07/29/2024 Market Strategy
The Urge to Diversify
Valuations and Prospects for Fed Policy Adjustments Suggest a Broader Equity Rally Ahead
Key Takeaways
- We discuss the broadening of market returns in recent weeks as investors have booked profits on high-flying tech names and have rotated into previously underperforming stocks, sectors, and styles.
- With 206 or 41% of the firms in the S&P 500 index having reported, earnings are up about 6.5% from Q2:2023 on revenue growth of 4.1%.
- Seven of the eleven sectors show positive earnings growth, with four at double-digit rates. Four sectors show earnings declining from a year earlier, two at double-digit rates.
- Last week’s GDP report for Q2 surprised to the upside, supported by resilient consumer spending and the fastest business investment in equipment growth in two years. Inflation pressures fell sharply in the report, increasing the odds of a “soft landing” for the US economy.
A fitting new catch phrase for the current period as “the great rotation” has emerged with a broader array of stock prices moving up as sectors, market capitalizations, and styles pretty much ignored for much of the first half of this year gain investors’ attention.
The success the Fed has had to date in putting a significant dent in the pace of inflation over the course of the current Fed Funds rate hike cycle has the futures markets pricing in nearly a 100% probability of a Fed rate cut in September.
Whether or not the Fed cuts rates in September the foundations of a broad rally seem to be coming into place in anticipation of it. Last week’s economic data suggested to us that the Fed has more reason to gain confidence in cutting interest rates without risk of an inflation blowback. Although economic growth in Q2 was stronger than expected, the GDP price indexes moved sharply lower.
For many, this signaled that a policy pivot was likely and could be undertaken as soon as September. In our view if the Fed still isn’t ready to cut as soon as September, then it’s more likely in November and again in December at a pace of 25 basis points each.
The Great Broadening
It’s not so much that investors are abandoning the “Magnificent Seven” stocks and the domination of market performance by the largest tech names but rather the broadening to us looks like a realistic perception by market participants that the next leg up requires a wider and less concentrated approach for stocks to move higher as the Fed gets nearer to cutting its benchmark rate.
In addition, interest rates priced by the market appear to be normalizing and a degree of resilience remains evident in labor, business, the consumer, and jobs postings.
It’s not so much a “Goldilocks” economy but one in process of extricating itself from a period of sequential crises: dysfunctional supply chains, an overblown fiscal stimulus, and wars in Europe and the Middle East moving towards a post-recovery period and a “next new normal” with an innovative edge empowered by artificial intelligence and AI proxies (broad economic factors, business and consumer segments) that will benefit from deployment of the next upgrade cycle in creating a more efficient economy ahead.
The dominance of a few tech names thus far this year appears not so much about California Dreamin’ or irrational exuberance but rather is reminiscent of the old adage that the technology genie once let out never goes back into its bottle but rather morphs into new developments and trends.
This cycle of tech leadership appears to extend well beyond the tech bubble of the 1990s period in that the current corporate leadership is well established, profitable, and deeply embedded in the lives of corporate entities, consumers, health care, education, and government.
We can’t help but think of all the upgrades needed across the economy in terms of chips, hardware, and software sooner than later to access the potential that appears to lie within AI today and tomorrow.
For business, educators, health care professionals, scientists, consumers and the designers of a myriad of things, AI-empowered search engines could help mine and manage a bounty of useful information that today may lie hidden in the mountains of data the world produces on a daily basis.
Disruption that comes with new technologies will inevitably cause dislocations and risks to industry and society but will also likely generate sizeable opportunities as positive offsets. It has been so since the invention of the wheel and likely even before that. We can’t help but think of all the “new age” businesses and lifestyle improvements that came out of the rise of the internet and the smart phone.
Embracing the degree of uncertainty that comes with change requires in our view that investors right size expectations via broader diversification within and across asset classes in seeking a prudent approach to investing.
Plenty for Investors to Focus and Ponder this Week
Key economic data and the Fed’s FOMC interest rate decision on Wednesday along with Q2 earnings results for 171 companies in the S&P 500 will keep market participants and observers busy this week. On Friday the week concludes with the jobs numbers for July, the unemployment rate, and hourly earnings data.
We remain positive on equities and continue to see fixed income securities as complimentary to stocks in providing portfolio diversification.
Some near term profit-taking in the day to day action of the market particularly in segments of the market that have had exceptional run-ups since last year into this year should be expected and continues to appear to us quite normal.
Such activity combined with a process of rebalancing and rotation into other segments of the stock market in our view can be healthy and should contribute to the broadening of the markets’ progress that began last year and becomes more evident in the second half of this year.
Economic and market transitions require patience and conviction of investors during periods when markets can churn from day to day as short term traders move in and out of positions and asset classes seeking short term gains.
Near term volatility could in our view continue to present opportunity for investors to “catch babies that get thrown out with the bath water” in periods of market down drafts as the market digests levels of uncertainty that are not uncommon to times of transition in monetary policy like these and in periods of elevated geopolitical risk.
In our view last week’s stellar performance by small-cap and mid-cap stocks could be challenged and come into question should the Fed not cut in September postponing a more sustainable rally in small-cap and mid-cap stocks until later this year post election day.
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