Resilient
Any way you slice it, the market has been remarkably resilient so far this year. Indeed, if at the end of 2023, investors were told in advance that the market would go from pricing in near certainty of a March Federal Reserve (Fed) rate cut to pushing that out to July, many of them would be surprised to see markets ending February at fresh all-time highs.
A large part of the offset to expectations of later rate cuts can be directly attributed to an economy and earnings which continue to see upward revisions and strength in technology shares.
As we have discussed in the past, we would take a stronger economy, even if that comes with a little more inflation, with fewer rate cuts, to a weaker economy that requires more rate cuts. Moreover, historically, some inflation is good for corporate profits, even though too much of it tends not to be great for valuation expansion.
Tech bubble?
Although we see pockets of speculation and the tech sector could be due for a breather, we don’t see a bubble.
Valuations are rich on most metrics, but with tech, comparative earnings momentum tends to be a more important near-term driver. And profit trends remain strong and are at new highs.
Moreover, the three-year outperformance of the tech sector to the S&P 500 is just above 30%. This is roughly in line with the 30-year average and far from the peak of just above 250% seen in March 2000.
“The lesson from history is new market highs tend to be a good signal, as long as stocks aren’t egregiously overvalued, or a recession isn’t around the corner”
Markets broader than perceived
The equity rally since the October 2023 price low has also been broader than many investors perceive.
- The S&P 500 Equal Weight Index, a proxy for the average stock, has trailed but is up more than 20%, while mid caps are at a two-year high.
- Financials are up almost as much as technology over roughly the past four months, and the industrial sector is at an all-time high.
- This broadening in participation is also a global affair. More than 80% of global markets are in uptrends (above their 200-day moving averages).
We have seen improved absolute performance in Japan and parts of Europe, such as Germany and France, even though the U.S. remains generally stronger on a relative basis.
Where do we go from here?
The weight of the evidence suggests the primary market trend remains positive, even if one should still expect normal pullbacks along the way.
- New market highs often make investors nervous, especially for those of us who have seen two mega bear markets since the turn of the century (the bursting of the technology bubble and the global financial crisis).
- However, the lesson from history is new market highs tend to be a good signal, as long as stocks aren’t egregiously overvalued, or a recession isn’t around the corner.
- Markets at the headline level, largely due to the dominant growth names with strong earnings power, are trading at richer valuations. Yet, the S&P 500 Equal Weight Index is trading closer to the long-term historical average, and mid and small caps are trading below average.
- In the near term, the economy should stay supported by workers that are now seeing wage growth, in aggregate, above inflation.
- Moreover, fiscal spending tied to previously passed stimulus packages, such as the CHIPS and Science Act and the Inflation Reduction Act, is picking up, and the party in power often tries to pull whatever levers they have to keep the economy moving forward during a presidential election year.
Portfolio positioning
Within equities, we maintain our long-standing U.S. preference over international and large caps over small caps.
Investors, though, do not need to go all in on any one area. Small caps, mid caps, and the equal-weighted S&P 500 are much cheaper, would likely benefit if interest rates come down, and help to hedge some of the extreme concentration risks in the market. Indeed, the top 10 stocks now account for 32% of the S&P 500’s weighting, the highest contribution seen over the past 40 years.
As mentioned, international markets, which are effectively value markets, are also acting somewhat better, with Japan leading. We still maintain exposure to these markets, although we continue to place a greater emphasis on the U.S.
Even China is starting to perform better as of late. That is not too surprising, as we discussed last month how extreme the underperformance had become. While China’s bounce may have further to go, longer term we remain skeptical given erratic policy and less emphasis on corporate profitability.
We still have a focus on high quality in the fixed income markets, which provides a healthy coupon now and at the same time acts as a hedge should the economy weaken later in the year.
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