Second Quarter 2024 - The Market Craves Certainty
Submitted by Alsworth Capital Management, LLC on July 26th, 2024
Market Recap
In the second quarter of 2024, the U.S. economy remained strong, much better than most economists were expecting when making forecasts a year ago. We have continued to be surprised by the strength of consumer spending and magnitude of corporate cash flowing into Artificial Intelligence related investments. This has led to strong corporate profits and expanding valuation multiples, as investors continue to buy technology-oriented companies, hoping to benefit from the positive short-term momentum. The S&P 500 index of large US stocks was up 4.5% for the quarter, reaching a new all-time high and has now fully recovered from the 2022 sell-off. The gains continue to be heavily concentrated in a handful of technology companies, the most noteworthy being Nvidia. The semiconductor chipmaker became the world’s most valuable company in late June, with investors pinning the value of the stock ownership at $3.34 trillion. The top ten technology companies accounted for 70% of the gains in the S&P 500 index year-to-date. That is historically narrow leadership and overstates the strength in the majority of the stocks that make up the “market.”
International markets were mixed, as they have much less exposure to technology companies and have a much broader base of industries. The MSCI EAFE index of large developed international stocks was down 0.2% for the quarter and the MSCE EM index of Emerging Market stocks was up 5%. Bond markets were relatively volatile in the quarter, as investors grappled with the timing of when the Federal Reserve will cut interest rates. Markets are now predicting that the Fed is likely to start lowering rates in the Fall of this year and traders have been jockeying for position based on forecasts of how quickly rates will come down. Over the second quarter, bonds in the Bloomberg US Aggregate index gained only 0.3% and lower quality high yield bonds represented by the ICE BofA HY index were up 1%.
Investment Outlook and Portfolio Positioning
While forecasts of a shallow run of the mill type of recession in late 2023 or early 2024 have proved incorrect, there are still signs of a slowing economy. The University of Michigan Consumer Sentiment Index fell in June, indicating increasing pessimism about the consumer’s personal finances. Retail Sales have come in lower than expected and many retail-oriented companies have been warning that their customers are paying more attention to value and cheaper deals. Consumer savings have dropped to pre-pandemic levels and big purchases like housing and vehicles have declined. On net, we expect that the economy will continue to slowdown, but remain generally positive for now. The risk of recession has been pushed off; however, it is not completely off the table. Corporate earnings have been strong, and we expect that to persist in the near term, but at a more modest pace. We have added to our stock exposure in the portfolio, but we remain cautious about valuations in the US tech sector.
The “new era” of Artificial Intelligence may be upon us and with it should come advances in productivity and cost savings. However, our history is nothing but a series of “new eras” that have been transformative. In the beginning there are winners, like Nvidia is now. Then there is increasing competition and an erosion of competitive advantage, which we fully expect will occur this time around as well. Buying into companies that benefit from the AI advances makes sense, but not at “any” price. It has been a relatively difficult market for value-oriented investors, like us, as valuations (price compared to fundamentals), measured by a multitude of different methods, have all returned to historic highs. Within the US, the Magnificent Seven tech stocks represent over 25% of the value of the entire S&P 500 index. There is nothing that prevents extreme valuations from getting more extreme. The momentum certainly could continue, and valuations are a terrible predictor of short-term market movements. The eagerness of investors to own an asset, is what determines valuations. This is true of tech stocks, paintings, rare wines and fast cars. This component of pricing is fraught with the trappings of human emotions. Stocks, unlike paintings, are at least predicated on the expectation of future tangible earnings and/or future dividend income paid to stock owners. When those expectations are not met, there is a natural cause for valuations to retreat. However, we can’t know what would trigger such a reassessment and when it would become more widely acted upon. When it does happen, it results in eagerness to sell at any price, just as there was eagerness to buy at any price on the way up. Rather than try to predict the future, we have aligned your portfolio to overweight investments that are trading at a discount to historical valuations and progressively underweight stocks trading at premiums to historical norms. This has caused performance to typically lag during speculative advances and to generally outperform during corrections. It can be difficult to maintain this strategy during extended momentum driven price action. However, the ultimate goal is to avoid catastrophic losses and collect excess returns when valuations normalize. In pursuit of this goal, we have an underweight position in high valuation tech stocks at present and a significant overweight in lower valuation stocks. We have a market weight to international and emerging markets. We continue to have an allocation to Gold on expectations of future weakening in the US dollar. The position has performed well recently, helping to offset our reduced exposure to US tech stocks. We continue to overweight shorter-term bonds and we expect to shift that allocation toward longer-term bonds at attractive yields in the coming months. If the Fed starts to cut interest rates, while the economy remains on a stable footing, we expect that this will aid bond performance.
Closing Thoughts
The US election is coming into focus and the news has been volatile, to say the least, with an assassination attempt on former President Trump and the recent decision by President Biden to not seek reelection. The election is important, but the factors that move an economy as large as we have in the US are plentiful and largely beyond the influence of a President or political party choice. We view the high valuations in the stock market as a vulnerability, so anything that increases uncertainty is likely to have an outsized impact. Similarly, anything that increases stability will be very important for markets from this vantage point. We will be paying more attention to the effects of stability in the coming months than the specific outcome of the elections. We continue to hope for unity and predictable order above all else. A coalescing of each party around their known candidate, then an orderly election process and transfer of power would be the optimal outcome.
We thank you for your continued trust in our process and we welcome any questions or feedback that you have.
Cordially,
Shane M. Alsworth, MBA, CFP®, CLU®, CIMA®
The views and opinions presented in this article are those of Shane Alsworth only
Sources: Morningstar/Ibbotson data, Ned Davis Research, BCA Research, Litman-Gregory, iMGP
*US large stocks (S&P 500 Index), US large cap growth (Russell 1000 Growth Index), US large cap value (Russell 1000 Value Index), US small stocks (Russell 2000 Index), (Developed international stocks (MSCI EAFE Index), Emerging Market stocks (MSCI EAFE EM Index), Core investment-grade bonds (Bloomberg U.S. Aggregate Bond Index), Floating Rate Loans (S&P/LSTA Performing Loan Index), US Dollar (DXY Index), Gold (Aberdeen Physical Gold ETF), Commodities (Bloomberg Commodity Index)
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