Commentary – 2024 3rd Quarter

7/9/2024

Halfway through 2024, certain segments of the economy and stock market have experienced much stronger recoveries than others, underscoring a severe bifurcation between the “haves” and “have nots”. This year’s tale of two markets has underscored resilience at the index level, but considerable weakness at the individual stock level, leading to massive performance divergences.

The Stock Market

In this year’s bull market, there are artificial-intelligence plays like Nvidia—and then there’s everything else. As the second half of the year begins, investors are wondering whether something will give.

Enthusiasm for the chip maker, whose products are seen as essential to powering AI technology, kept building through the second quarter. Nvidia reported sales and profits in May that blew past Wall Street expectations for the fifth consecutive quarter. The stock rose 37% in the second quarter and is up 149% for the year.

Much of the rest of the market has languished. The average stock within the S&P 500 is up 4.1% this year, while the broad index is up 14.5%. That is the largest underperformance since at least 1990, according to Dow Jones Market Data. Six of the 11 sectors in the index declined in the second quarter.

While we believe the general uptrend should continue, the return focus of the mega cap tech stocks does come with its problems. The danger with just a couple of companies dominating the market comes the potential that, if one or more have disappointing news, the entire market would likely suffer. The same can be said of whether the “AI investment thesis” is able to deliver on its promise.

Technically speaking, a strong market tends to lead to greater gains if for no other reason than momentum. The market has recorded 31 new all-time highs thus far in 2024. Since WWII, the 10 years that enjoyed the highest number of new highs through mid-year went on to post full-year gains 100% of the time, rising an average of 21.5%.

The first half of the year has been unusually calm—the S&P 500 has gone over 380 days since the last selloff of more than 2.05%, the longest stretch for such an occurrence since the financial crisis of 2008. It seems unlikely that level of calm will continue in the second half of the year. July will feature earnings season, and investors will be looking for signs that the Fed’s rate hikes are having more of an impact.

Elevated valuations also pose a major risk and tend to suggest a volatile future for the stock market. The S&P 500 currently trades at a 33% premium to its 20-year average price-to-earnings ratio, while the S&P 500 tech sector sports a hefty 71% premium, the highest since 2000.

Currently, the Treasury yield backdrop should be supportive of the stock market, but a sharper move either higher (driven by an inflation reacceleration) or lower (driven by much weaker economic growth) would likely lead to weaker performance and/or higher volatility. In other words, the likelihood of a persistent “goldilocks” scenario is diminishing. Market concentration risk reigns supreme with significant underlying weakness. But we believe that underlying weakness also tends to provide opportunity, with a continued emphasis on quality.

The Economy

The broader market was supported by softer inflation data that raised hopes that the Federal Reserve would be cutting rates sooner rather than later. The June Fed meeting did little to dissuade those beliefs, even though the expectation reduced the number of interest rate cuts this year from three to one. We continue to believe that these expectations will be volatile and tied to every release of economic and inflation data point.

Throughout many of our commentaries for the past couple of years we have highlighted the likely end of the so-called “Great Moderation Era” that spanned from the late 1990s to the early stages of the pandemic. It was marked by persistent disinflation and a generally positive correlation between bond yields and stock prices. We now appear to be in an inverse relationship that is mirroring the start of the so-called “Temperamental Era” from the mid-1960s to the mid-1990s. That was an era marked by greater inflation volatility and a generally negative correlation between bond yields and stock prices. At least for the remainder of this year, we expect this correlation to remain negative. More persistence in this relationship beyond this year would, in our view, be a confirming sign that a new era is upon us.

Even though headline numbers have dwindled, the effects of inflation continue to persist. Recent economic data has shown that the consumer, especially at the lower end, is getting strained, and investors will be looking to see how severe that stress is becoming. Sales have softened in recent months, but the data can be volatile and it’s too soon to say if the consumer is in actual trouble. 

This high cost of living has dented consumer confidence. In terms of the path forward, inflation is likely to be the primary needle-mover for the trajectory of lower income confidence, while job security may hold the key to the trajectory of higher income confidence.

Although there is heightened focus on headline vs. core inflation and rates of change for both month/month and year/year readings, the typical consumer is focused on levels. Consumers are discouraged by the simple fact that prices remain significantly higher than they were pre-pandemic.

While we believe in the disinflation story, it will likely be a slow slog with bouts of volatility, leading to jumpy expectations around Fed policy. Absent a swift move down in core inflation (which is unlikely), the green light for the Fed to begin easing policy rests with the labor market.

Currently, nominal incomes (not adjusted for inflation) are approaching all-time highs and unemployment remains low, both signaling a healthy labor market. Assuming inflation can remain at its current, moderated level, it is therefore likely that interest rates will begin their descent this year.

Of course, the risk with a reduction in interest rates is that inflation then rears its ugly head once again. Such was the case during the aforementioned “Temperamental Era” and, we believe, the largest risk to the current economic landscape.

The Bond Market

Although signs of economic softening pushed yields slightly lower in Q2, broad economic resilience has been a key driver of the strong corporate bond performance to start the year. Despite concerns of rising borrowing costs given the aggressive pace of Federal Reserve rate hikes, corporate fundamentals are solid, with profits remaining elevated and balance sheets appearing relatively strong.

We continue to suggest investors gradually extend bond duration with intermediate-term bonds, and investment-grade corporate bonds can make sense as investors can earn similar yields to short-term alternatives such as Treasuries and CDs without much additional risk.

The extra yield that corporate bonds offer relative to Treasuries, however, is well below its long-term average. This can make outperformance more difficult to achieve, but we still believe positive total returns are likely.

Lastly, the yield curve for the broad bond market is less inverted than the U.S. Treasury yield curve, meaning that holding Treasury bills or other short-term investments opens the door for reinvestment risk once the Fed begins to cut rates, while considering intermediate-term bonds allows investors to create more stability of returns within the bond portfolio over time.

We encourage all clients to attend our live webinar, Quarterly Conversations, on Thursday, July 18^th at 4:00 PM, where we will discuss these topics in greater detail. The market commentary and recorded webinars are also available on our website.

Sincerely,

The Planning Capital Team

Daniel B. Brady, MBA, CFP® │ Partner

Richard W. Bell, Jr., CKA® │ Partner

David A. Emery, MBA, CDFA®, CFP® │ Senior Financial Planner

Jay D. Ahlbeck, CLU®, ChFC® │ Senior Financial Planner

Paul C. McClatchy, MBA, CFP® │ Senior Financial Planner

Quinn S. Michel │ Paraplanner Associate

Jill M. Hofknecht │ Client Service Associate