“AI Frenzy Propels Stocks to Monster First Half” read the headline in July 1st’s Wall Street Journal. J.P. Morgan’s Chief Global Strategist David Kelly was quoted elsewhere as believing “the outsized sway of technology giants over US stocks is likely to persist, absent a major market rout.” Outsized it certainly is as the average stock in the S&P 500 declined 2.45% during the quarter in contrast to the index’s rise of 4.28%. “The Magnificent 7” stocks (Nvidia, Apple, Amazon, Tesla, Meta, Alphabet (Google) and Microsoft) have risen 33% year to date in contrast to 5% for the remainder of the index with the S&P 500 itself returning 15.29%. Six of the indices’ eleven sectors were negative for the quarter, as were the MidCap and SmallCap indices and the venerable Dow Jones Industrial Average. Foreign Developed Markets fell 0.54% though Emerging Markets rose 5.65% outperforming the S&P 500. Interest rates finished close to where they began the quarter, allowing fixed income securities to earn their cash flow without an appreciable decline in their market value.
The Federal Reserve seems to have succeeded in convincing the financial markets that any reduction in interest rate this year will be modest and likely to be late in coming. Beneath the surface though a very great deal has changed, and investors may wish to pay heed to this emerging reality. The engines of the US economy are exhibiting sufficient thrust for the time being to keep it aloft, but it is clearly losing altitude and its ability to obtain a “soft landing” increasingly in doubt. The Atlanta Fed’s GDPNow real GDP estimate for this year’s 2nd quarter was forecasting growth for the quarter at over 4% six weeks ago. The current estimate is now 1.5%. Real (inflation adjusted) Personal Consumption Expenditures one year ago were growing at a 3.25% annualized rate. It is now 0.8%. Two years ago, employment was growing at a three-month average rate of 300,000 and the unemployment rate was 3 ½%. Now employment is rising 177,000 and the unemployment rate is 4 ½%. Interestingly, full-time jobs have actually declined on a year-over-year basis with the increase in employment solely attributable to the rise in the number of part-time jobs. Meanwhile inflation shows increasing evidence of drifting down to its 2% target. The Fed’s preferred measure of inflation, the Personal Consumption Expenditure (PCE) Core Rate (excluding Food and Energy) is at 2.74% but excluding Healthcare, notoriously difficult to calculate due to the timing of the reset on insurance premiums, it is below zero.
Much of the market forecasting fraternity is suggesting the possibility of a market correction due to a visibly slowing economies effects on corporate earnings. An alternative and possibly more accurate view is that earnings are no longer the primary driver of equity market returns having been supplanted by valuations. This is evidenced by 14% of the 26.3% 2023 return and 8% of the 15.3% year to date return of the S&P 500 attributable to that source. And what is the primary determinant of valuations? Interest rates because the primary demand for capital is no longer the provision of capital for investment in the “real” economy but to provide sufficient liquidity to roll over the $300 trillion of global debt. Lower interest rates increase the ease with which the $100 trillion global economy can roll over the approximately $60 trillion in global debt that will mature this year. The “balance sheet” of the global economy lacks sufficient size to retire the debt and so, like an interest only mortgage, it must be refinanced. So long as the global financial markets permit this all things are possible. Should the day ever dawn when it does not nothing is.
The effects of the Federal Reserve’s lowering of interest rates by possibly 2% over the next six months may not be just the extent of the rise in the equity markets but where that rise may disproportionately occur. Perhaps the market we’ve been experiencing this past year and a half hasn’t been a bull market in stocks but rather a relatively small share of the totality of the market experiencing something approximating a mania. Extending one’s time horizon an additional year is helpful to obtain some additional perspective. 2022 was not a good year for investors in the stock market with the S&P 500 declining 18.11%. Investors who purchased $1,000 of each of “The Magnificent 7” at the onset of 2022 would have earned $4,193 by June 30, 2024, but $3,200 of those earnings came from Nvidia. The $6,000 invested in the other six stocks would have returned 6.31% per annum, a lower return than that of 7.27% for the S&P 500. Perhaps it isn’t the seven that are so magnificent but the one that has no equals. 60/40 portfolios returned 1.84% for the quarter and 9.90% through the year’s first half. The equity 60% share returned 2.20% and 10.60% year to date. The 40% fixed income share was +.80% for the quarter and is +.75% for the year. It should be noted that Commercial Backed Securities (CMBS’s) are significantly outperforming the fixed income universe as the prospect for lower interest rates is leading the market to become increasingly confident that the commercial mortgages composing those securities will be able to be refinanced at reasonable rates when their refinancing dates occur.
Mark H. Tekamp/July 6, 2024
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