Market Commentary July 2024

Presented with a highlight reel of 2023’s economic and financial headlines, the average investor could have been forgiven for feeling the need to batten down the hatches in 2024. Decreasing tech exposure, shifting to companies with lower growth rates but stronger balance sheets, adding bonds, and focusing more on income would have sounded like a rational strategy. Why? Take a look at the backdrop as markets transitioned from 2023 to 2024:

• The S&P 500 had just returned over 26% for the year (how much better could it get? Answer: another 14.5% since then)
• Inflation was falling, but still persistent.
• 2024 election predictions were still a close call and promised to provide uncertainty in D.C.
• Tech companies were soaring in price, seemingly carrying the market on their backs.
• With rates still elevated, bank exposure to commercial real estate remained uncertain.
• Fitch downgraded the U.S. Government credit rating last August as debt hit an all-time high.

As is so often the case, the short term has proven unpredictable, and the market doesn’t always care about or agree with the implications of what is happening in the moment. What initially felt like “waiting for the other shoe to drop” has proven to be a continued “melt-up” for stocks leaving lower risk assets in the dust while hitting all-time highs on multiple occasions. As of the halfway mark for 2024, riskier assets were rewarding investors for their bravery, while cash and bonds were trailing far behind. So far.

A common concern expressed by investors is the fact that the stock market is at an “all-time high” as if this is a bad thing. The opposite is true most of the time. The chart below illustrates that all-time highs typically occur multiple times per year. Since 1980, the market has achieved 873 new all-time highs and experienced only 5 economic recessions over this time period. In a similar vein, the stock market has positive returns 73% of calendar years since 1926. Whether you are a young investor or entering retirement, your time horizon for most of your portfolio is decades, not months.

Artificial Intelligence (A.I.) – Something to Fear or Something to Cheer?

The frenzy that has persisted around A.I. – related stocks is truly remarkable, and unlike anything we’ve seen in decades. The stocks of A.I. companies are soaring, but so too are the stocks of companies suspected to benefit from the A.I. revolution. Even some utility stocks are in on the action! 

Consider the dot.com boom that happened in the late 90’s. At the time, it was clear that a new technology was changing how we would do business, communicate, shop, and play games. But it was unclear exactly how it would benefit investors and which companies would be able to execute a successful strategy to take advantage. There was a period when any company with “.com” at the end of their name was bought by investors with no questions asked. That ended badly for a large percentage of startups. Today, we’re seeing familiar themes emerge as companies try to associate themselves with the A.I. phenomenon. Callaway Golf’s latest driver is called the Paradym A.I. Smoke. It’s as if Callaway wants us to think they’ve created a club that is so smart it’s going to improve your golf game like Chat GPT improves your research capabilities. Not quite, but nice try, Callaway.

The biggest difference between 2024 and 1998 is the size of the innovators. Today we are seeing mature, mega-cap companies with fortress balance sheets and in many cases, cash flows that are already hard-to-fathom with seemingly limitless demand. The poster child for the boom, Nvidia, has gained over 3,000% in the last 5 years. That kind of return has never been seen in a company their size. Nvidia recently passed Apple and Microsoft to become the largest company in the world by market cap. If you don’t own the stock individually, don’t worry. It’s become such a large percentage of the indices; it would be hard to not have exposure in your portfolio somewhere.

There is no doubt that recent advances in computer chips and processors will change the way we go about our lives and some of that change will be scary. Nevertheless, I believe that the positive will far outweigh the negative. Similar to what the internet and smartphones have done for civilization, this technology will be a giant leap forward for medical research, transportation safety, and human productivity. What’s more, it will level the playing field. Much of A.I.’s power comes in the form of open-sourced, and often free access that anyone can use to supercharge their capabilities.  Whether you need to read, write, translate, or even generate images, the tools now exist to do it faster and better than any human (or even many thousands of humans) could in just seconds. Fears around job security abound, and indeed, some jobs will eventually go away. But first, most A.I. technology will supercharge employees’ capabilities in the workplace, so embracing the tools instead of shunning them is a wise move.

A.I. will likely change the world in three ways. First, there will be unintended consequences and even abuse. For example, students will make teachers’ lives even more difficult than they already are until an equilibrium is reached (after all, teachers can use A.I. too). Second, individuals and businesses will become unimaginably efficient while increasing profitability. This will result in more time to spend on the things we want to do, exponential progress in medical research and scientific discovery, and more earnings potential for stocks (thus the recent market reaction). Finally, it will give the regulators fits. As is almost always the case with innovative technology, the regulatory bodies will lag behind the innovators in their response and regulatory framework. This will undoubtedly lead to controversy, abuse, and frustration for the consumer, much like the chaos the internet unleashed as it was widely adopted.

We believe that even considering potential hiccups, A.I. and the inevitable breakthroughs related to its development will not only provide investors with many years of growth opportunities, but also assist with the inflation fight. The ability to expedite manufacturing and provide more services at scale will continue to explode. This is one of the reasons we haven’t lost much sleep over inflation. The chart below offers some insight into the historical rollout of some of the most world-changing advances, as well as the resulting growth of the U.S. stock market. Notice how recently the A.I. story came about. We are still in the early innings, and breakthroughs are coming almost weekly.

Signs of a Slowdown? Yes & No.

While unemployment remains low by historical standards, and corporate earnings have continued to surprise to the upside each quarter, the consumer seems to be getting close to exhausting the free money dropped on them during the pandemic. Travel demand remains high, but it’s clear that consumers are starting to get more disciplined after 2023 saw them spending wildly to get whatever it was they wanted.

While 2023 was the year of inflation concerns (I’m sick of writing about it), we’re starting to see price increases abate, and absolute prices in many areas actually deflate. If 2023 was the year of sold-out Taylor Swift concerts, 2024 may be the year of cancelled tours. Jennifer Lopez, the Black Keys, and others have recently cancelled or scaled-back plans for large tours, seemingly due to lack of demand. This is not to say that the consumer is in trouble, just that the drunken spending spree may be coming to an end. We are starting to see retailers and automakers (especially EV makers) mark down inventory to get it moving. It will take some time, but these changes will eventually show up in the government inflation data. 

As you can see in the chart below, while prices are still rising on most services, they are starting to enter negative (deflationary) territory for core goods.

While the consumer may be getting smarter about their spending, the question remains, how long can companies keep growing their earnings? After all, no other data point has a closer correlation over the long-term with stock prices. See the chart below.

With 92% of S&P 500 companies having reported their first quarter earnings results, the trends have been positive. According to FactSet, 78% of large cap companies had positive earnings-per-share surprises last quarter, which is better than the 10-year average. Blended earnings growth is coming in around 5.4% year-over-year, the highest in almost two years, making this the third straight quarter of earnings growth. Investors will be anxious to see if the trend can continue for 2nd quarter earnings. If it does, the market may have a reason to continue climbing higher in the second half. This, along with other pending data points, will factor heavily into the Fed’s decisions on interest rate levels.

K Shaped Recovery

While we haven’t seen a traditional recession in the U.S. for a while, many Americans feel that we’re in one now. In fact, a recent Harris poll of over 2,000 adults asked whether or not we were in a recession, and 56% of them said they believed we were. 49% also said they thought the benchmark S&P 500 index was negative for the year and that unemployment was at a 50-year high. None of this is true, so how can this be?  

Simply put, the prices of things people buy have gone up by more than most wages have over the past three years. Although wages have risen, prices have risen even more. For those who own assets such as real estate, stocks, bonds, or other investments, they’ve seen their net worth increase dramatically. To these “owners”, it doesn’t feel anything like a recession. However, for Americans who don’t hold substantial assets and measure their progress by their monthly cash flow alone, it’s been a tough road since 2020. Economists sometimes refer to a recovery as “K-Shaped” when different participants experience divergent outcomes. One group’s prospects move up and to the right, while the other’s slumps down and to the right to form the shape of a “K”. That’s exactly how some would describe the post-pandemic period.

Bad Breadth?

While stock prices tend to grind higher over time, the ebbs and flows of the market are cyclical in nature. Periods favoring riskier assets eventually give way as dollars flow to safe havens like bonds or dividend-paying stocks. If you’re positioned in lower risk strategies because of your financial objectives or risk appetite, you may feel like you’re missing out on the party. Don’t despair. The case is growing for a “mean reversion” favoring bonds and higher quality stocks. Those positioned in these areas should feel more confident in their ability to weather the next downturn. The next tick down in interest rates should, historically speaking, be a boon to these investors who have patiently waited for the Fed to change course. 

When market “breadth” is this narrow, meaning just a few big names are carrying the rest of the market, it usually leads to one of two eventualities: either the rest of the market catches up, powering the indices even higher, or a correction ensues, and markets reset. Either way, if you’ve missed out on some of the euphoria due to a somewhat lower risk portfolio, be patient, and remember why your risk levels and investment objectives were set that way in the first place. Continue to share those thoughts with your advisor, and you’ll likely feel more confident about your positioning and long-term strategy. Diversification always feels “dumb” when one or two names are having all the fun. On the contrary, diversification is the foundation of any shrewd investment strategy, even if we only appreciate it sporadically. 

What We’re Doing

We are maintaining portfolio positioning consistent with the previous quarter. A few interest rate cuts by the Fed would be welcome, but several would be worrisome. While positive on Artificial Intelligence, we are trying to determine when/if the hype might exceed profit potential. At some point, the sector will get ahead of itself resulting in a significant pullback. Surges and pullbacks are predictable. Timing is not. For long-term investors, we’ll continue to use diversification to weather any potential storms so we can take advantage of the recovery which reliably follows.

As always, thank you for your trust and friendship!  

Chris Proctor, CIMA®

Chief Investment Officer