Apr 15, 2024 2024 1st Quarter Investment Commentary

  • The S&P 500 TR Index continued its strong momentum and reached new all-time highs. Momentum often creates momentum, which leaves us optimistic about stocks currently. However, a near-term pullback wouldn’t surprise us.
  • The U.S. economy continued to grow due to a strong labor market, healthy consumer balance sheets, and robust services activity. Due to an upswing in manufacturing, leading economic indicators also turned positive for the first time since 2022.
  • Inflation remained sticky above 3% during the quarter, pushing back on investor expectations of interest rate cuts. Inflation risks remained a concern.

Market Summary

U.S. large-cap stocks (as measured by the S&P 500 TR) continued their positive momentum and reached new all-time highs in the quarter. The quarterly gain of over 10% took the index’s total returns to just shy of 30% over the last 12 months, significantly above its average 12-month return. Comparable periods with strong momentum have continued to rally. The absence of significant downside volatility since the rally began was noteworthy. There hasn’t been a 3% correction in the S&P 500 since October 2023.

Underneath the surface, performance broadened out away from the mega-cap tech names that dominated performance in 2023. For instance, 10 of the 11 S&P 500 sectors posted positive gains for the quarter, and the equally weighted S&P 500, which removes the large-cap tech concentration, reached a record high (1). Returns outside the U.S. continued to underperform U.S. stocks but still performed well.

The U.S. economy continued to experience steady growth and moderating inflation, a favorable backdrop for healthy corporate profits and stock returns. Economic data showed improved manufacturing conditions, a robust labor market, and strong service activity. Inflation remained in a downtrend, despite recent signs that it may be stabilizing near 3%. Moving from 3% to 2% will likely prove harder than moving from 6% to 3%. Despite the inflation risks, recent guidance from central banks suggested a stable policy outlook and paved the way for potential interest rate cuts later this year.

The same economic strength that propelled U.S. stock prices higher forced investors to recalibrate hopes of interest rate cuts from the Federal Reserve. At the beginning of the quarter, markets were expecting six rate cuts in 2024, but by the end of the quarter, the expectations were for three cuts. Bond yields rose, and prices fell, with longer-term bonds suffering the most. Gold prices surged to record highs, and Bitcoin reached new peaks following regulatory approvals for exchange-traded funds. Below is a summary of the benchmark returns (2).

Markets

History has long demonstrated that momentum is a critical factor in the stock market. The S&P 500 Index posted its fifth straight positive monthly return, up over 25% since October 31st, 2023 (3). With stocks having done so well, it’s natural to assume stocks were overbought and must head back down. Many historical studies point out that when stocks were this strong in the past, forward returns were both better than market averages and had higher odds of gains. In essence, upside momentum persists.

For example, the S&P 500’s average forward 12-month return after a five-month winning streak is 12.55%, and the index has closed higher in 26 of 28 samples, or ~93% (4). In addition, down years are rare after strong first quarters. The S&P 500 has been up 10 out of the last 11 times when first-quarter gains were greater than 10% (5).

To be clear, these examples don’t guarantee positive forward returns. They are meant to provide historical context.

The momentum has been unusually positive, with very few draw-downs. The average year includes about ten 3% pullbacks and three 5% pullbacks and we haven’t seen a 3% pullback in five months.

But, with a solid economic backdrop, improving corporate earnings, and broad, long-term price trends in place, we believe that a minor correction wouldn’t necessarily degrade into a bear market.

Another reason for an optimistic view was that market breadth (i.e., the number of stocks, sectors, and global markets in uptrends) remained relatively healthy. A sign of a healthy stock market is when all stocks participate, not just a few. Near the end of bull markets, we usually see fewer and fewer stocks participating. Over the last two quarters, we started to see glimpses of markets broadening into value, small-cap, and non-US markets, and we think this trend could continue.

From a fundamental perspective, the background for earnings improved. The economy continued to exhibit positive momentum, and corporations could expand their profit margins despite sticky (or because of) inflation. For now, there was a fortuitous cycle whereby employment was strong, consumer spending was solid, profits were trending higher, and companies were retaining employees. Most recent analyst expectations were for 11% earnings growth for 2024 and more growth to continue into 2025 (6).

Economy

Investors went into the first quarter optimistic that the economy would experience a soft landing, avoiding a recession and continuing to improve inflation. They were right about economic growth but wrong (at least so far) about inflation.

The overall economic picture was one of solid growth, a strong but rebalancing labor market, and moderating but still sticky inflation. U.S. economic growth exceeded previous estimates, with real GDP rising to a 3.4% annualized rate. Recession risks appeared to decrease as the previously slumping manufacturing sector grew at the fastest pace since 2022 (7). In addition, leading economic indicators, as measured by the Leading Economic Index, rose for the first time since February 2022.

Other signs of resilience came from the consumer side. Household balance sheets continued to be in great shape, jobs were still plentiful, and real wages were rising, meaning consumers had money to spend.

Strong growth in the U.S. labor supply, driven by increased labor force participation and a surge in immigration, supported impressive job gains without higher inflation. We don’t see a material risk of recession without a rise in the unemployment rate. The data pointed to a labor market normalizing to a sustainable level rather than descending toward a recessionary level.

For instance, looking at the total number of people with a job and multiplying that by the average hours they work and their total hourly pay makes a good proxy for how much spending power the U.S. consumer had. It’s certainly slowed since COVID, but it has grown by 5.3% year over year (8).

In addition, the number of job openings relative to unemployed individuals narrowed, but there were still 1.1 job openings for every unemployed person, down from over 2 in 2022 (9). Employees quit their jobs at a slower rate, and hiring eased, but it was not enough for major concerns. All these trends were consistent with a so-called soft landing.

Inflation risks

Along with solid economic growth came an increase in inflation. February headline CPI increased to 3.2% year over year, sparking concerns that inflation may be sticky above the Fed’s 2% target.

Other longer-term dynamics, such as changing labor markets, continued fiscal stimulus, deglobalization of supply chains, and underinvestment in infrastructure, kept inflation risks higher than normal. The potential for increased tariffs also increases inflation risks, as the cost of imported goods could rise while reducing competition for domestic producers, allowing them to raise prices.

 

The higher inflation caused rate cut expectations to be pushed out further in time and level. In January, markets were confident that the Fed had all but beaten inflation and would start cutting rates in March. Traders anticipated six cuts in 2024, but by the end of the quarter, markets were pricing in three cuts starting in June.

As a result, the Fed may have to keep interest rates higher for longer, raising the risk of a recession. This isn’t our base case scenario, but we have positioned portfolios around this risk. In addition, our base case is that inflation peaked in 2022 and will continue to come down modestly over the year.

Do election years have a big impact on the market?

Election years often evoke emotions about their potential impact on financial markets. However, historical data suggests that they typically have little direct influence on market performance.

Many investors have let their political beliefs influence their investment choices, often to their detriment. Investing based on politics is not a winning strategy. If you invested $10,000 in 1961 but only participated in the market when there was a republican president, your investment grew to over $100,000. If you decided that you could only tolerate investing when the Oval Office was blue, your $10,000 grew to over $500,000. However, if you invested your $10,000 and let it ride, regardless of the party in office, your investment grows to an impressive $5M (see graph (10)).

While a presidential election means the possibility of significant change and may introduce short-term uncertainty and volatility, its long-term impact on market performance is generally limited. Stocks and economic growth have historically done well under Republican and Democratic leadership. It is essential to remember that we don’t invest in presidents or governments but in corporations that are constantly adapting to the political and economic environment.

Portfolio Positioning

During the quarter, we rebalanced most accounts and shifted some stocks into bonds to keep accounts aligned with their objectives. Technical indicators continued to be positive, suggesting stocks could continue to produce solid gains in 2024. At the same time, investor sentiment was overly optimistic, so we wouldn’t be surprised to see a pullback in the near term.

We still see a more supportive backdrop for equities. U.S. inflation eased from its pandemic highs, and growth remained strong. Expectations for S&P 500 earnings growth for 2024 were higher. Plus, despite higher inflation readings, the Federal Reserve reaffirmed its intention to cut rates this year.

Against that backdrop, we remain slightly overweight U.S. stocks. We continue to like undervalued parts of the market – such as exposure to US large value and US midcap – and are overweight US equities vs. non-US equities. We will attempt to exploit any equity weakness by increasing equity positions.

Turning to bonds, we saw bond markets reprice on the back of higher-than-expected CPI and Fed officials expressing concern about the idea of cutting interest rates too soon.

A new regime of positive correlations between stocks and bonds suggests that higher interest rates have the power to “break” things on the equity side. As a result, we remained overweight shorter-term bonds. Short-term bonds have been a better ballast during uncertain or “risk-off” markets the last three years, and we are not getting paid much more interest to take on longer maturity bonds.

Lastly, we believe that select diversification, such as gold and energy stocks, could continue to play a critical role in portfolios, potentially helping hedge inflation risk. Inflation could remain sticky and present challenges to both stocks and bonds, so we believe it’s necessary to have something to help diversify risk.

Not all portfolios are identical. We manage accounts that have additional complexities not discussed in this update. Some of the statements are forward-looking but do not guarantee future performance. Please reach out to your advisor with any questions.

 

 

  1. Morningstar Direct, S&P indices
  2. Morningstar Direct, as of 3/31/2024
  3. Koyfin
  4. Data from LPL Research. Data since 1954
  5. Optuma, S&P 500 1950-curent)
  6. Factset Research, as of 3/31/24
  7. Based on ISM manufacturing survey
  8. Natixis, data from Bloomberg
  9. FRED. Job Openings: Total Nonfarm/Unemployment Level
  10. Schwab Center for Financial Research. The example is hypothetical and provided for illustrative purposes only.

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Important Disclosures

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