by Brad M. Weafer, CFA | Chief Investment Officer
Key Points
- Large U.S. stocks were strong again in Q2 and indices posted another positive quarter leading many equity indices to all-time highs. Market leadership has been incredibly narrow however, and results varied markedly across diversified global portfolios.
- The combination of healthy economic growth and disinflation supports equities and sets the stage for the back half of the year.
- Performance and construction of the S&P 500 have grown increasingly concentrated. We see the greatest opportunities going forward in differentiated and diversified portfolios.
Second Quarter Results
Global stocks posted a third consecutive quarter of positive results during Q2 2024. This winning streak has helped deliver double-digit total returns year-to-date and near 20% over the previous twelve months (see Figure 1 below). Recent equity strength has been highly selective (more on this later). The largest U.S. companies, spurred by investor enthusiasm for Artificial Intelligence, have dominated performance leading to significant differences in return by company size, investment style, and geography. During the second quarter, the popular capitalization-weighted S&P 500 Index (in which larger companies are more heavily weighted) returned a positive 4.3%. There were very different results from small cap stocks (down -3.1%), dividend stocks (the Dividend Aristocrat Index down -4.6%), and international stocks (the MSCI All World excluding the U.S. up only 1%).
Figure 1: Performance for select asset classes as of 6/30/2024
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.
Economic Growth and Lower Inflation are Still Positive for Stocks
Historically, periods with economic growth that does not generate accelerating inflation have created a positive backdrop for equities. This should make intuitive sense as stocks follow corporate profits. Economic growth supports the demand for goods and services that companies provide. As long as inflation stays in check, companies can better manage their expenses and profits can grow. Often this backdrop is also met with easier monetary policy, making it less costly to finance that growth. The macro economy remains constructive in this regard. The most recent consensus estimates point to 2% GDP growth in the latest quarter and slowing modestly to 1.6% for the remainder of the year. Inflation has dominated investor attention in recent years but has continued to slow (see Figure 2 below). After a slight acceleration to start the year, the month-over-month change in the Consumer Price Index (CPI) has decelerated sequentially for four straight months, and actually declined month-over-month in June. We expect this trend to continue. We see additional measures of real-time price changes, including market rents, continuing to lead the official price indices lower. With official measures of inflation already nearing levels deemed appropriate to policy setters, we expect the Federal Reserve to ease policy in the near future.
Figure 2: U.S. Inflation (Year-Over-Year, Seasonally Adjusted)
Data Source: Federal Reserve of St. Louis. Core CPI excludes food and energy.
Labor Market Softening on the Margin
Despite a sanguine view of current conditions, it is important to try and look around corners for areas of risk. The health of the labor market continues to be the lynchpin for our outlook. Employment conditions have softened in recent months, and the unemployment rate has increased from a generational low of 3.4% in January of 2023 to 4.1% in June. Using almost any historical reference, today’s level of employment would be considered remarkable, but the trend certainly bears watching. Changes in unemployment tend to behave nonlinearly; once job losses begin to mount, they feed on themselves and accelerate, causing the unemployment rate to lurch higher with force. These sharp moves also limit the use of this data as a forecasting tool; once it becomes evident that unemployment has reached dangerous levels, it is too late to address. Other signs of labor market health have also cooled down. Initial claims for unemployment benefits have risen in recent months (see Figure 3). The absolute number of job loss implied by this data are not concerning but a continuation of this trend higher would be worrying. Continuing jobless claims have also moved higher, suggesting it is taking longer for unemployed persons to find employment. Estimates for earnings growth are robust and likely necessitate healthy economic growth to meet double-digit year-on-year expectations. This will be a critical factor in equity returns continuing their recent pace.
Figure 3: Initial and Continuing U.S. Jobless Claims
Data Source: Bloomberg
Index Concentration
Recent market activity compares with some of the most concentrated in history. Ned Davis Research reports that only 24% of stocks in the S&P 500 outperformed the index in Q2, on pace for a record low in the last 50 years. The six-month performance spread between the S&P 500 and S&P 500 Equal Weight Index has only been higher than it is now during a brief moment at the height of the dot com bubble in March 2000. Following the 12% outperformance in 2023, the end of the dot com bubble would be the only period that marked a higher spread over two years. It is not just performance that has become concentrated. The top ten stocks now comprise over 35% of the S&P 500 Index, a 50-year high. By all accounts, the S&P 500 Index has become unrepresentative of the broader U.S. stock market.
Figure 4: Top 10 Positions as a Percentage of the S&P 500
Data Source: Strategas, Bloomberg
Concentration Creates Opportunity
This year, owning anything but the S&P 500 Index has seemed like a mistake looking through the investing proverbial rearview mirror. Historically, periods following similar setups have proven the worth of looking outside the major indices and finding value away from the investing herd. As an example today, mid cap stocks (as represented by the Russell Mid Cap Index) are trading at a near 20% discount to large cap stocks (see Figure 5: P/E ratios below). We see other idiosyncratic opportunities in Japanese stocks as another example where diversification can contribute to returns.
Figure 5: P/E Ratios
Data Source: Bloomberg. U.S. Large Cap stocks represented by the S&P 500 Index. U.S. Mid Cap stocks represented by the Russell Mid Cap Index.
Balanced Positioning is Still Prudent
While we remain constructive on the general economic environment, a balanced view on risk remains the best approach. The end of the economic cycle keeps every data point front and center and a source of volatility. Central bank policy reaction to said data also plays into sentiment. If that isn’t enough to create market suspense, we are living through one of the more dramatic U.S. presidential elections in modern history. It might be an understatement to say investors should expect the unexpected from now until the end of the year. Fortunately, traditional fixed income and select diversifying alternative investments present healthy outlooks that provide the ability to be patient and still earn attractive balanced portfolio returns.
As always, we are happy to discuss the current outlook and portfolio positioning. Please reach out to your wealth manager with any 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 examinations.