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by Wealthstone Group on Jul 26, 2024
What Happens When the Parrot's Head Falls Off?
We got no food, we got no jobs... our PETS' HEADS ARE FALLING OFF!
-Dumb and Dumber (1994)
Executive Summary
- Politically, we have seen a number of large events in the last several months: assassination attempt on a past president and current candidate and the current sitting president decided not to run for re-election a month out of the Democratic convention.
- From a market perspective, large-cap AI driven growth stocks have continued to dominate returns.
- But, of late we have seen some weaker than expected earnings from some of these names, higher capital expenditures related to AI build out and have seen some very short-term shifts in return amongst the most loved and least loved areas of the market
- With recent strength in economic numbers, the probability of an initial Fed rate cut at the next meeting is diminished but the market is pricing in deeper rate cuts towards year end.
With all of the political turmoil we have seen this year, much of the news has been focused on the political intrigue. While the emotional reaction to the news heard from the election cycle makes many feel like everything is tied to together. This reminds us of Lloyd Christmas in the movie Dumb and Dumber when he comes home after losing his job to find there to be no food in the apartment and his pet bird’s head to have “fallen off”. It is most certainly true that many items are very closely tied together but long-term, the strength of the economy and both equity and fixed income markets are not as tied to politics as it may appear.
Second quarter GDP growth accelerated more than forecast increasing at a 2.8% annualized rate and personal spending, the main driver of the US economy grew 2.3 in the same quarter. Both measures came in above expectations. While both of these metrics accelerated on a quarter over quarter basis, this represented some moderation on a year over year basis. The PCE ex. food and energy, which is a closely watched measure of inflation, came in slightly above expectations at 2.9% quarter over quarter. Overall, this combination of data further points to a non-recessionary outcome.
Interest rates play an important indicator on the overall health of the economy. For the last two years we have been in an inverted rate environment where short rates are higher than long rates. As you can see from the chart below, this scenario has played out since July of 2022. There are multiple causes of a yield curve inversion but at its simplest form means that investors are more pessimistic about the near term prospects for the economy than the longer-term prospects. Along with the higher probability of a non-recessionary outcome, we have seen a sharply decreased amount of the inversion in the curve of late.
Much of the returns in the market this year have been focused on mega-cap tech stocks, especially those perceived to be on the forefront of AI. While we believe AI has a very robust future ahead of, we believe this trade had gotten a little ahead of itself. As Louis-Vincent Gave, the CDO of Gavehal Research recently wrote, “It does seem that an unwinding has begun of popular trades that brough valuations to stupid levels.” We might not have used such strong language but certainly concur that valuations in that segment of the market have been getting stretched or “priced for perfection”. From the end of 2022 to the end of June, the S&P 500, or the largest 500 stocks in the US, had significantly outperformed the Russell 2000, which represents the smallest companies in the US. As seen in the chart below, the S&P 500 outperformed the Russell 2000 by 26.5%. Several weeks does not a trend make, but we have seen a significant mean reversion between these two indices from June 30 with the Russell 2000 outperforming by 9.0% or taking back over a third of the performance difference since the start of 2023.
Will small-cap continue to outperform? Should we sell all of the mega-cap tech and buy smallcap? Or should we go all-in on fixed income prior to expected rate decreases? As with most items, investing is one of balancing moderation. We see the following trends continuing to play out and are looking to emphasize each of these through at least the end of the year:
- Valuations have been stretched in much of the tech sector and earnings have so far been lackluster at best. We like this area of the market long-term but are continuing to emphasize areas of the market, such as small-cap, that we believe have a better near-term risk/return characteristics.
- We do expect lower interest rates towards the end of the year and into 2025. There is significant re-investment risk on the short end of the yield curve and are continuing to move towards long duration. Rolling short-term treasuries and/or CDs has been the sweet spot of the curve for last several years. We anticipate this trade to break down near term and do not consider this to be appropriate as part of a long-term investment strategy
- Volatility will likely be elevated at least until after the election. A well diversified portfolio of broad based equities, fixed income for volatility dampening and potentially some addition of asset classes with slightly lower correlation to both equity and fixed income are very appropriate except for the most risk seeking of investor.
Louis Tucci; Partner | Senior Investment Advisor
Paulo Aguilar, CAIA; Partner | Senior Investment Advisor
Mark H. Tucker, CFA; Portfolio Manager
David Crook; Macro Economist
Securities offered through Arkadios Capital. Member FINRA/SIPC. Advisory services through Arkadios Wealth.
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