Atlantic Edge Insights
July 2024
Market Commentary
*Performance Year-to-date is through June 30, 2024
Stocks:
The S&P 500 built on its strong start to the year and was up 3.92% in the second quarter bringing it to 14.48% for the year through June 30. Semiconductor giant, Nvidia, continued to dominate market returns and briefly overtook Microsoft to become the largest public company in the world. Nvidia accounted for almost half of the S&P 500’s gain this quarter while indexes that weigh all 500 companies equally finished lower. The Dow Jones was also in negative territory as well as small, mid-size company stocks. In fact, this year’s performance is on pace for a record low percentage of stocks beating the S&P 500 (see below).
International stocks were also down in the second quarter, though still gained almost 1% in local dollar terms as dollar strength and political uncertainty weighed on returns. Last month we wrote that US stocks often lag early in election years due to political uncertainty. In June, this dynamic played out internationally as non-US stocks fell while political uncertainty increased. In the UK, the Prime Minister received permission from the King to dissolve Parliament and call for General Elections. In France, after right-wing parties outperformed, the French President dissolved Parliament, calling for snap elections that appear likely to backfire and hand power to the conservative, right-wing party.
Election uncertainty was not confined to Europe. Indexes covering India fell over 6% after the party of the current Prime Minister underperformed in national elections. Despite losing a majority, Minister Modi was able to cobble together a coalition government, which allowed India’s markets quickly rebounded, finishing up over 8% this quarter. In China, the CCP introduced further economic stimulus when they began allowing local governments to purchase homes. Increasing optimism and continued stimulus in China led the Chinese market to increase as much as 19% in the 2nd quarter before finishing with a 6.6% return as concerns about systemic risks to the economy remain.
Bonds:
The steep rise in rates at the start of the quarter favored short-term bonds. Once rates began to fall as CPI data softened later in the quarter, longer-term bonds performed better, narrowing the gap in performance. Both short and intermediate-term indexes finished positive during the quarter.
Yield spread (the difference between interest received on a bond with default risk versus the yield on a bond that is guaranteed) remained at historically low levels during the 2nd quarter. When the spreads between lower and higher quality bonds are low that is usually a sign of a strong economy as investors demand less of a premium to hold riskier assets. Buoyed by consistent spreads, high yield outperformed intermediate-bonds and returned over 1% for the quarter.
Concentrated Markets and Irrational Investors
"In the short run, the market is a voting machine but in the long run, it is a weighing machine"
– Benjamin Graham, Warren Buffett's mentor.
The stock market can often appear irrational in the short term as stock prices respond to supply and demand. However, it’s the fundamental health and intrinsic value of companies that drives returns over longer periods. During the last quarter, stock prices for a small number of companies rose far faster than their earnings would support in a rational market. As a result, market concentration rose higher than its previous peak in 2021, surpassing levels not seen since the 1970s (see graphic below).
Adding to the concentration within the S&P 500 are the “Magnificent 7” stocks (Microsoft, Apple, NVDIA, Meta, Google, Amazon, and Tesla), who alone have accounted for over 60% of all stocks returns in the S&P 500 during the first half of 2024. The forward-looking P/E ratio of those stocks are 32.4, compared to just 17.5 for the equal-weighted S&P 500. This means that on a forward-looking basis, investors are valuing the same per share profit of these companies twice as much. While some of the outperformance can be explained by earnings, the rest of the market’s earnings growth is expected to rise as earnings growth for the Magnificent 7 companies are expected to fall (graphic below). This dynamic should allow market concentrations to recede, meaning that the largest companies should underperform the broader market. It’s impossible to say when this will happen, therefore, wise investors should rebalance by trimming these extremely large stocks in favor of ones that have lagged.
Positioning portfolios with strategies that underweight exposure to the largest stocks provide downside protection against mega-cap underperformance caused by weakening earnings growth over the next year.
The Federal Reserve’s patient approach on inflation
Back in March, we wrote that after sharp disinflation in 2023, we expected that the “last mile” on inflation would likely be the most difficult. Inflation data came in higher than expected in March before continuing its downward trajectory in May. Despite the drop in May, headline CPI still increased 3.3% annually, well above the Federal Reserve’s 2% target. CPI is largely propped up by the shelter component of inflation, which tends to lag real time inflation. There is strong evidence that when we measure shelter in real time, inflation appears to be below 2%. Despite this evidence, the Fed has kept interest rates high and will not likely cut until September at the earliest. Chairman Powell has characterized the first cut as “consequential,” meaning that he intends to make a series of cuts following the first and wants to be confident that inflation is on a sustainable glidepath back to target and unlikely to accelerate higher. History tells us that leading into the first cut, intermediate term rates decline. In preparation for that, we increased the portfolio’s sensitivity to interest rates by adding more intermediate bonds earlier this year.
Portfolio Positioning
Stocks:
Short-term: Market returns in the 2nd quarter were driven by a handful of very large companies. The market is historically narrow, and we anticipate the “rest of the market” to catch up on performance given expectations of profit growth for these companies. We will continue to stay disciplined by underweighting the largest and most expensive stocks relative to the rest of the market to take advantage of this emerging dynamic.
Long-term: Global economic growth remains strong. While returns in global markets have lagged the US stock market in dollar terms, local currency returns have kept pace. These lower returns were caused by a strengthening US Dollar that was supported by the Fed’s restrictive interest rate policy. As the Fed prepares to begin cutting rates later this year, we expect the dollar to weaken modestly, which would increase non-US stock returns. In response to strong global growth and the potential for a weakening dollar, we added modestly to non-US stocks from fixed income. Portfolios are now positioned with a small overweight to equities. Within equities, we remain underweight to China, where we are skeptical that massive government stimulus can paper over systemic risks throughout their economy.
Bonds:
The aggregate bond index was flat during the second quarter. However, portfolio bond returns faired far better as riskier assets such as corporate bonds, high yield bonds, and private credit outperformed government bonds. Corporate balance sheets remain strong, supporting a continued overweight to riskier fixed income holdings. However, if economic fundamentals start to turn, we remain ready to reduce lower quality bonds in favor of higher quality bonds.
Portfolio duration remains in-line with our benchmark. We added to intermediate bonds earlier in the year as we were confident that an end to the Fed’s hiking cycle would put a ceiling on rising bond yields. These bonds should do better if intermediate rates decrease, as has happened historically around the time that the Federal Reserve has begun lowering rates.
Atlantic Edge Insights
Matthew Cochran, CFA
Robert Filosa, CFA
Ethan Caldarelli, CFA
Opinions expressed in this commentary may change as conditions warrant and are for informational purposes only. Information contained herein is not intended to be personal investment advice for any specific person for any particular purpose. We utilize information sources that we believe to be reliable but cannot guarantee the accuracy of those sources. Past performance is no guarantee of future performance; investing involves risk and may result in loss of capital. No graph, chart, formula or other device can, in and of itself, be used to determine which securities to buy or sell, or when to buy or sell such securities, or can assist persons in making those decisions. Consider seeking advice from a professional before implementing any investing strategy.
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