Altair Insight: An Airy Market (2Q24)- Quarterly Market Review
Human: “Is the stock market’s fixation on artificial intelligence overdone?”
ChatGPT (AI): “The stock market’s fixation on artificial intelligence can be seen as both warranted and potentially overdone, depending on the perspective.”
Some summer surprises have jolted the U.S. presidential race lately, confirming among other things that a changing of the guard in the White House is at hand (more on that below). For investors, though, nothing yet tops the market’s AI frenzy as the story of 2024.
Nvidia and a few other tech stocks tied to the AI boom, equipped with longer poles, have significantly outperformed the market this year.
Artificial intelligence is a world-changing technology that will revolutionize product innovation, health care, the workplace, business efficiency and more. So far, though, perhaps its biggest impact is having turbocharged a handful of tech stocks, as investors are willing to make big bets on their potential future earnings derived from this transformational technology. Investors are caught up in a craze that has engulfed and warped markets, leaving diversified portfolios badly trailing the S&P 500 and many other indexes – their holdings now unprecedentedly concentrated and tech-dominated due to the outsized performance of a few stocks.
Let us be clear. We are not suggesting that this has the makings of a 1990s-type bubble or, to take it to an extreme, the tulip mania that infamously caused a Dutch market collapse. The froth that preceded the demise of the dotcom era is less evident today. Microsoft, Apple and their high-tech peers have abundant earnings and capital to invest in AI and keep powering ahead, unlike the money-losing high flyers of a quarter-century ago. Yet it is inevitable that the craze that, among other things, has driven Nvidia shares up as much as 150% in 2024 will abate.
That time does not appear imminent. AI-everything fever has infected more than markets. Now available at a pro shop near you: AI-powered golf clubs (which we hope will eliminate our double bogeys). A $400 electric toothbrush with AI also can be had. And companies are dumping every capital expenditure possible into an “AI investments” category to show they are on top of this trend.
Nvidia stock, now up 3,000% in five years, could keep out-vaulting the field (as we show in our OIympic-themed cartoon), joined by the other mega-tech stocks. Or it could return to earth with the rest of the market as another tech giant and market darling, Cisco Systems, once did. Not that we are predicting that fate. But we bring up Cisco to illustrate our point and share an illuminating anecdote from the dotcom days that baseball fans may recall.
The opening game of a playoff series in Chicago between the White Sox and the Mariners in October 2000 was tied 4-4 in the 10th inning when Seattle Manager Lou Piniella surprisingly walked out to first base to talk to his baserunner, Mike Cameron. His unconventional chat ultimately was concluded to have been a successful ploy to disrupt the pitcher. An apparently rattled Keith Foulke gave up three runs as the Mariners won the game and went on to sweep the American League Division Series. What made big news, however, was Piniella’s quip when asked what he had said to Cameron: “I told him the Nasdaq was down 113 points and Cisco was a heck of a buy.”
As a household name and hot stock, in other words, Cisco was the equivalent of today’s Nvidia. A leader in digital communications technology, today it is a $57 billion tech giant that makes much of the technology that connects the internet. But its shares trade at about the level where they were when Piniella strolled onto the field. We like Nvidia, and some of our recommended fund managers hold it. However, its colossal outperformance, like Cisco’s, will level off one day. While maintaining our tactical overweight to U.S. large caps, we will not chase performance by overconcentrating portfolios in Nvidia or any other Magnificent Seven company.
We believe strongly in diversification and will continue to recommend balance in portfolios, which over time has proven to be the best way to both grow and protect assets. When AI mania ebbs, as it inevitably will, we believe diversification will once again prove its effectiveness by protecting portfolios and delivering better long-term, risk-adjusted returns.
Please read on for our quarterly discussion of issues affecting the economy and the markets, where we address the upheaval in the presidential race along with other election-related observations. Topics also include the timing of Federal Reserve rate cuts and the outlook for inflation.
1. A top-heavy market has been ‘Magnificent’ for only a few stocks, an imbalance we do not expect to last.
Markets have rarely been this lopsided, with a very short list of big winners and a long tally of laggards and losers. Nvidia led the way in the first half with a 149% surge and has quadrupled in the past 14 months. The Magnificent Seven minus Tesla (Microsoft, Apple, Nvidia, Alphabet, Meta Platforms, Amazon.com Inc. and Broadcom in place of temporarily slumping Tesla) accounted for two-thirds of the S&P 500’s 15.3% first-half gain. Meanwhile, almost 40% of the index’s stocks actually were down for the year. We agree with the analyst who recently quipped that this is “a generationally weird U.S. stock market.”
The numbers show that it is the most concentrated market in modern history:
- 10: The biggest 10 U.S. stocks represent 36% of the S&P 500 market cap – a record high over the past 150 years, according to Morningstar Data.
- 5: The top five stocks (Microsoft, Apple, Nvidia, Alphabet and Amazon) represent 26% of the S&P 500 – also unprecedented.
- 3: Just three companies – Microsoft, Apple and Nvidia – make up a tenth of global market cap.
- 1: Nvidia alone generated a third of the S&P 500’s 15.3% first-half gain. Since the November 2022 release of ChatGPT accentuated its role as the world’s leading maker of AI chips, its market cap has rocketed from $400 billion to $3 trillion, making it briefly the world’s most valuable company.
In the short run, this lopsidedness is problematic for diversified portfolios such as ours. Prudent, risk-conscious investment strategies would never allow such an extreme level of concentration in their portfolios by betting on only a handful of hot stocks to repeat their extraordinary gains. The short-term drawback is that virtually every active stock fund and asset class not focused on the Magnificent Seven has significantly underperformed this year. It has been difficult to outperform the S&P 500 or other index funds without holding outsize, and in our view risky, weightings in today’s highfliers.
We do not see a bust coming for these well-heeled tech companies. Besides dominating market capitalization, they are generating the majority of all corporate profits. But we do anticipate an inevitable fading of the Magnificent Seven’s “superpowers.” Some recent hiccups in their shares heighten the skepticism we already had about the sustainability of their continued meteoric run-up. In a healthy economy with corporate profits accelerating, we think the market’s one-sidedness will begin to even out. Estimates of future company profits hint at such a likelihood: FactSet projects earnings growth for the S&P 493 to roughly equal the Magnificent Seven’s earnings growth in the back half of 2024 and into 2025.
Since 1928, there have been 29 other years like this one when the S&P 500 was up 10% or more through June. The average gain by year-end was 24%. And in each of the last 12 instances of such strong starts going back to 1988, the second half generated positive returns.
We also believe patience is merited in other stocks and asset classes that have underperformed. Small caps, international developed stocks and bonds are well-positioned for improvement, and coming rate cuts can help lift them all, along with real estate.
2. Global central banks have begun loosening restrictive monetary policy, a trend the Fed should soon follow.
Let the loosening begin. The European Central Bank (ECB) kicked off what is expected to be concerted rate-cutting among the “Big Four” central banks – Bank of England, Bank of Japan, Federal Reserve and ECB, which lowered rates in June for the first time in nearly five years. That followed similar actions by smaller central banks in Canada, Sweden and Switzerland, all signaling the end of an aggressive global policy to eradicate a surge in inflation.
The Fed’s conditions for cutting rates have effectively been met, in our view. Now it just needs to begin cutting. Chair Jerome Powell has been saying for months that policymakers need to see more data showing progress in the inflation battle. While Powell is not always explicit, a few news headlines from this year confirm that his message has been nothing if not consistent:
January 31st: “When Will the Fed Cut Rates? More Data Needed, Powell Says”
March 6th: “Powell: Fed needs more data to boost rate cut confidence”
July 2nd: “More data of falling inflation needed before rate cut: Powell”
We applaud the emphasis on caution. Prematurely declaring victory over inflation has dearly cost the Fed and the economy in the past, as we have noted in prior commentaries. Allowing inflation to persist in the late 1960s, for example, enabled it to become entrenched in the ‘70s. Letting it skyrocket in 2021, while maintaining rates at zero for close to another year and continuing to add liquidity through quantitative easing programs caused problems that have only recently unwound.
However, recent economic reports convince us that the time to lower rates has arrived. They show that the Fed’s dual goals as mandated by Congress – price stability and maximum or full employment – are seemingly at or near Goldilocks levels, as we will discuss further in the next two sections. Core inflation is down to an annual rate of 3.3% by one recent measure (CPI) and 2.6% by another (PCE), cooling even more in recent months as the 2% target nears.
We believe the risk of a near-term recession is low and the Fed is poised to pull off a soft landing if rate cuts begin by this fall. Fed policymakers, while still noncommittal, appear to be coming around to the same conclusion. Powell himself says labor-market conditions have returned to their pre-pandemic level. He and his colleagues have indicated that recent inflation data has been encouraging.
We expect the Fed to lower rates at least once this year, starting soon, and likely twice. Three cuts by year-end, as is currently forecast by a narrow consensus of market traders, strikes us as unlikely.
Reducing rates at the Fed’s September meeting, with perhaps one more cut to come in 2024, would mark an important step forward for businesses, consumers and the economy. It is time for the Fed to join the great global loosening.
3. Inflation is back to pre-pandemic levels by some measures, with housing slowly following.
The bumpy road toward the Fed’s 2% inflation target that we discussed in last quarter’s commentary has since become smoother, which bodes well for a successful conclusion to the journey. Housing costs still present potholes, but progress has been notable.
An inflation report card:
- The Fed’s preferred inflation gauge, the Personal Consumption Expenditures (PCE) price index, is back at 2.6%, the lowest since early 2021, after minuscule monthly inflation of 0.1% in May.
- The Labor Department’s Consumer Price Index cooled in June to the slowest pace (3.0%) since 2021, falling on a monthly basis for the first time since the onset of the pandemic.
- The percentage of CPI components rising by more than 2% is in line with the pre-2020 average.
- Wholesale prices fell in May and are trending lower despite edging back up in June, leaving their index up 2.2% year over year.
- Goods deflation continues to pull inflation closer to 2%.
In short, while it remains unlikely that the Fed’s 2% goal will be achieved this year, the latest moderation suggests it should be reached soon, with time to spare as the economy has held up long enough for the Fed to remain patient and engineer the improbable soft landing.
One major sticking point remains within the service economy: housing, or shelter, as the government’s inflation indexes categorize U.S. rental prices. The housing PCE price index accelerated to 5.2% in May from April and was above where it was last August, continuing to defy expectations for a quicker slowdown.
Housing costs did finally ease a bit in June as tracked by the CPI index. Chicago Fed President Austan Goolsbee called that “profoundly encouraging,” pointing out that housing inflation has been trending lower for two months. It still is a laggard in the effort to quash inflation, however. Shelter accounts for 36% of CPI, so its glacial pace of decline remains the biggest reason the index has not yet fallen back to 2%.
The delay has been fueled in part by homeowners opting to stay put after locking in low mortgage rates during the pandemic, which limits the supply of existing houses. And rents have been mostly stable since 2022 but remain elevated.
We expect shelter inflation to keep cooling based on data from private housing gauges that the government’s methodology excludes from its official inflation readings. It should moderate further as new rental contracts and an increase in rental units are factored in. But even if the pace is frustratingly slow, the overall trend of inflation is clear: It is closing in on the 2% target.
4. The economy has downshifted into a period of slower growth without jeopardizing its healthy long-term outlook.
If the organizers of the Paris Olympics had concocted a track event based on the current global economy – after all, they added one for “breaking” (break dancing) – we would see the United States move out to a commanding lead and then ease the pace while remaining solidly ahead. Not that this is about winning a gold medal or outdoing smaller economies. Nevertheless, the modest decline in speed without the stumble and fall that many economists once expected spells a victory of its own.
Government spending and corporate investments in AI have been difference-makers in maintaining a still-robust pace. A slowdown in either, which we do not expect in the near term, could present challenges for the broader economy. But heavy government spending, while unsustainable in the long term, is supportive for the economy in the short run.
Underpinning the economy’s resilience are corporate profits. S&P 500 companies are expected to post a fourth consecutive quarter of earnings growth, up a projected 9.7% from a year ago, according to FactSet. That would be the biggest increase since the first quarter of 2022.
The effects of inflation and higher interest rates are not yet weighing heavily on the economy. Real GDP growth in the second quarter was estimated by the Atlanta Fed at an annualized 2.6% after dipping to 1.4% in the first quarter, compared with 2.4% expansion in 2023. The economy’s two mainstays, consumer spending and the labor market, remain strong but are moderating:
- Consumers have kept the economy buoyant since early in the pandemic. This year, they have begun to pull back on spending with excess household savings from the pandemic having run out. When adjusted for inflation, retail sales (which exclude services) were negative on a year-over-year basis in four of the last five months through May. So far, spending remains above the longer-term trend and is not close to the level of prior recessions. But we are watching the data closely as it heads back down to that trend line.
- The job market is stable, with hiring continuing even as unemployment edged up to a still-low 4.1% in June. Most importantly, a once-overheated market is fast returning toward its pre-pandemic norm: The ratio of openings to unemployed people, which peaked at two available jobs per job seeker, has fallen to 1.2, matching the figure from February 2020. Wage growth has moderated but is still above inflation, bolstering workers’ finances.
Housing and manufacturing remain question marks. Still, the U.S. economy continues to benefit from strength in employment and other areas and is pulling the global economy forward at a better-than-expected pace in 2024. Historical precedent suggests that interest-rate cuts will provide another boost. In 1995, real GDP fell to an annual rate of 1% over a six-month period. It accelerated when the Fed cut rates.
Rate cuts should also provide a tailwind for some leading international economies, with global central banks getting a head-start on the Fed. The economic outlook overseas is improving, albeit modestly. Business and economic activity appear to finally be on the uptick in Europe, Japan appears to be gaining momentum, and China’s recovery has gained some traction after a sluggish post-pandemic period.
All told, the outlook is for steady if modest economic expansion.
5. History has shown that presidential elections have little impact on markets in the long run.
It’s only July. Already, though, no U.S. election year in recent memory can match this one for turmoil in the presidential race (although the baby boomers among our readers and staff will quickly cite 1968, when “the whole world was watching”). In just the past eight weeks, the election campaign has been rocked by felony convictions, a race-altering debate flop, an attempted assassination and an 11th-hour withdrawal at the top of the Democratic ticket. Yet the market remains largely unswayed by any of those events.
While we are paying close attention to the investment implications of a November victory by either Donald Trump, Kamala Harris or another Democratic nominee to succeed Joe Biden, we believe it is far too early and risky to start positioning for a specific outcome. We are all but certain there will be more surprises in the 100-odd days that remain.
Investors have looked on uneasily this year at elections not just here but around the world portending possible shifts in government leadership. Such votes heighten the uncertainty that markets dislike and can result in substantial short-term swings. Trying to forecast outcomes and act on their presumed consequences is a gambler’s undertaking, however, as some investors in India, Mexico and France have learned. Those were trades, not investments, and can produce big losses.
A November sweep of Congress and the presidency by either major party, should it happen, would certainly have broader implications for taxes, regulation and other policies and would likely increase market volatility in the near term.
But the most reliable guideline we have for how markets might perform is their historical record – including the fact that stocks have delivered strong returns during the presidencies of both Trump and Biden.
Going further back, we reviewed how the stock market has performed during presidential election years since World War II and found a pattern of mostly expansion and long-term stability. We wanted to see in particular how it performed after a big first half like this year’s, when the index was up 15.3%.
While past performance is not a guarantee of future results, a strong first half in election years has led to a productive second half as well. This is the sixth time in the postwar era that the S&P 500 has delivered a double-digit return in the first six months. All but one (1948) of those years also saw positive returns in the back half of the year, ranging from 3.4% to 11.7%.
Sorted another way, the first half has been above the election-year average (5.2% return) nine times since World War II and the average return in the second half has been 7.6%, positive under both Democratic and Republican victors. Returns also have usually been positive into the next administration. Among the 19 election years in that period, only 1972 and 2008 produced negative returns over the subsequent 36 months.
The takeaway for investors is that economic fundamentals, sometimes influenced by unexpected events like a pandemic – not politics or elections – are generally what drive the markets. We will be ready to consider any needed portfolio changes in that eventuality. But with the election still months away and the future makeup of both houses of Congress and the presidency in doubt, we believe no changes are in order based on political speculation. We end with the same words with which we began: It’s only July.
Our Outlook
- The Federal Reserve appears on a course to finally begin reducing interest rates starting this fall. The market believes there could be three cuts by year-end, but we view one or two as more likely.
- A slightly cooling U.S. economy is good news for investors, signaling that the Federal Reserve’s restrictive monetary policy is paying off. We expect both inflation and the job market, previously overheated, to continue normalizing to pre-pandemic levels.
- Diversification has restrained portfolios this year because of the market’s unusually concentrated gains from mostly just a few tech stocks. We believe markets will broaden with the arrival of rate cuts, helping underperforming asset classes to improve in the second half.
- The Magnificent Seven stocks that have paced the market should still generate strong growth going forward, based on their companies’ underlying strength. But we believe the extraordinary rate of their gains in the past year and a half is not sustainable.
- The biggest risks are uncertainty surrounding the amount and timing of rate cuts, the limited breadth of the U.S. stock market rally, and geopolitical uncertainty tied to global elections and the ongoing wars in Ukraine and Gaza.
Quotes of the Quarter
“This is what the path to 2% [inflation] looks like.” – Austan Goolsbee, Chicago Fed president
“Globally, overall things are better today than they were just four or five months ago. A big part of this has to do with the resilience of the U.S. economy.” – Indermit Gill, World Bank chief economist
“The AI story is legitimate. There’s a lot of companies that are benefiting from AI.” – Ed Yardeni, Yardeni Research president and chief investment strategist
Market Data
U.S. Stocks
AI exuberance, strong earnings and an encouraging outlook for inflation and the economy helped power the market – at least an important part of it – to more record highs in the quarter. The iShares S&P 500 ETF added 4.4% thanks almost exclusively to a handful of tech stocks, particularly Nvidia, which extended its 2024 ascent to 149%. The 15.3% total return through six months was the third-best first-half performance since the dotcom era, trailing only 2019 (18.5%) and 2023 (16.8%). Technology (28%) and communication services (26%) led as 10 of 11 S&P 500 sectors were higher. The lone outlier for the second consecutive quarter was real estate (-4%), which posted its worst first half in terms of underperformance to the broad index since it was recognized as its own section within the S&P in the late 1990s.
Value and small-cap stocks continued to be bystanders to the rally, with both negative for the quarter. The iShares Russell 2000 ETF shed 3.3%, trimming its year-to-date gain to just 1.6%, as investors favored bigger stocks with more AI potential and larger balance sheets to endure high interest rates. Even growth stocks fell at the small-cap level. At the large-cap level, the growth benchmark (Russell 1000 Growth ETF) walloped value by 14 percentage points (20.5% to 6.5%) in the first half.
International Stocks
International developed stocks retreated slightly after a strong (+6.0%) first quarter. The iShares MSCI EAFE ETF reached midyear with a 5.8% gain after declining by 0.2%, pressured by the strong dollar, continued high interest rates, and weakness in France (-7%) due to political turbulence. The dollar’s 4% rise in the first half against other leading currencies turned gains into losses for U.S. investors. Before conversion to the dollar, the benchmark was up 1.3% in the quarter and 11.5% for the year.
Emerging markets fared much better thanks to strong performances from the category’s two behemoths, India and China. The iShares MSCI Emerging Markets ETF matched the S&P 500’s return with a 4.4% rise, leaving it up 6.6% for 2024.
Real Estate
Central banks’ strict monetary policies and elevated rates continued to restrain the performance of real estate investment trusts and related stocks. The Vanguard Real Estate Index Fund, which invests in REITs that purchase office buildings, hotels and other properties, shed 1.9% for a half-year return of -3.1%. The Vanguard Global ex-US Real Estate ETF, proxy for international real estate stocks in more than 30 countries, declined 4.1% and was down 4.8% at midyear.
Some overseas central banks began reducing rates, but U.S. rates passed the one-year mark above 5% as investors wait for further rate relief and a turnaround in the industry. High rates increase the challenge for REITs in investing in new properties as well as making REITs’ yields less competitive with other income investments.
Hedged/Opportunistic
Direct lending – private loans from non-bank lenders to businesses – continued to deliver solid returns in a low default-rate environment but lagged the broad U.S. stock market. Although available returns from direct loans are slightly lower as more competition has entered the market – primarily the banks – they have meaningfully outperformed bank loans and U.S. taxable core bonds.
Investments in publicly traded senior bank loans as benchmarked by the Invesco Senior Bank Loan ETF gained 1.6% for a 3.5% return through six months.
Fixed Income
Bonds fell early in the quarter during a period of market gloom about interest-rate cuts, with inflation then more stubborn than expected, before recovering to finish little-changed.
Taxable bonds as benchmarked by the Vanguard Total Bond Market ETF remained down 0.6% for 2024 after inching up 0.1% from April through June. Returns roughly mirrored the path of the 10-year U.S. Treasury yield, which began the year at 3.9% and jumped to 4.7% before slipping back below 4.4%. (Bonds’ prices move inversely to their yields.)
Tax-free municipal bonds, benchmarked by a blend of the Market Vectors short and intermediate ETFs, were flat in the quarter at 0.0% and slightly negative for 2024 at -0.2%. Higher yields in the first half were largely offset by the after-tax yield that our recommended muni managers delivered.
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