U.S. STOCKS AT RECORD LEVELS
The largest U.S. stocks, represented by the S&P 500, ended the first quarter in 2024 at an all-time high. Human nature makes us question the longevity of the stock market’s current rally, but stock market history provides optimism. Observing data going back to 1988, forward returns after reaching an all-time high have outpaced all stock-market returns on 6-, 12-, and 36-month increments. On top of this, one-year forward returns have been positive over 70% of the time after reaching all-time highs. The overwhelming similarities between all stock market rallies is that they correspond with firm economic activity and continued earnings acceleration. While the U.S. economy has had challenges post-2020 (i.e. inflation), it has shown to be durable in the face of higher interest rates. All things considered, investors must be cognizant of risks. The sustainability of market performance is reliant on a broadening of market leadership, the Federal Reserve refraining from policy errors, and a broadening of geopolitical risks or conflicts is avoided.
FEDERAL RESERVE
The Federal Open Market Committee (FOMC), the monetary policymaking committee of the Federal Reserve (Fed), left the range for its target policy rate unchanged at 5.25%-5.50% in March for a fifth straight meeting. This meeting garnered more attention because it provided an updated glimpse into the FOMC members’ expectation on rates. The FOMC’s median dot plot, which suggests the future level of the Fed’s target policy, was unchanged at a total of 0.75% in cuts for 2024, for a cumulative 2.25% of cuts through 2024-2026.
At the end of March 2024, its target rate projection was equal to the Fed Funds Futures (a market estimate based on the Fed’s target policy) in 2024-2025, then deviates in 2026. Fed chair Jay Powell has been steadfast on the trajectory of the FOMC target policy but won’t provide much guidance on timing other than the FOMC’s consensus view of three 0.25% cuts in 2024.
With the market consensus expectation and Federal Reserve effectively on the same page, a sharp change in the economic environment is the most significant risk moving forward. As of now, the FOMC expects inflation to slow on falling shelter and services costs amid firming economic activity, providing ample room to cut interest rates. However, if economic activity accelerates prices again, the Federal Reserve could consider tighter monetary policy for longer, to slow a second wave of inflation. As of now, the path of least resistance remains slowing inflation to the Federal Reserve’s goal of 2% alongside a steadily growing U.S. economy, a suitable environment for risk assets.
CHANGE IN LEADERSHIP?
The S&P 500 extended its monumental performance that began in October 2023 through the first quarter this year, returning nearly 28.5%. Despite this return number being magnified by a few concentrated and large company members, returns have broadened to other smaller company indexes. The Russell Midcap Index and the Russell 2000 Index (small companies) have outperformed their large company counterpart by more than 2% since the end of October 2023. A few reasons can explain the catch-up in performance: an improvement in the global economy, productivity gains, and smaller company’s lower relative valuation.
The simplest indicator to communicate the near-term improvement in the economy is through the Conference Board’s U.S. Leading Indicator Index. Leading economic indicators are used to provide early signals of significant turning points in the business cycle. Leading economic indicators have been in negative territory since July 2022 on a year-over-year basis. It appears slowing economic growth has found a trough late last year and has accelerated through the start of 2024. The wealth effect from rising stock prices, employment and strong credit conditions have been the biggest positive contributors to the leading economic indicators.
Improving economic conditions are important for the entire stock market, but smaller companies are more dependent on strengthening economic conditions. This is due to their compositional reliance on the success of the economy. Industrials, Real Estate, Materials, and Financials sectors have higher weights in smaller-capitalization indexes compared to large-capitalization indexes.
Warren Buffett once said, “Stock market valuations are based on what other people will pay”. Valuation is second in importance to fundamentals, but valuation can offer insight into investor sentiment. Small- and mid-capitalization indexes (SMID) remain relatively inexpensive to large-capitalization stocks despite the recent better relative performance. There are two reasons for the shift in valuation: structural and cyclical. First, successful SMID stocks either grow into larger, more diverse businesses or they are acquired. The emergence of private equity has limited the pool of high quality, public small-capitalization stocks, thus decreases the overall valuation of the group. Second, the unique cyclical headwinds SMID faced since 2020 should soon fade. Smaller companies are more dependent on the change of interest rates and are financially levered. Cyclical headwinds are slowly becoming tailwinds.
BROADER STOCK PARTICIPATION
Catalysts behind the pickup in SMID performance have contributed to overall S&P 500 performance. Last year, only three sectors outperformed the overall stock market: Information Technology, Consumer Discretionary, and Communication Services, due to exposure to the magnificent seven or those companies with little debt, high margins, and earnings growth. As a result of better economic conditions, investors are more willing to consider economic sensitive stocks within the S&P 500. So far this year, Energy, Financials, and Industrials are outperforming the stock market. A greater number of companies contributing to equity returns is considered a positive signal for the stock market in the near-term.
In addition to increased market breadth, robust Q1 performance augured for better returns to come. Going back to 1960, strong starts to the year have been followed by strong finishes. The 15 best Q1 market performances have been followed by average returns of 7.4% to complete the year.
VALUE TAKES THE LEAD ALONGSIDE SMID?
A broadening of market returns hasn’t necessarily led to value turning into a market leader because of the extraordinary returns of artificial intelligence (AI) related growth stocks. In the first quarter of 2024, the S&P value index returned about 8%, lagging the S&P growth index by a little less than 5%. This is more of the market rewarding the potential earnings catalyst of growth stocks, as opposed to being a mark against the value segment. It is no secret that we are potentially in the early innings of the productivity-driven AI revolution; however, the current macro-environment tends to benefit value stocks.
(R): Refers to the right-axis, which is representing the 10-Year Treasury Yield (inverted).
The value segment has many similarities to SMID, as the composition is heavily influenced by Financials, Industrials, and Materials sectors, thus an improvement in economic activity usually determines the value and growth performance differences. One of the easiest gauges of determining economic activity are long-term interest rates, particularly the 10-year Treasury yield. When it is elevated and rising, economic growth is positive and expanding, leading to an environment of “a rising tide lifts all boats.” The 10-year Treasury yield advanced to 4.20% to close out the 1st quarter of 2024, after settling below 4% to end 2023. Historically, elevated long-term interest rates tend to favor value segment. According to JPMorgan Asset Management, value stocks have outperformed growth stocks by a 2% annual rate going back to 1979 when the 10-year Treasury yield exceeds 4%.
RESILIENT ECONOMY REMAINS A BACKDROP FOR RISK ASSETS
As noted in the Q1 2024 Portfolio Insights & Outlook, the valuation of stocks and bonds reflects resilient economic activity. The price investors are willing to pay for stocks’ earnings is above the long-term average and bonds with credit risk are exhibiting tighter spreads relative to Treasury bonds. Asset valuation is important because it serves as a guide for future long-term performance capacity. However, risk asset performance will always depend on earnings potential. The correlation between earnings and the price of the S&P 500 index is high and nearly perfect (97% correlation) going back 70 years. Corporate earnings are expected to advance by low double-digits in 2024 & 2025 on elevated margins made possible through productivity gains continuing to tick higher. This sustainability of earnings is the primary consideration for investors as we move through 2024.
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