Quarterly Market Perspective for 1Q24
Summary
The stock rally that began in late October continued through this past March. The S&P 500 added 10.6% last quarter[1]. Investors tended to favor companies with strong balance sheets because they don’t need to borrow in order to finance their activities (since interest rates are driving financing costs higher). Large companies are also the best able to capitalize on artificial intelligence (AI) at this point. Smaller companies did manage to add 5.2%[2]. Investors had expected the Federal Reserve to begin cutting interest rates by now in response to a slowing economy, but the economy hasn’t weakened thus far, so rates have remained unchanged. Investors have decided that the glass is half full, so to speak, because a stronger economy means rising corporate profits even if interest rates remain at elevated levels. The critical issue for investors is that they get the rate cuts eventually; any suggestion that the rate cuts won’t happen at all would not go over well.
As of this writing, both Nvidia and Meta Platforms are up over 50% year-to-date, so investors still have a strong preference for large companies with strong growth outlooks. That said, investment performance did broaden during the quarter – which is usually a good sign. Beyond technology, the energy, financial services, and industrial sectors also had double-digit returns. Only real estate posted a loss.
Japan was by far the best major market last quarter. It rose 19.3% in local terms, but dollar-based investors only saw an 11.2% return due to the depreciation of the yen. Taiwan was the top emerging market at 17.3% (12.5%). Most major foreign markets were in mid-single digits. Overall, foreign stocks gained 5.7% in dollar terms. China was the main drag once again, falling about -2%[3]. We try to minimize China exposure in portfolios.
The bond market rally unfortunately didn’t carry over into this quarter. The economy did not weaken as expected and therefore the Federal Reserve didn’t cut interest rates as investors had hoped. The benchmark Bloomberg Aggregate Bond Index fell -0.8%, but it was quite possible (if not downright easy) to beat that return in other areas of the bond market. Short term corporates, convertible bonds, floating rate debt, asset backed securities and private debt all generated positive returns last quarter. Even money market mutual funds earned a return of more than one percent.
The strength in the economy that negatively impacted most bond returns was a nice tailwind for commodities prices. Gold was up over 7.6% last quarter[4]. Oil, copper, and uranium also rose on the back of rising industrial demand.
Activity
Since the end of last October, the stock market has been in an uptrend. Five months is a fairly long period to go without even a 5% pull-back. We have been waiting for signs that the market is going to take a breather, so to speak, but we really didn’t see any during the first quarter. Even the January reversal in the bond market (from lower to higher yields) did not prompt a sell-off – even in interest-rate sensitive areas such as homebuilding. Therefore, it was a pretty quiet quarter in terms of portfolio moves. Gold and other alternatives probably intrigue us the most right now because the long-term bond cycle appears to have turned negative.
The forty-year bond bull market appears to have ended in 2021. There were several periods where bonds out-performed stocks during this period, but recent bond performance is looking more like the 1970s.
Outlook
Last quarter this Outlook section said essentially “there are always reasons to be concerned, but staying the course has almost always been the better decision”. That is all still true, but I will confess to being a little less confident in the near term than I was three months ago. The 10%+ advance in the S&P 500 last quarter was considerably more than fundamentals warranted, especially as inflation trends are no longer improving and the Middle East conflict threatens to expand. Oddly enough, the strength of stocks in recent months has largely silenced the naysayers, which actually makes the market riskier. In the absence of macro events like war and recession, markets tend to grind higher over time by scaring people out, then rising as those who have fled ultimately buy back in at higher prices. If there is nobody left trying to get back into the market, who is going to push prices up from here? The next “correction” might have to be deeper than usual in order to shake enough people out of their positions. Again, it will be important to listen to the Federal Reserve. Recent Fed comments about two or fewer rate cuts this year might give stock investors pause.
Commentary – OK, Let’s Talk Foreign Stocks
The performance of foreign stocks versus domestic stocks over the past decade plus is such that many investors could be forgiven for asking, why even bother? I’m not going to make the case for over-weighting foreign stocks. I am, however, going to use charts to show why you do want some foreign stock exposure and why now might not be a bad time to add one’s foreign position.
The chart above shows the massive recent out-performance of U.S. stock over foreign stocks since the great financial crisis (2007-09). In the 35 or so years before this, U.S. and foreign stock performance was very comparable. You should regard the 1984-1989 period as the great Japanese stock bubble, and the following eleven years (1990-2000) as the unwinding of that bubble. Hopefully, future investors will not have to deal with the unwinding of the great American stock bubble.
Below is a chart of global stock market capitalization. U.S. stocks as a percentage of global stock market capitalization has been rising strongly since 2009, and is now at the highest level ever (64%). There are several reasons for this – the strong post-great financial crisis performance of the U.S. economy, the breakout of the technology sector (which is dominated by U.S. firms), and the high degree of fiscal and monetary stimulus in the U.S. relative to the rest of world. Still, this is kind of shocking.
All of that said, since the United States is just over 4% of the world’s population, how high can we possibly expect this percentage to get? Clearly, Brexit was a negative for the U.K. and Europe, and Xi’s crackdown on Chinese technology companies in 2021 is easy to spot.
It seems like at some point we will see mean reversion here, if for no other reason than the rest of the worst can’t screw up perpetually, can they?
The left chart below shows the valuation discount between the U.S. and the rest of the world. There are several reasons why the U.S. merits a valuation premium to the rest of the world – safe haven status, higher growth rate, the dollar is the world’s reserve currency, among others. Again, has the market pushed this too far? The current discount that foreign stocks trade at versus the U.S is the highest in history. It is quite above the normal discount (in fact it is more than twice the average).
The chart on the right side shows that while U.S. stocks offer greater growth potential, they offer less than half the dividend yield of foreign stocks. Just like with price-earnings multiples, foreign market dividend rates are little changed over the past twenty years. This stands in stark contrast to the U.S. market, where dividend yields have fallen to a paltry 1.4%. The way to read this is that global investors have had very modest expectations of non-U.S. stocks since the late 2000s, so foreign stock prices have only kept pace with the modest profit growth those companies have posted in aggregate. Conversely, led by the technology sector but also bolstered by a robust consumer sector, U.S. stocks have posted tremendous gains since 2009. The U.S. economy did well, but its stocks did even better. Today’s prices don’t just reflect the robust profit growth of the past 15 years but the strong conviction that those superior rates of growth will persist well into the future.
I am not writing this to say that investors are wrong to have bid up U.S. stocks, nor am I saying that investors should anticipate an imminent surge in foreign economies and profits. I am simply stating that all trends end eventually. Sustaining superior performance for a long time is difficult. The New York Yankees had a tremendous run from the mid-1990s through 2001. The New England Patriots went to nine Super Bowls between 2001 and 2019. To some extent, however, the more you win the more you have to spend to keep the winning going. In the U.S. we deficit spend to a degree no other country could afford. Our politics are increasingly divisive, to the extent that sometimes we can’t pass obviously necessary legislation for the sole reason that we don’t want the “other side” to get a “win”. At some point these things will probably catch up with us. U.S. stocks have done very well for quite some time for reasons I think we all understand. At this point, however, foreign stocks trade at a huge discount and they yield far more, so the cost to diversify is close to as low as it ever has been.
[1] Index performance courtesy JPMorgan Guide to the Markets 1st Quarter 2024 [2] JPMorgan Guide to the Markets 1st Quarter 2024 [3] JPMorgan Guide to the Markets 1st Quarter 2024 [4] JPMorgan Guide to the Markets 1st Quarter 2024
DISCLOSURE
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