Equity Markets – Broadening Participation
For most of 2023 and first half of 2024, the S&P’s over 40% gain was fueled by the performance of the Magnificent 71. In the third quarter we saw the market broaden out as 66% of S&P 500 companies outperformed the index’s 5.89% return2. Year-to-date, about 36% of S&P 500 companies are outperforming the index’s total return, compared to only 27% of companies in 20232. Other signs of market broadening included NASDAQ’s 2.8% third-quarter return being outpaced by the Russell 2000 Small Cap Index’s 9.27% return, the MSCI EAFE Index’s 7.26% return, and the MSCI Emerging Market Index’s 8.72% return3. Markets that are supported by positive performance across a broader number of companies are healthier and market performance is more sustainable.
The year-to-date rally has been driven by expanding Price-to-Earning (“P/E”) valuation multiples, as increases in equity prices have outpaced expected growth in corporate earnings. The S&P’s Forward P/E ratio rose to 24.8x from 20.2x at the start of the year 2. While current valuations are elevated and pose more risk, a broader-based rally is indicative of investors expecting a healthier future economic environment. If the economy avoids a mild or more severe recession, we expect corporate earnings to catch up to recent equity price increases and result in more normal valuation multiples.
Our equity allocations remain tilted toward value style strategies. We expect more cyclical, value-style companies to benefit most from a soft- or no-landing scenario, as their profits and cash flows rise with accelerating economic growth. The income these companies produce also helps protect portfolios during an economic downturn. We’re closely monitoring asset classes like US small cap and foreign equities for investment opportunities as valuations are more attractive than US large cap equities. US small cap and foreign equities showed initial signs of relative outperformance to US large cap equities in the third quarter but require further supporting data to merit an increased allocation across our strategies. Unfavorable economic or geopolitical developments tend to have larger impacts on these asset classes which have struggled to maintain performance in-line with US large cap in recent years.
US Economy – Still on Solid Ground
The US economy is on solid footing after some initial labor market concerns at the start of the third quarter. September’s recent employment report was strong, although indicators such as time spent unemployed remain worth watching, and September inflation was slightly higher than expectations. Core inflation in September came in slightly hotter than expectations at 3.3%. While markets viewed the data as neutral, it will complicate near-term rate cut decisions as the Fed works to bring inflation down to its 2.0% target. Another positive sign for the economy is the growth in the money supply (measured by M2), which has continued to accelerate and is growing at a more normalized level. Growth in the money supply, which exploded in 2020 following the large amount of stimulus in the wake of the Covid-19 pandemic, has been declining during 2023 and the early part of 2024. A steady and gradually increasing money supply is positive for a healthy economy. However, if the money supply grows too fast, it can push inflation higher.
Fixed Income
The 10-Year Treasury yield dropped by 0.55% to 3.81% in the 3rd quarter in anticipation that the Fed would kick off the latest interest rate easing cycle at their September meeting. The Fed decided to cut the Fed Funds rate by 0.5% (equivalent to two rate cuts) during the September meeting to head off potentially harmful economic impacts of overly restrictive monetary conditions. Fixed income returns benefited from falling yields (bond prices increase when market yields fall) and the Bloomberg US Aggregate Bond Index was up 5.2% in the third quarter3. Since the end of the quarter, the 10 Year Treasury has risen to slightly over 4%. Solid economic and slightly hot inflation data produced skepticism the Fed will be able to stick to its projected path of 1.5% of rate cuts4 (six cuts) by Year-End 2025.
There is still time for investors to lock in higher intermediate term rates, as short-term bond rates have peaked. Intermediate bonds will outperform even if the Fed cuts rates at a slower rate than currently expected. Intermediate duration bonds will provide better portfolio protection during economic recessions and high yields for the long-term. We are closely monitoring economic trends for signs of deterioration as High Yield, Floating Rate, and Private Credit strategies are more vulnerable to economic turbulence. Our allocation to these credit-based strategies is relatively low and we remain positive regarding the near-term outlook.
Election
One month remains before the November election where Americans will elect a new president, 33 U.S. Senators, and 435 Representatives for new terms. It is important for investors to remember there is little historical evidence to support the notion that markets perform better under one party or another. We do think election uncertainty has delayed typical business demand, which could materialize after the election giving a boost to the economy and the market. Commentary in a recent ISM (Institute for Supply Management) survey, a small business survey, and the Fed’s August Beige Book all discuss that firms are hesitant to make plans for 2025 and will maintain current conditions until there is more clarity on the election and interest rates. We don’t think this issue is specific to 2024. Since 1972 the market has averaged a 5.0% gain in the three months after an election compared to a 1.5% gain in the three months before5. A presidential election is an input businesses only have consider once every four years. It makes more sense to delay business decisions until there is more clarity on the future business environment. Once the election is decided, businesses adjust and the resumption after the delayed decisions release new demand into the economy, which could drive a post-election market bump.
1 – The Magnificent 7 includes AAPL, AMZN, GOOG, GOOGL, META, MSFT, NVDA, and TSLA;
2 – “Three on Thursday”, First Trust, October 3, 2024;
3 – Morningstar;
4 – “Summary of Economic Projections”, Federal Reserve Board members and Bank presidents, Federal Reserve https://www.federalreserve.gov/monetarypolicy/files/ fomcprojtabl20240918.pdf;
5 – “Thinking of Changing Your Portfolio Because of the Election? Think Again.”, Hartford Funds, https://www.hartfordfunds.com/practice-management/client-conversations/investing-for-growth/thinking-of-changing-your-portfolio-because-of-the-election-think-again.html