normalization of supply chains (ability to get parts and raw materials) has helped bring down inflation.  The impact of higher interest rates hasn’t been painless, as there have been significant earnings declines at some companies, due to higher borrowing costs and higher labor costs.  However, on net, the positive impact of a tight labor market, higher wages and more money in the pocket of consumers, has prevailed.  It’s not all easy street though, as consumer debt levels have risen and savings levels have been declining.  There are also signs of slower consumer spending as retail sales have declined, but the absolute levels remain strong enough to keep the economy chugging along and avoiding a widespread recession, thus far.  It appears that the elusive “soft landing” is playing out with inflation moderating, while economic growth remains positive.  

The stock market is a long-term reflection of the overall economy, but it tends to bounce around with much more volatility, as investors try to position themselves based on predictions of future economic outcomes.  The value of common stock in a particular company should be the lump sum value of a properly discounted estimate of future earnings from the company.  Changes in interest rates can also have a dramatic impact on the calculated value, since the risk of the stock’s earnings forecast has to be weighed against the returns that can be earned on more stable bond investments.  Higher bond yields necessitate higher projected returns (lower starting values) to justify the risk of the stock investment.  Then we need to add to the equation our human nature and propensity for making financial decisions based on emotion rather than calculations.  

Currently, the stock market is reflecting better than anticipated economic growth, particularly in the US, but also worldwide.  This should broadly benefit the value of stocks both in the US and around the globe.  This has been a fundamentally sound basis for expectations of continued positive stock market returns.  Market expectations of interest rates have been a more volatile component of the calculation, lately.  Last year, the market was pricing in expectations that the Fed would quickly lower rates from 5% to 3.25% during 2024.  Today, the consensus is that rates will only drop to 4.25% by year-end.  With interest rates likely to stay higher for longer, the valuation calculation gets more conservative and high valuation stocks look more vulnerable to a pullback.  Treasury bonds earning over 5% look relatively attractive and even if they drop to 4%, you need stronger earnings growth forecasts to justify stock market and forecasting risk.  The human nature component of prices has also gotten more volatile recently.  Eagerness to participate in exciting new evolving technologies, like blockchain, electronic autonomous vehicles and Artificial Intelligence (AI) is causing some stock valuations to far exceed what the accountants and sober number crunchers can justify.  Just as the excitement has driven valuations up on some stocks, small disappointments in guidance have led to steep declines in valuations.    

The US stock market, represented most commonly by indexes that are skewed heavily toward technology companies, has recovered to new highs up to the end of the first quarter.  International stocks have not held up as well.  They have given us positive, but comparatively lower returns for an extended duration of time.  Bonds have continued to provide lower volatility to our portfolios, but at the expense of lower overall returns.  Gold has given us protection in the portfolio by behaving differently than both stocks and bonds and the returns have been strong, albeit not at the same pace as US growth stocks.  All of this has led to more clients asking me why we are so conservative or why we have invested so much in areas of the market that have not been doing as well as US growth stocks recently.  It’s a fair question, since it seems that we are blindly investing in the laggards.  Fear of Missing Out (FOMO) is a powerful human emotion when one area of the market is outpacing the rest.  I’m always reminded that risk aversion is also a powerful emotion, and it only seems to show up when it’s too late and market values have declined precipitously.

 Managing risk and managing our emotions is the hardest part of investing.  There are long periods in market history when being broadly diversified can be frustrating.  However, it is well established in logic and in market history, that being broadly diversified can help avoid catastrophic risks.  I continually come back to the dot.com bubble and real estate bubble as the most recent examples of risk, that some current investors are old enough to remember.  The S&P 500 Index took 14 years to recover from the dot.com sell-off, on an inflation adjusted basis.  The more growth-oriented NASDAQ index took even longer.  Less diversified investments in many single companies never recovered.  Being broadly diversified helped mitigate this inevitable downside risk.  

Recently, the stock price of chipmaker NVIDIA has been incredible.  It seems like it can’t lose.  But, in a competitive economy with many interested parties and governments, it is not hard to imagine a world in which other companies can compete away the current advantages this one company possesses.  When valuations paid for a stock require decades of unprecedented growth to justify, it doesn’t take much for reality to diverge from the projections.  The same can be said for Tesla, Meta and many other companies.  It doesn’t mean that we shouldn’t invest in the most promising companies.  I simply provide caution against eschewing diversification and risk management in pursuit of returns that happened in the rear-view mirror.  Putting your eggs in many baskets, in different locations, has always been an important component of risk management.  It can be tempting to put them all in the newest, shiny basket, but that basket is much more likely to attract attention and get knocked out of your hands.  Risk management can be tedious and boring, but the alternative is just gambling on last week’s numbers. 

Closing Thoughts

The U.S. economy currently appears to be in decent shape. The stock market continues to trend positive, as economic growth continues. There continues to be a high level of concentration in the “Magnificent Seven” stocks, which comprise about a quarter of the value of the S&P 500. In our view, this creates relative opportunity in the remaining 493 stocks in the S&P 500, which have not seen valuations so stretched. The possibility of a recession isn’t off the table by any means, but if it does happen, the timing is likely pushed back until late this year or 2025.  

As we look ahead, we anticipate markets will continue to be more volatile than usual.  Ongoing wars in Europe and the Middle East continue to increase the odds of drawing in more countries and more conflicts.  We also have a divisive upcoming US presidential election.  Historically, markets have been more volatile in election years, and this cycle appears to be a very close contest.  The results of the election are likely to impact certain industries, which is likely to cause more volatility as the polls get more meaningful.  US debt levels continue to expand and market expectations of higher interest rates for longer will only make that debt more expensive to sustain.  Currency markets around the world are getting more volatile, as they adjust to higher US interest rates.  All of this price action also creates opportunity as markets tend to overshoot valuations to the upside, as well as to the downside.  
We have been increasing our position in US Value and US Small/Midcap stocks.  

We have been reducing our exposure to China within the Emerging Markets position, due to their economic woes, less market friendly policies and increasing geopolitical risks.  We continue to see opportunity in the broader Emerging Markets space.  We trimmed some of our Gold position on strong market action and we have recently added to our allocation in Developed International stocks.  We continue to have minimal exposure to US large cap growth stocks trading at historically high valuations.

 Our bond allocation remains largely unchanged, as we continue to benefit from maturing old bonds that are getting reinvested into newer higher yielding bonds.  
We thank you for your continued confidence and trust. If you have any questions, please feel free to contact our office for an appointment.  

Cordially,

Shane M. Alsworth, MBA, CFP®, CLU®, CIMA®