Summary
The third quarter of 2024 was an investment advisor’s dream. Performance was very good, but better yet it was widely distributed (meaning one didn’t have to overweight a small segment of the market in order to obtain superior returns). In fact, the largest tech stocks as a whole were a drag on performance during the quarter; almost every other part of the market performed better. The S&P 500 rose 5.9% last quarter, but eight of the eleven industry groups rose more than that. Real Estate, Industrials, and Financial Services each gained more than 10%. Technology, up just 1.6%, ranked tenth (energy was last at -2.3%)[1]. Almost all areas of the U.S. stock market hit all-time highs last quarter. Only real estate and consumer discretionary (retail, in other words) remain below their 2021 highs[2].
The best explanation for the stock market surge is that the economy was expected to show signs of weakness by now but it hasn’t, while inflation was expected to decline and it has – at least enough to allow the Federal Reserve to start cutting interest rates. A strong economy, decelerating inflation, and lower borrowing costs? Buy me some stocks! This is what market professionals call a “Goldilocks” situation. Instead of being forced to buy a small list of recession-defying technology leaders, investors discovered they could make money almost anywhere – especially in beat-up places like real estate, banks, and miners. There is nothing wrong with tech leaders like Microsoft and Apple – investors were just ready to take some profits after a very profitable run.
Foreign stocks also had a nice third quarter. According to MSCI, foreign stocks rose 7.2% last quarter and are ahead 13% for the year. JPMorgan computes the foreign stock discount versus the U.S. now at a record 35.9%[3], but profit margins and earnings growth are just so much better here. At some point the discount is going to widen meaningfully, but I’m not betting on that day being soon. Taiwan has done well in 2024 because its market is dominated by semiconductor giant TSM. China surged in late September on hopes for a major fiscal stimulus program, but here in October this has largely fizzled. India has probably been the most consistently strong foreign market this year.
Bonds had a very strong (5.2%) quarter, more than erasing their first half loss. With inflation falling to less than 3% and the Fed cutting rates a surprising 50 basis points in September, bonds were primed to perform. Short-term bonds were better in the first and second quarters because interest rates were still high, but rate cuts tend to bring big gains to longer duration bonds. That is what we saw in the third quarter. Riskier corporate bonds and private debt are way ahead year-to-date, but treasury bonds and notes did better last quarter. If the economy is as strong as the stock market seems to think it is, however, bond prices will not stay this high. In fact, they’ve given back two percent so far this month.
Gold gained 7.2% last quarter. As the spread between bold yields and interest rates narrows, gold becomes more attractive. We have been selectively adding.
Activity
July and August are typically strong months for the stock market, but September is not. Stocks fell in four of the last five Septembers going back to 2019. Given economic concerns and knowing that the election typically brings uncertainty, we were prepared for another rough September. The surprisingly strong August employment report (released September 6th) and the favorable inflation report the following week reset expectations and necessitated more “risk-on” choices in U.S. small and mid-cap stocks and in bonds. We expected to trim stock positions into market weakness in September, but since there wasn’t any weakness, we made very few sales. As a result, we have been fully able to participate in a rally that is now in its sixth week.
Wild international market swings around Japanese central bank currency policies and Chinese economic stimulus (or lack thereof) made the quarter difficult because they caused huge fluctuations in the yen in the first case and in Chinese equities (and by extension all emerging markets) in the second. Given the superior earnings predictability of U.S. companies over foreign ones, we shifted a little bit of foreign exposure to the U.S. despite our market’s rich valuation.
Outlook
I can’t imagine putting down an outlook right now with a high degree of confidence. The investment community was more concerned than it should have been about an economic slowdown beginning by the end of 2024, but it is hard to say that we are completely out of the woods. The markets don’t seem afraid of either candidate being elected, strange as that may seem (or is equally afraid of both?). I am always more comfortable when there is some fear out there because that (fear) represents money that is not currently invested that in the future could push prices higher. When nobody is worried and everyone is all-in, where is the next price surge going to come from?
This chart from JPMorgan shows the Price to Earnings Ratio of the U.S. stock market today compared to the average of the past 20 years. This removes misleading low readings from the Depression and the high inflation 1970s. It shows the extent to which one has to pay up for growth (technology, etc.) stocks today. Today’s growth stock investor is making an implicit bet that the advantages that U.S. stocks have will continue for a long time.
The chart below references the Q-Ratio for the S&P 500. Tobin’s Q is a measure of stock prices relative to replacement value. In essence it argues that you could build a new Apple or Nvidia far cheaper than it would cost you to buy up all the company’s stock. Which is over $3.5 trillion each, if you were wondering.
Commentary – Time to Pull Down the Safety Bar
In the charts preceding this Commentary, I’m trying to emphasize that U.S. stocks are really expensive relative to market history. I want to stress that this does not mean that stock prices are going to fall meaningfully anytime soon. It simply means that there is no “low hanging fruit” (attractive opportunities at cheap prices) anymore. Companies and industries that have above average growth prospects are currently fully priced to reflect their potential. Today, you have to pay much higher prices for the opportunity to earn superior returns, and some of those opportunities won’t pan out.
The best analogy I can give is riding up in a chair lift at a ski resort in the Rocky Mountains. Most of the ride has you going up over the snowy incline. If you were to somehow fall forward off the lift, you would fall into the snow from 20-25 feet. You might break an ankle or a leg, but it is unlikely to be fatal. That is how I look at the stock market most of the time. Every time people give me a scary “what if” hypothetical – what if the national debt doubles, what if inflation surges like it did in the 1970s, what if the Middle East totally goes to war, etc. I think of those events as having a serious impact on markets but not being catastrophic to portfolios. A metaphorical broken ankle, so to speak – it hurts, it takes time, but you expect to fully recover.
Notice, however, that in the chair lift analogy I wrote “most of the time”. There is a stretch on the mountain where the chair lift goes over a ravine where the snowmelt from higher altitudes runs off. You would not survive a fall here. At present, the U.S. stock market is at very high altitude and the distance between where it is now and the historical median (not the bottom but the long term average) is really wide. Read the charts above as telling you that in the event of a crisis, stock prices could fall much more than they would have in 2014 or 2004 or 1994.
I do not write this because I expect it to happen anytime soon. I don’t, and I’m not aware of any credible market professional who does. There is just too much liquidity out there right now. Price declines get bought before they get significant. The point is, almost nobody ever expects large sell-offs to happen, even though history is full of them. We are going through an incredible period for stocks right now for several good (justifiable) reasons:
· The U.S. leads the world by far in the fastest growing industry (technology)
· Corporate profit margins at the highest in the world, and because of technology those profits are growing
· The U.S. has a culture of shareholder activism which forces underperforming companies to change.[4]
Faster growth, greater profit growth, and better “recycling” of mis-spent capital are very good reasons to continue to overweight U.S. companies. Primarily because of these factors, U.S. future outperformance is taken for granted[5]. U.S. stocks have outperformed foreign stocks for so long that I’m not even going to put up that performance chart again. I observe that strong stock returns have allowed U.S. investors to support the economy through spending some of those gains[6], and that this has helped us avoid recession when we had cyclical slumps in 2015, 2018, and 2022 but – there is no guarantee that this will always bail us out. A declining stock market could lead to a negative feedback loop where falling portfolio values depress spending and worsen an economic downturn, causing more selling.
One way or another, there will be a point in our future that all of the factors that have led to massive U.S. outperformance will not be working for us. Price-earnings ratios will have fallen. The market’s price will no longer exceed the median line on the chart. If my investment horizon is five years or less, I probably don’t care – I will most likely have gotten out of the market beforehand. If, on the other hand, my investment horizon is 20-25 years or more, then I need to start thinking about investing differently. I probably will experience the end of the virtuous cycle of massive Federal Reserve liquidity and its resulting wealth effect. Because I will experience the next severe downturn[7], I need to ensure I can financially survive that fall. I should, as Morningstar’s Dan Kemp suggests, trade in my race car for an SUV. That means giving up some near-term performance in favor of added safety features.
It means taking some profits in stocks and putting the proceeds in cash equivalents, gold, and alternatives whose performance is not primarily driven by interest rates or economic cycles. Each of these would be expected to perform better in a crash than stocks would.
In summary, as U.S. stock investors we have enjoyed a tremendous run over the very long term (since the end of World War 2), the long term (since the peak of inflation in 1981), the intermediate term (since the March 2009 financial crash market bottom), and the short term (since the end of the 2022 correction). No other market, no other investment class can touch what U.S. stocks have done over the long term. And as far as I know, they will continue to perform well. At this point, however, it may be time to think about pulling down the safety bar on this lift. I can’t help but remember that the greatest American economist of his time, Irving Fisher, didn’t see the Depression coming less than two weeks before the 1929 market crash[8]. I wouldn’t be writing this if stocks weren’t so far above their long-term averages; if they weren’t, the consequences would be much more manageable. My goal isn’t to scare people but to ask everyone with a long-term horizon to think a little less about maximizing portfolio value and a little more about being protected when things change. Inevitably, they always do.
[1] JPMorgan Guide to the Market 4Q24, page 15.
[2] Energy actually made its all-time high in 2022 when the other industry groups were falling. Energy often moves opposite to the bond market, which is why it’s a good diversifier. Gold, on the other hand, tends to move higher when interest rates fall (as stocks usually do) which is why it isn’t a very good diversifier.
[3] JPMorgan Guide to the Market 4Q24, page 47.
[4] Harry Mamaysky, US Versus International Stock Performance, Advisor Perspectives, 10/14/2024
[5] it could be argued that U.S. stocks are the greatest momentum trade ever. Over the years it was argued that various countries were poised to challenge U.S economic dominance (Japan in the late 1980s, China as recently as a few year ago), but there are really no competitors today.
[6] There are 21.9 million millionaires in the U.S., according to Wikipedia
[7] The 1973-74 crisis took nine years to recover, (20 in inflation-adjusted terms) and the 2000-09 dot com crash/great financial crisis took twelve years, (15 adjusted for the lower inflation of the 2000s).
[8] Fisher proclaimed that “Stocks have reached a permanently high plateau” on October 16, 2029 Black Thursday, the Wall Street Crash, occurred eight days later.
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DISCLOSURE
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