Mid-Year Review and Outlook

So far it has been a good year with the S&P 500 up 15.3% in the first half.¹ However, there are some dangers lurking beneath the surface, which we will discuss. We will also dive into the interest rate environment and inflation and how it forms the basis for managing portfolios.

One thing I’m watching closely, more so than economic data, are the market internals. They have deteriorated materially in the last couple of months presenting a bunch of warning flags for this summer.

That just means that fewer and fewer stocks are participating in the S&P 500’s rally. The market in 2023 was driven by the Magnificent 7 stocks. They accounted for half of the index’s 24% return in 2023.²

The Dominance of the Magnificent Seven

This year, there are just three: Nvidia, Apple, and Microsoft. Nvidia alone is up 135% year-to-date.³

In fact, Nvidia alone is responsible for 34% of the S&P 500s 14.5% rise.⁴ Yes, you read that correctly. If Nvidia was not in the S&P 500, the market would only be up a fraction of a percent.

_{^{Source: X, as of 07/14/2024. Post by @bespokeinvest. S&P 500's six mega-cap stocks' performance vs remaining stock average performance in Q2.}}

The entire market is being driven by an artificial intelligence euphoria. It is based on the same anticipation that the Internet generated in the mid-1990s.

The chart below from Bloomberg shows what the Magnificent 7 stocks did once ChatGPT was launched.

^{_{Source: Bloomberg, "Momentum Is Still Drawing Magnificent Mojo," as of 07/14/2024. Graph illustrating ChatGPT's emergence coinciding with surge in momentum's adjusted P/E ratio.}}

The euphoria is somewhat warranted, however, as the earnings are already there. Back in the late 1990s, most of the internet companies made no profit.

The question becomes, will the earnings last? So many companies are double and triple buying to get their own “AI business” off the ground. Once established, it remains to be seen whether these drivers will continue and if the productivity surge anticipated will materialize.

So how worrisome is the current concentration in the markets?

From a historical perspective, the current concentration in the markets, where the top several stocks account for an outsized portion of the index, is the highest since the 1960s.

Market Concentration: Past vs Present

_{^{Source: FactSet, as of 07/14/2024. Graph illustrating the US Stock Market Concentration from 1950-2023.}}

That level of concentration is high. In the 1960s however, stocks did just fine returning about 8.7% per year. Nothing really came of the high concentration until a more widespread recession in the early 1970s caused by exogenous factors.

I would caution that this time is not the same. Everything is occurring far more rapidly. The pace of concentration is historic. A recent paper by Michael J Maubossin from Morgan Stanley noted that rising concentrations coincide with higher annualized returns and vice versa. In other words, is this rising concentration a risk down the road fueled by irrational exuberance?⁵

The other thing that is different this time is valuations are much higher than in the 1960s. There was a lot of room for the price multiple that investors paid for a given level of earnings to expand.

Today, the forward P/E of the market is 20.5x, which is more than one standard deviation above the long-term median average.⁶ That means that the current time period is more like the late 1990s than the 1960s where P/Es were far lower. But again, this doesn’t look like a tech bubble since the earnings are there to support the AI-fueled stocks. These are the most profitable businesses in the history of this planet.

_{^{Source: JP Morgan, as of 07/24/2024. Graph Illustrating Forward P/E Ratio of S&P 500 Index.}}

The rate of change of everything is increasing rapidly. Business cycles seems to be becoming more compressed and new technology is making company business models obsolete at an ever faster rate.

While the rate of change and the current valuations are a risk, over the long-term, they will likely be ok. As compared to the 1960s, I would expect to simply see lower annual average rates of returns. 8.7%, the average return we saw in that decade, may be at least two points too high this time around given the starting valuations.

The tech bubble and its bursting was a brutal event for investors at the time but if you held from 1999 to 2019, you actually did above average (relative to long-term 1926-2019 S&P 500 returns). You just needed to be patient.

I think we are likely to see a replay of that though the valuation reset likely won’t be as extreme.

Patience, Objectives, Risk Tolerance, and Trade Offs...

Today’s markets warrant that same kind of long-term thinking. The current valuations in these mega cap tech stocks likely aren’t wrong. There just may be some short-term risks percolating under the surface that we don’t yet know about.

It comes down to patience, objectives, risk tolerance and trade offs.

The volatility in the markets is likely to increase based on the above factors. In the meantime, the other story outside of the AI mania is still inflation and interest rates.

Our thesis is still playing out. Disinflation remains the theme though as I wrote more than a year ago, the last mile will take time. We’ve gone from 9.0% to 3.0% quickly but that last one percent will be a hard fought battle.

As that plays out, we think the Federal Reserve will begin to cut interest rates but it will be gradual – that is until or unless something more significant happens that causes a downturn in the economy.

The projected slowdown in the economy has finally arrived with GDP estimates coming in far lower than the fast pace of the fourth quarter of last year.

The consumer is currently tapped as the cost of nearly everything is more than 20% higher relative to a few years ago. The labor market is also showing some signs of weakening and housing, a key component of this economy, appears to be slowing.

Impact of the Upcoming Election on the Market

The election should be a non-event though it will draw considerable attention. We continue to advocate not investing based on political emotions.

The largest “risk” we see from the election is lower government spending. That would curtail growth and lower interest rates moderately. However, this would be highly beneficial for our overall strategy focused on high-quality investment grade bonds.

A Long-Term Mindset

At Noble Wealth, we continue to manage money on a cash flow basis with the leftover being long-term and allowed to compound in higher-risk, higher return assets.

This gives us a long-term mindset and the ability to weather any volatility that materializes – as it always does for one reason or another.

Interest rates where they are give us a generational opportunity in fixed income that we think creates a more equal footing between stock and bond returns in the near-term. Vanguard continues to show in their capital asset market projections US equities returns that are well below average and better fixed income returns than we’ve seen in nearly two decades.

In other words, stocks rich and bonds cheap.

_{^{Source: Vanguard, "Market Perspectives," as of 07/24/24. Illustrating Capital Market Assumptions.}}

That is skewing the return profile in favor of bonds. Most retirees would take the 5.5%-6.0% higher probability, steady-eddy return over the maybe 6.0%+ equity return with a lot of variability and potentially.

Small caps are now historically cheap and in the 99^th percentile relative to US large cap stocks. In fact, we recently saw a historic phenomenon where the small cap premium was completely erased. If and when rates come down, small caps could rip.

In conclusion, the trade-offs favor bonds. Risk tolerance or lack thereof also favors bonds, but patience favors stocks. This is why we will be allocated to both for most clients.

With a decade or more of time horizon and a well-fortified bond allocation that is producing strong income (thank you higher interest rates), we can weather down drafts in the stock market. Over those decades, I have no doubt that the returns will be favorable. Short-term, however, we think they will struggle.

As always, we appreciate the trust you place in us.

Mark J Asaro, CFA
Noble Wealth Management

_{¹ https://www.edwardjones.com/us-en/market-news-insights/stock-market-news/stock-market-weekly-update} 

_{² https://www.morningstar.com/stocks/2023-review-2024-market-outlook} 

_{³ Calculated via ycharts through June 30^th. YTR Tr.} 

_{⁴ https://www.apolloacademy.com/extreme-concentration-in-returns-in-the-sp-500/}

_{⁵ https://www.morganstanley.com/im/publication/insights/articles/article_stockmarketconcentration.pdf?1717517980691}

_{⁶ https://am.jpmorgan.com/us/en/asset-management/adv/insights/market-insights/guide-to-the-markets/}