by Brad M. Weafer, CFA | Chief Investment Officer
Key Points
- Equity returns had a strong start to 2024, but bond returns were modestly negative during the first quarter. The combination yielded healthy returns for balanced portfolios.
- The near-term environment for stocks is still benign with falling inflation, stable labor markets, and a positive outlook for fiscal and monetary policies.
- Less obviously timed risks including extreme valuations, increased debt burdens, and geopolitical concerns highlight the need for thoughtful rebalancing.
First Quarter Results
Global equity markets started 2024 with strength, as the MSCI All Country World Index returned 8.1% during the first quarter. Performance was once again led by large U.S. stocks, as evidenced by the S&P 500 Index’s 10.6% return (see Figure 1 below). After several years of major ups and downs, this quarter was marked by a lack of volatility. According to Goldman Sachs, nearly 40% of all trading days in the quarter finished at record closing highs, and the index did not experience even a 2% decline from previous highs. This caps a remarkable five-year run of 15% annual returns, well ahead of historical averages. The healthy equity returns offset lackluster results from the bond market. The Bloomberg U.S. Aggregate Bond Index had modest negative returns in the quarter, with income not high enough to offset an increase in interest rates (bond prices move inversely with interest rates). With abnormally low starting interest rates, the last five years have had historically poor bond returns, averaging just 0.4% per year. Despite the weak bond returns, balanced portfolios (consisting of 60% global stocks and U.S. 40% bonds) still finished the first quarter up nearly 5%. A similar dynamic has been playing out for the better part of the last decade. Take the last five years, during which equity returns compensated for poor bond performance, resulting in returns of nearly 7% per year in a balanced portfolio, just shy of the 7.6% that portfolio has averaged over the last 30 years.
Figure 1: Performance for select asset classes as of 3/31/2024
Data Source: Bloomberg. Global Stocks represented by the MSCI ACWI TR Index, U.S. Large Cap represented by the S&P 500 TR Index, U.S. Small Cap by the S&P 600 TR Index, International Developed by the MSCI EAFE TR Index, International Emerging by the MSCI EM TR Index, U.S. Agg Bond by the Bloomberg U.S. Aggregate Bond TR Index, Global 60/40 by 60% MSCI ACWI and 40% Bloomberg U.S. Aggregate Bond Index.
Quarter in Review
U.S. stock indices surged over the last six months behind surprisingly high economic growth in the U.S. and better than feared results overseas (See Figure 2 below). Economic momentum picked up considerably at the end of 2023, with GDP growth accelerating to 3.4% year-over-year in the fourth quarter, and estimated to be over 2% in the first quarter of 2024. A healthy labor market continues to be the key driver. U.S. unemployment has been below 4% for 26 straight months. Policymakers are also playing a role. Central bankers have expressed a willingness to reduce interest rates this coming year, ending a 2-year period of tighter financial conditions. Meanwhile, with the presidential campaigns in full swing, lawmakers have pressed ahead with fiscal growth initiatives further supporting economic health.
Figure 2: Citi Economic Surprise Index—United States and Global
Data Source: Bloomberg
With the S&P 500 index sitting at all-time highs, it is fair to ask, what’s next? The outlook faces a challenging dichotomy. Namely, the factors influencing near-term drivers of returns appear positive, but the risks facing longer-term returns continue to mount. Finding ways to balance the opportunities of the short-term while confidently meeting long-term objectives will be critical to investment success through the remainder of 2024.
Near-Term Positive Indicators
Recent market strength matches up well with a benign fundamental outlook for U.S. economic growth and central bank policy. We see a healthy labor market and expect inflation to continue to fall.
Employment Market Remains Healthy
Consumption is a critical driver for the U.S., with spending making up two-thirds of the economy. As the consumer goes, so goes U.S. growth. Unsurprisingly, spending most directly correlates to employment. As long as U.S. consumers are gainfully employed, they spend! Researchers from UCLA tried to quantify the impact in a study conducted in 2020. The study examined how people reacted to new 12-month highs in their local metro area’s jobless rate, and the results were sobering. They found when the unemployment rate reached a new one-year high, consumers cut their discretionary spending by an average of 2%. When unemployment persisted for five consecutive months, spending fell 5%.
Initial unemployment claims are the most useful leading indicator for labor. Changes in the trend of this data series (released weekly) have proven to be an early indicator of increases in the unemployment rate and key changes in the business cycle. Unless we see weakness in employment, it is difficult to make too negative a case for the state of the economy. The U.S. Bureau of Labor Statistics (BLS) reported a solid 300,000 jobs gained in March, causing the unemployment rate to decline to 3.8%. In the week ending March 30, seasonally adjusted initial jobless claims were 221,000. This is far below the 40-year average of over 300,000. As you can see in Figure 3 below, there has been no upward bias to the data for the last two years, suggesting weakness in the labor market is still a ways away.
Figure 3: U.S. Unemployment and Initial Jobless Claims
Data Source: Bloomberg
Disinflation Still the Dominant Theme
Official inflation statistics in recent months have unfortunately surprised to the upside. The Consumer Price Index (CPI) rose 0.4% month-over-month in March (following 0.3% in February and 0.4% in January) and the year-on-year rate ticked up to 3.5% from 3.2% in February. Excluding the more volatile components of food and energy, inflation has been running at a 3.8% annual rate, the highest since last May. The recent uptick has concerned some investors that the widely expected cuts in interest rates will not materialize this year. Even worse, some fear we will see a resurgence in inflationary pressures on the economy writ large. Recent comments from Fed Chairman Jerome Powell show less concern, suggesting there will be “bumps” on the road to achieving the 2% inflation target, but policymakers continue to watch the data to increase their confidence this is the case.
We do not expect housing-related inflation, a key driver of recent increases, to continue. Shelter inflation encompasses both rent and utility payments for renters and the estimated rental cost of similar houses for homeowners. Methods for official measurement are rather arcane and have been shown to have a significant lag to real-time price changes. Shelter accounts for nearly a third of the CPI inflation basket, and 40% of core CPI. Nearly two-thirds of the recent increase in the official inflation statistics have been captured by this category alone.
Our friends at Wisdom Tree have done significant work tracking this issue. Rather than use the official BLS statistics, they track real-time data (using ApartmentList.com, Zillow, etc.) to estimate the measurement. They find that when using those market rents (which declined 0.9% year-on-year in March versus BLS figures of +5.7%), both core and headline CPI are tracking less than 2% (see Figure 4 below). This is dramatically lower than headline numbers and well below levels consistent with current monetary policy. While recent increases in a number of commodity prices are enough to provide some pause, as this lagged data “catches up” to real-world experience, the path forward to lower inflation and lower policy rates looks clearer.
Figure 4: Trailing 12M Headline Inflation with Alternative Shelter Metrics
Data Source: WisdomTree. Alternative measure of shelter uses Average of Zillow ZORI and ApartmentList Historic Rent Price Estimates.
Strength Begets Strength
Isaac Newton’s First Law of Motion describes inertia: “A body at rest will remain at rest, and a body in motion will remain in motion unless it is acted upon by an external force.” Stocks also have a strong tendency to trend. Whether it is the wisdom of crowds or a behavioral bias, strong market returns in past periods have led to more positive returns in the future. Consider the thirteen previous episodes of 10% or better first quarter returns for the S&P 500 in the last 100 years. Only once did stocks experience negative returns during the remaining part of the year.
Figure 5: S&P 500 Returns in Years with Greater than 10% Returns through March
Data Source: Bank of America
Longer Term Concerns
The coast may look clear in the short term, but we see a number of risks that threaten the outlook for longer-term returns. Large U.S. stocks and their returns (as measured by the S&P 500) have been dominated by just a handful of companies that now collectively trade at historically high levels. While difficult to predict, the state of fiscal deficits and rising geopolitical tensions are areas ripe to introduce negative surprises. We aren’t predicting any catastrophes, but elevated market prices raise the specter of weaker long-term returns.
Indices More Concentrated Than Ever
Equities have become remarkably reliant on a select group of very large U.S. companies. U.S. equities now account for more than 70% of the world’s developed markets as global stock market concentration has risen to its highest level in decades. The weight of the top 10 stocks in the S&P 500 index has averaged 20% over the last 35 years but now sits at 32%, eclipsing the 27% level seen at the height of the dot-com bubble.
Figure 6: The 10 Largest Companies have reached Over 30% of the S&P 500’s Market Value
Top 10 Companies as a Percentage of the S&P 500’s Market Value
Data Source: Goldman Sachs Global Investment Research. Blue shaded regions indicate periods of economic recession.
The largest companies today have been dubbed the “Magnificent 7” for good reason. These companies are highly profitable, have strong balance sheets, and competitive advantages that support future growth. That does not excuse them from risk. Despite the clever nickname, they are not monoliths. A number of these companies have very real cyclical exposure to advertising, discretionary consumer spending, and the semiconductor inventory cycle. History has also not been kind to the largest companies. Competition from new entrants, vulnerability to innovation and disruption, as well as antitrust concerns, have felled many once-dominant giants throughout the years. The 10 largest stocks in the S&P 500 have underperformed an equal-weighted index of the remaining 490 stocks by 2.4% per year since 1957.
Valuations Approaching Dot-Com Bubble Levels
The S&P 500 index currently trades at a historically high 21 times calendar year 2024 forecasted profits. Even worse, the largest companies in the index are the most expensive, with the largest 10 stocks trading for an average multiple of 33 times 2024 expected profits! This is rarified air, only eclipsed by the dot-com bubble and late 2021. All else equal, higher starting valuations deliver lower equity returns over time. Valuation has shown little predictive use in estimating short-term returns (essentially 0% correlation when measured over 1-year) but has greater correlation over longer periods. The price/earnings multiple has averaged roughly 17x “next year’s” profits over the last 30 years and has been over 20x on only three occasions (see Figure 7). The sample size is small, but subsequent three- and five-year returns were negative in all prior periods when the starting valuation was above 20x.
Figure 7: S&P 500 Forward P/E Ratio
Data Source: Bloomberg
Portfolio Positioning
Balancing short-term considerations with long-term risks is always a challenge. Equity market strength has continued in the face of the risks we have highlighted. On top of that, unexpected risks occur with unfortunate regularity (think of the 9/11 attacks and the Covid-19 pandemic). Dealing with the unknowns and the lack of predictability of risks is exactly why investors must have a plan. A strategic allocation designed to meet long-term objectives with lower volatility along the way is the smartest way to stay on track. The first quarter of 2024 saw equities perform vastly better than bonds and likely requires active rebalancing to keep portfolios in line with strategic targets. Despite the concern that high valuations pose to equity returns, higher current yields on high-quality government and corporate bonds present a compelling offset to that risk today. Within equity portfolios, there is an increasing need to manage risk posed by the valuations of individual positions. In certain cases, this may require reducing or selling positions in excellent companies. High-quality companies with high profitability, low leverage, and durable growth in cash flow and dividends often trade at deservedly premium valuations, but that does not preclude them from the laws of gravity. At a time when concentration and valuation of equity indices are at their highest, the value of discipline on both price and business quality should deliver outsized value.
If you have questions about the capital markets, your portfolio, or how your assets are invested, please reach out to your Wealth Manager. We are always happy to take your calls and questions.
Market Commentary Disclaimer
This publication is for informational purposes only and should not be considered investment advice or a recommendation of any particular security, strategy or investment product. The information contained herein is the opinion of Boston Financial Management and is subject to change at any time based upon unforeseen events or market conditions.
Professional Designation Minimum Requirements Disclosure
CFA® – Chartered Financial Analyst. Minimum requirements for the CFA® designation include an undergraduate degree and four years of professional experience involving investment decision-making, in addition to successful completion of each of the three CFA® level exams.