2024 June Market Update
Equity markets continued their move higher in June to cap a very strong, albeit choppy, first half of 2024. “Artificial Intelligence (AI)” has proven to be the market’s biggest catalyst, driving outperformance of the Technology-oriented NASDAQ Composite Index over the broader S&P 500 Index and the laggard Dow Jones Industrial Average. Economic data has started to show a few cracks but continues to thwart pessimistic forecasts. Encouraging inflation readings further offer support for the “soft-landing” narrative despite continued hawkish positioning from the Fed. Most importantly, aggregate corporate earnings have remained strong, buoyed by a recovery in operating margins following inflation induced weakness. Positive sentiment also continues to build, with earnings estimates rising over the past few weeks, in contrast to the consistent downward revisions we’ve seen for much of the past few years.
Driving this strength have been semiconductor and “Mega Tech” companies, which are reaping the early benefits from the nascent AI space. While short-term performance in these names has been impressive and some portfolio exposure is certainly warranted, we would caution that share prices could be euphorically rallying to valuations hard to justify by forward earnings. Significant uncertainty remains around the long-term margin profiles and demand outlooks of semiconductor and “AI-enabler” companies. Current share prices relying on parabolic growth and continued expansion of profit margins (in what has historically been a highly cyclical sector) appear perilous through a risk-conscious valuation lens.
Although we should not equate the two periods, as there are many reasons why the “AI-boom” is structurally different than the “dot-com” bubble, there are still lessons to draw from the past. AI (as was the Internet) is an innovation that can fundamentally and durably change the growth profile and profitability of almost any company. While it’s natural to focus investment interest today on companies that will see the quickest impact from AI, investors should not eschew other parts of the market. The global economy is teeming with companies that will leverage AI to improve their workflows and drive greater profitability. Even better, there will be companies able to incorporate AI to transform and expand their business into entirely new areas. After all, who would have guessed in 1994 that an online bookstore (Amazon.com) would have been able to leverage the rise of the internet to become one of the largest and most profitable companies in the world?
In the meantime, while the strength of these AI-related companies has pulled markets higher, they have overshadowed quite a bit of weakness in the average stock. Non-AI companies continue to underperform their technology peers, perhaps pricing in the potential for an economic slowdown and weakening of consumer spending. This has driven the relative underperformance of Value (to Growth), Small-Cap (to Large-Cap), and International (to US) stocks to record levels. Simultaneously, only the largest decile of companies in the S&P 500 showed positive returns, in aggregate, over the past quarter. This bifurcation of performance continues to contribute to the increasing concentration of most market-capitalization weighted indices. In fact, just three (highly correlated) stocks now make up over 20% of the S&P 500! This phenomenon is even more noticeable in market sector funds, in which a single “Mega Cap” company can comprise over 20% of the fund! We worry that many investors, who think owning multiple funds has increased their diversification, might be surprised to learn their holdings all own the same concentrated positions. While this has not worked against investors so far this year, one only must look as far back as 2022 to find a time that the “average stock” significantly outperformed market behemoths. Although true asset class and stock diversification hasn’t been rewarded recently, we continue to believe it’s best to position for a wide variety of outcomes, not just what the momentum trade du jour suggests. On portfolio diversification we hearken back to the old market truism: “If everything in your portfolio is going up at the same time, you’re probably doing something wrong.”
The S&P 500 Index today trades over 20x 2025 estimates, well above historical averages. As we have often noted, valuations are not a reliable market timing indicator, but are relevant to future returns. Barring either a major acceleration in growth or further increase in valuation multiples, the overall market will likely struggle to match returns from the past decade. However, this is not to say all equity investing will be fruitless. Given the significant performance divergences between various asset classes and among individual stocks, we believe there are considerable opportunities for selective and patient investors over an appropriate time horizon.
These lofty valuations also imply that the return profile of bonds might prove competitive with what we could reasonably expect from the broader equity markets. As we have consistently noted this year, there exists a very strong historical correlation between starting bond yields and bond returns over the next 7-10 years. With the Fed taking a very patient approach toward eventually lowering rates, the window remains open to lock in attractive fixed income yields.
Turning the page to the second half of 2024, we hope everyone has had a great start to their summers! Maybe contrary to the old saying, we invite you to use the “dog days” to reach out and chat with us about your portfolios and any changes in your lives. We wish you all a happy and safe Fourth of July Week and hope to hear from you soon!
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