Market Commentary April 2024
2024 began with debates over a “soft” versus “hard” landing as the Fed attempted to stabilize the economy, as well as the sustainability of last year’s market rally. Only three months later, those concerns have given way to a calmer environment centered around fading inflation and the Fed’s plans for reducing interest rates. The result has been a strong market rally with the S&P 500 index, Dow Jones Industrial Average, and Nasdaq each breaching their all-time highs on numerous occasions.
The economic environment has surprised many investors as inflation continues to fade. The Fed’s preferred measure of inflation, the Personal Consumption Expenditures index, rose 2.5% on a year-over-year basis for all prices and 2.8% when excluding food and energy, both significant improvements from their peaks only a year and a half ago. While some elements of inflation such as shelter and energy costs remain problematic, inflation is steadily moving back to the Fed’s long-term 2% target.
Meanwhile, the unemployment rate remains low (under 4%), interest rates have stabilized, and positive stock market returns have broadened beyond artificial intelligence stocks.
Market Breadth Expanding: Can It Continue?
The S&P 500 has ripped off five straight months of gains and a first quarter return of 10.2%. Research from Fund Strat indicates that this was the 11th best first quarter since 1950. So far for 2024, 5 of 11 sectors are outperforming the broad stock market; up from just two last year.
Broadening participation by sectors other than technology is a healthy sign for markets, but we’re beginning to hear concerns from market pundits as well as clients about the sustainability of the rally. The upcoming election, Fed action (or inaction), and a “what goes up must come down” mentality have all contributed to the generalized anxiety many investors are feeling right now. Can the rally end or even reverse this year? Yes. Is it a foregone conclusion? No.
Steady Economic Growth Has Driven Markets to New All-Time Highs
The S&P 500 has achieved 20 new all-time highs so far this year despite the brief market pullback during the first two weeks of the year. While this is positive for investors, it causes some to worry that continued market growth may not be sustainable.
While price swings are an unavoidable part of investing, and the market does experience pullbacks from time to time, history shows that markets also tend to rise over long periods. During a bull market cycle, major stock market indices will naturally spend a significant amount of time near record levels, as shown in the chart above. For instance, 2021 experienced 70 days with the market closing at new all-time highs, adding to the hundreds that were achieved since 2013.
Taking a long-term perspective allows investors to benefit from these market trends without constantly worrying about when a pullback might occur. In addition, holding an appropriately diversified portfolio can help to weather market pullbacks without focusing too much on the exact level of the market.
Speaking of long-term, most investors think of this term when referring to anything longer than a few years. However, there is no agreed-upon definition. Patience over months or even a few years can be tough to muster. But earlier this year, Japanese investors experienced a milestone that was hard to fathom.
Speaking Japanese
While 2020-2023 was a psychologically challenging period for US investors, if one was patient and disciplined enough to resist the urge to bail out when markets got volatile, it was survivable. Nevertheless, there was a two-year wait for most investors to regain the paper losses they saw after markets peaked at the end of 2021.
It could have been worse. Just ask Japan. Their stock market as measured by the Nikkei 225 index hit a peak of 38,915 in December of 1989. Subsequently, the index faltered. It failed to regain that level until about six weeks ago, 34 years after its prior high! Imagine waiting more than a generation for stock prices to recover. Our investment committee has been overweight for Legacy clients in US stocks for many years now, and for good reason. The chart below looks similar to what we saw in the US markets during the 2022-2024 period; except the Japanese version took three decades to recover. Talk about patience!
The United States enjoys not only the good fortune of hosting some of the largest and fastest growing companies on the planet, but a stable economy with low unemployment, the strongest currency in the world, geographical dominance, and a capitalist system that fosters innovation and technological breakthroughs. We’re mostly self-sustaining in terms of agriculture and energy, and we’re nearly impossible to invade militarily.
Our stock indexes reflect many of these advantages, and although we could use more workers, less debt, and less disfunction in Congress, few countries would balk at trading places. Japan is a cautionary tale and a reminder that while international investing can provide diversification, no country or region has come close to our combination of growth opportunities, stability, and self-sufficiency. This is not to say we can’t find opportunities outside the US, but from a risk/reward standpoint, we don’t plan to replace American companies as the core of our strategies any time soon.
Markets Are Indifferent to Election Outcomes, Despite Rhetoric
Coverage of the presidential election is heating up ahead of the November rematch between Presidents Biden and Trump. While elections are an important way for Americans to help shape the direction of the country as citizens, voters, and taxpayers, it’s important to vote at the ballot box and not with investment portfolios.
This is because history shows that markets can perform well under both Democrats and Republicans. As the accompanying chart shows, the economy and stock market have grown for decades regardless of who was in the White House. What mattered more during these periods were the ups and downs of the business cycle. The Clinton years, for instance, benefited greatly from the long expansion of the 1990s. The George W. Bush years, on the other hand, overlapped with both the dot-com crash and the 2008 global financial crisis. Business and market cycles defined their presidencies, and not the other way around.
Of course, politics can impact taxes, trade, industrial activity, regulations, and more. However, not only do these policy changes tend to be incremental, but the exact timing and effects are often overestimated. Thus, it’s important to focus less on day-to-day election poll results and more on the long-term economic and market trends.
Fed Expected to Cut Rates as Inflation Stabilizes
The Fed is expected to cut rates later this year although the timing remains uncertain. The chart above shows the possible path of the federal funds rate based on the Fed’s latest projections, including three cuts this year. At its last meeting, the Fed cited strong job gains and low unemployment as indicators of solid economic activity but emphasized that “the Committee does not expect it will be appropriate to reduce [interest rates] until it has gained greater confidence that inflation is moving sustainably toward 2 percent.”
Regardless of the exact timing and path of Fed rate cuts, these projections represent a reversal of the emergency monetary policy actions that began in early 2022. For investors, it’s important to adapt to this changing environment and not focus solely on the events of the past few years. In the meantime, the Fed’s decisions or lack thereof will continue to cause volatility as interest rates transition to their next phase.
A Risk Worth Mentioning
Recent increases in the Fed Funds rate have resulted in the highest interest rates for money markets, savings accounts, and CDs in over 16 years. While it’s a good thing when low-risk or risk-free assets pay investors interest of over 5%, we feel it’s worth noting the high probability that eventually, a familiar risk will surface.
When the Federal Reserve sees fit to lower interest rates again, it will be either because they feel confident inflation rates are appropriate or because the economy is weakening and in need of stimulus. When this occurs, cash savings rates will drop. At the same time, it’s possible (and likely) that bond prices will rise significantly. Investors left with money markets and similar instruments paying 1-2% again may look for alternatives such as bond funds. While bonds may pay higher interest rates than cash at that point, the price appreciation that occurs in bonds (inversely) when interest rates drop will have already occurred, an unfortunate dilemma known as “reinvestment risk”. During this sequence, investors are susceptible to a “double whammy”. Their cash rate drops to a level that can’t beat inflation, and while that is occurring, they’ve missed the recovery in bond (and sometimes stock) prices.
Why is this important? The common strategy of sitting in cash until rates drop often backfires. Successful investors tend to move out of cash before rates drop to avoid getting “stuck” in low yielding cash with few alternatives at attractive prices. This is a good reminder to avoid complacency if you’re one of millions currently “parking” cash because of what feels like incredibly high interest rates. For context (see chart below), current rates are closer to the long-term averages, but can feel high relative to the recent interest rate experience (since the early 2000’s)
What We’re Doing
Our model portfolios remain exposed to a core broad stock market ETF which benefits from both holdings in the “Magnificent 7” and the broadening stock market participation noted earlier. Despite concerns about concentration risk in the big technology companies, their earnings growth expectations far outpace the “average” stock. Accordingly, we continue to hold a dedicated technology position in many client accounts that benefit from the rapid adoption of Artificial Intelligence (AI) and the ongoing labor shortage.
Our small cap ETF holding also stands to benefit from broadening participation of stocks outside big Tech. In addition, we anticipate small cap earnings should grow faster, on average, than large companies. When interest rates peak and head lower, this could certainly benefit these smaller companies.
We are also watching the Fed closely for any signs that warrant further changes to our bond allocations that we amended in the fall. In our view, we remain in a period when patience and discipline will reward investors, particularly bond holders who have yet to experience a full recovery following 2022-2023 price declines.
Final Thoughts
Last quarter, I closed with wishes for a boring and predictable year. Neither wish has been granted yet, but I have no complaints about economic or stock market performance. Barring major geopolitical happenings, the remainder of 2024’s performance will likely hinge on progress in the inflation fight and the ensuing Fed reaction. While we’re monitoring legislative potential in Washington based on election outcomes in both Congress and the White House for 2024, we’re still in the early innings. And, as we’ve mentioned ad nauseum, the election outcome will likely drive short-term market moves only, not direction over the long-term, which is what matters most to us and our clients.
Thanks, as always, for your trust and partnership.
Chris Proctor, CIMA®
Chief Investment Officer
