Market Update July 2024
With the first half of the year in the books, we now seem to be rumbling towards the potential of a more volatile second half. Let’s review the past six months, and then spend most of our time looking ahead.
2024 has, so far, behaved much like the year that preceded it, at least as far as the US stock market is concerned. Strong gains in stocks, with extremely low volatility, have been in place since the start of the year. Large cap stocks have once again dominated their smaller brethren, and US stocks have significantly outperformed international equities over this time as well. You can thank a strong US dollar and a relatively strong US economy for that.
Bonds have been an income contributor in 2024, but this interest income has been slightly offset by minor declines in overall market value, as rates have risen slightly since the beginning of the year. Risk has also been rewarded in the bond market, as high yield debt has performed well, even though spreads to Treasuries remain historically narrow.
Don’t count on the rest of 2024 being that easy.
The back half of 2024 may prove to be much more challenging for a couple of reasons. Firstly, the November elections. All markets have had some practice with Presidential cycles. Even so, this one may prove to be particularly interesting. The prospect of a blurry outcome may keep markets on edge for months, even after the election has passed. Markets may take some comfort in knowing that candidate Trump was President before, but the Democrats now seem to be searching for answers, with Harris the most likely nominee, but not assured, as of this writing.
Markets, for now, seem to be taking the Democratic upheaval in stride, perhaps giving the Democrats the benefit of the doubt, at least for now. Typically, markets really begin to focus on election after the second convention; in this case, after August 19th-22nd, when the Democrats hold their convention in Chicago.
To offer some longer-term perspective, I turn to the great work of my friend and Schwab’s Chief Investment Strategist, Liz Ann Sonders. She recently analyzed Presidential returns. An investor who put $10,000 in the S&P 500 in 1961 and only invested when Republicans were in office made $103,000 by the end of last year versus $500,000 for another investor who only invested when Democrats were president. (A word to the wise: markets rise and fall depending upon many more important variables than Presidential party. Also, this is a very short time period, so please don’t think that investing under Democrats is better than investing when Republicans are in power). The punch line is this: One who stayed invested since 1961, regardless of who was President, made $5.1 million. This proves once again the old adage. It is not timing the market that is important, but time in the market.
Of course, we will be monitoring the election and its ramifications for the economy, interest rates and equity markets around the world, and want to keep this all in perspective. Which brings us to the second reason why markets may be a bit more challenged in the second half, valuation. When you remove the magnificent 7 (a group of stocks that include Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia and Tesla) from the calculation, stocks are trading about 18 times forward earnings, roughly in line with long-term historical norms. While this, in itself, is not a reason to become overly cautious, it is a reason not to become overly optimistic about future returns. When we include the magnificent 7 in this calculation, we find that valuations have become a bit stretched. We believe the overall theme of artificial intelligence has many years to run, but there will inevitably be pull backs in markets as this theme fully plays out. We feel we may be approaching one of those periods now. Valuations are such that many stocks within the magnificent 7 are priced based upon extraordinary growth in the future. If anything were to come along to disrupt, delay or question the viability of this growth, these stocks become ripe for correction. There are several factors now in markets which lead us to believe we may be at a near term inflection point for some of these stocks, including the fact that they are now being purchased by a very naïve investor base. These investors have historically been an indicator that popular stocks have reached their price crescendos, at least in the near term.
While we may see a pullback in the magnificent 7 in the near term, we believe that we still may be in the early innings of the AI revolution. After all, the magnificent 7 have outperformed all other public equity investments over the recent past, and while others have called for this broad phenomenon to end, we disagree. For historical perspective, let’s look at other themes to see how long they tended to last. History shows that large-cap outperformance has been going on for the better part of a century. This outperformance has sometimes lasted for decades before it switched to the next favored sector or theme. In the early 1900s, railroads dominated, followed in the 1920s and 1930s by automobiles and airplanes. Chemical stocks, along with automobile companies, dominated the 1940s to the 1960s. The 1970 and 1980s gave us energy domination as the price of oil spiked amid Middle East tensions. The 1990s gave us the Internet and the technology bubble, the period to which the magnificent 7 is most often compared, and thus seems to have brought us full circle to where we are today. Is a correction in the near-term possible, yes, but the end of the AI-themed run seems to be a long way off. On the flip side of the coin, and despite the recent move in small cap stocks, which are up 10% in just over a week, we believe you shouldn’t count on small caps to return to their past glory and so recommend that you do not chase these strong returns that may be caused by investors temporarily leaving large cap.
The main reason for this belief is that markets do not historically reset to favor small cap stocks after favoring large cap stocks in a bull run. Markets actually do tend to do the opposite. Of course there have been periods of small cap outperformance during the past 100 years, and the small cap asset class for a period of time was considered to be riskier (and still is), but also was able to provide the courageous investor with higher returns over time. This belief of small cap outperformance over time may now be false, as the most recent period has been dominated by large cap returns over small, that large cap and small cap historical returns may now be considered roughly the same, depending on what time period you use. Furthermore, with changes that will be discussed below, you could make the argument that large cap stocks offer the greatest potential for return in the public markets because of the many changes that have taken place in the small cap arena.
One of these major changes is that smaller companies are postponing going public, and staying private instead, for long periods of time. This has changed the makeup of the small-cap index significantly. Now, many companies upon going public have market caps in excess of $10 billion, qualifying them to be in mid cap or large cap indexes upon their trading debut. Small cap indexes nowadays are therefore made up of companies that went public long ago, and have not grown out of their small cap status. The opposite has also happened, as the small cap index is made up of companies that used to be larger but have fallen in market cap through poor performance and now find themselves in the small cap index instead. Add to this that earnings have also been flat in the index for the past few years and you can see why the possible conclusion that zombie companies (a company that is heavily in debt and only has enough cash to make their minimum payments) may be more ubiquitous in this index than commonly thought is quite a viable conclusion.
Small cap indexes also have large exposure to regional banks and biotech, and are thus subject to swings in these two industry groups particularly. In summary, while the second half of 2024, may prove to be a bit more difficult than the first half because of the election and the potentially stretched valuations that exist in some areas of the market, we remain constructive on markets overall. This is especially true as we look out over the next 12-18 months, and will continue to have a slight overweight to the US and to large cap stocks in particular. But we warn that volatility is to be expected as we progress through the second half of 2024. We will look to see if that volatility is projecting something sinister, or if it may instead be presenting us with a buying opportunity to add exposure to risk assets at better (lower) valuations against a backdrop of tamer inflation, a more friendly Federal Reserve, an election which will eventually be behind us and the theme of AI which may be just getting started.
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