Market Commentary | Q2 2024 Halftime Report

Summary

This Halftime Report begins (like many others…) with a discussion on inflation, highlighting that the inflation rate on goods responded much better to the Fed Rate hikes than the inflation rate on services did.

The discussion switched gears to review leading economic indicators of a recession or expansion, with an overall signal for caution. The discussion moves on to market performance and recovery, before heading into a discussion of valuations. Sam Chaplin compares the current market valuations to the dot-com bubble numbers, highlighting the biggest difference between the two is that during the Dot-Com Bubble, the average forward Price-To-Earnings in 1999 was 52.0x, but presently, in select tech companies we are seeing 24.9x, while those companies are still showing strong earnings potential.

Jim takes over with a review of growth versus value performance, followed by an international investing chat with Sam. Sam & Jim wrap up the Half Time report with one of our favorite election year graphs, showing how a hypothetical $1 investment in the S&P 500 would perform across presidencies from 1926 through the present.

Disclaimer: The foregoing content reflects the opinions of Penobscot Financial Advisors and is subject to change at any time without notice. The content provided is intended for informational purposes only and should not be construed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions, or forecasts provided herein will be correct.

Transcription

Sam Chaplin:

Hi everybody. Welcome back again for another… advisors. My name is Sam Chaplin, joined by our chief investment officer, James Bradley. Welcome James.

James Bradley:

How are you doing, Sam?

Sam Chaplin:

I’m doing well, thank you very much. All right, so our goal is to keep it short for you today. Hit all the high points. Let’s jump right into it.

Number one, inflation. Still going to talk about inflation. It’s not gone yet. It is getting better. The top chart here is going to look at PC inflation, dispersion between inflation on goods and inflation on services.

Overall, PC inflation has come down from 7.12% down to 3.4. This is the Federal Reserve’s preferred measure of inflation. Goal there is to get it to 2%, so still higher than we want to be, but much better than where we were not so long ago.

The interesting part about this chart is you’ll see the dispersion between services and goods, services still showing some pretty significant inflation at 5.4% while goods are declining, and that has a lot to do with the bottom chart there. How interest rates have been risen by the Federal Reserve pretty significantly over the last couple of years.

Those interest rate increases have done a lot to keep a lid on the prices of goods. You can think like an automobile, when your financing rate goes up, you’re less likely to purchase an automobile. Less so on the services side. Example I like to give there is auto insurance, right? You’re not going to not get auto insurance because interest rates went up. I wish it was that easy sometimes. And then the other factor to notice there is that services often operate more of a lag. Not only does interest rates not affect the price of insurance, but your insurance company can’t raise your insurance rate on you until your term comes to an end. So this kind of a rolling factor there that happens over a period of time.

On the bottom, the increase in interest rates pretty consensus now that the Federal Reserve has done hiking interest rates. And the question is when will they start cutting and how aggressively. So that’s what the market forecasters are all watching and looking at the data to try to get a guesstimate on when the economy’s going to slow to the degree that it will justify lowering interest rates to stimulate the economy hopefully without reigniting inflation.

So looking into the trailing data of how the economy has developed over the last couple years, largely positive relative to a lot of doomsday scenarios people were worried about when the interest rate increases did happen.

The concern is that interest rates go up, companies start laying off their employees, which means unemployment goes up, less people working means less people spending money, retail sales goes down, consumer spending makes up about 60% of GDP. So then GDP falls off, we fall into a recession.

That was the fear. This chart will show you that a lot of those things have not happened yet to any significant degree. Unemployment still historically low, retail sales even when adjusted for inflation, still pretty stable. And then real GDP at 3% is still above the long-term trend of 2%. So still looking at this pretty strong economy here overall from the trailing basis, keep in mind that these are reports of past data that have already happened. We always want to keep a look at data that are leading indicators, things that are going to potentially show the cards of what the economy’s got to do in the future. So I’ll kick it over to Jim for this next slide, which is looking at how the leading indicators have developed.

James Bradley:

Right, and when we talk about hard landing, soft landing, those types of things, for those of you who aren’t tremendously familiar, it’s just a matter of how this cycle ends up in the markets. A hard landing would be a hard recession where we have pretty significant increase in job losses and really a downturn in economic activity that’s relatively substantial, whereas a soft landing we do kind of slow down and maybe even hit a recession, but not such a bad one as we’ve seen in some of these cases in the past. And then there’s some that are talking about this no landing idea, where we don’t even slow down, we just keep on growing our way right out of this.

One of the contra indicators to that last one would be where leading into economic indicators are and this little chart of 12 different leading economic indicators across financial business activity and consumer areas.

One of the things you can notice that on the left we’re looking at the most recent indicators and as you go to the right, it’s one and two quarters back. Back two quarters ago in September of 2023, I’d say the majority of these leading economic indicators were pointing toward a recession, either a soft landing or hard landing kind of recession.

One thing that hasn’t changed is that there are still some areas in the economy where these leading economic indicators are pointing to recession, but there’s not as many of them as there were one or two quarters ago. On a level, it’s looking less likely like we see a sharp recession, but we’ll continue to watch these as we go along. But at the same time, you’ll notice there’s a big absence of any green here, anything that indicates expansion in any particular area.

I think the school of thought that thinks that we get through this without any substantial slowing of the economy at all is maybe a little bit far-fetched and we should be prepared for a bit of a slowdown.

Going to the next slide, we looked at how have markets responded, especially given this improved, although muted outlook coming at us from the leading indicators. And the answer, as you can see is that since October of 2023, it’s been doing quite well on the stock side. So the stocks or the Morgan Stanley Capital Index All Country World Index that we use to track global stocks has really shown some good performance over that period of time. So, over the trailing 12 months of just above 23% by any means, that’s a good stretch of returns for stocks.

But what about bonds? And that’s the PFA teal line that we see here. Bonds haven’t done much and that makes a little bit of sense to most of us who watch bonds. Bond prices are quite often driven primarily by interest rate movements and they’re really, if you remember over the past 12 months, haven’t been all that much in the way of interest rate movements.

And so instead of the rates moving bond prices, what we’ve actually kind of done is what we call clipping coupons where even if the bond prices don’t move, they’re still in today’s interest rate environment giving us a reasonable rate of return, an above inflation rate of return. And so that 4.14% reflects again, just not much price movement on the bonds, but while bond prices don’t move, we’re still able to get a little bit of a real return from them, which we can’t… We weren’t able to say just four or five years ago when we had almost zero returns on these fixed income instruments.

Going to the next slide, what we see here, and it’s not terribly surprising to see, is that as a result of all of this, stocks have recovered back to pretty close to where they were and just more recently have broken through domestically at least to more record high levels and almost to those record high levels again on a global basis, whereas bonds still haven’t seen that recovery back to where they were before interest rates started to go up.

On a whole, if you’re waiting for a reversion to normalcy, you’ve seen it on stocks, you just haven’t seen it on bonds yet, and that should be something that raises eyebrows for somebody who’s looking for where the next potential returns might come from in these capital markets. Over to Sam for some talk about interesting things like valuations.

Sam Chaplin:

Yeah, well, whenever you see a massive run-up in stock prices like this, that really banner year, you have to question is it justified? Where are the valuations at now? Are things getting expensive? Where are they getting expensive? So this next slide will look at price to earnings ratios on a trailing basis. So how much in price are you paying for the earnings the company made over the last 12 months? You’ll see here that largely the biggest benefactors of the market rally over the past year has been the magnificent seven, which are the largest seven tech companies in the US. A whole lot of the upside has been driven by these companies based on AI optimism. Those are looking pretty expensive on a trailing basis, 38.5 relative to the S & P itself down at 23.9. So they are very much the most expensive companies that are out there right now.

Expensive isn’t always bad. Things can be expensive for a good reason. They can be cheap for good reasons. It can be just valuations themselves. It doesn’t drive the whole story, but even so they are the most expensive there relative to the S & P and then a couple of international benchmarks. EAFE’s international developed, then MSCI EM’s emerging market. So those are still looking pretty cheap relatively.

So once again, this is on a trailing basis, but what we’re really worried about is what is the price you’re paying now versus what the company’s going to make over the next 12 months. So we’re looking at that leading PE or forward PE here on the next chart. And so you look at that trailing PE and a question we get a lot is are we in another tech bubble? So we want to address that here.

On the left side, you’re going to see forward PEs during the tech bubble of some of the largest companies that were involved in that you can see how they really shot up relative to what the company was expected to make over the next 12 months. People were paying a lot more than they are currently on the right side where you can see those forward PEs are much more in line with the recent history.

So the difference here, and the reason we think not in a massive tech bubble, is that the companies are actually growing earnings fast enough to justify these higher prices. And another stat that I think is useful is that during the tech bubble back in late 90s-2000, the top seven companies were valued at a PE of about 52 times. Right now, those top seven companies are about 25 times, so much more reasonable historically speaking because companies are growing those revenues really fast even though expectations are high.

So far, earnings have been high as well. We just saw NVIDIA’s earnings last night, sky-high expectations and then came through and beat them. So a lot of this rally we do think is justified. However, that doesn’t mean that it’s the only story going on. Sometimes when there’s a new shiny object, everybody goes for that and they kind of forget about things that are left behind on the sidelines. And we do think for this rally in the market to continue, it does need to broaden out beyond just those large seven companies. So that’s why there are a few areas elsewhere that we want to keep an eye on. We think there’s some good relative valuations. I’ll let Jim touch on those.

James Bradley:

Sure. Yeah, like Sam says, there may be justification to the high amount you’re paying to get a dollar’s worth of earnings off of some of these companies, especially they continue to grow at really great paces. But historically that growth dynamic when you compare it in the markets to value companies, which aren’t companies that necessarily grow quite as quickly but tend to be a little bit more reliable when it comes to earnings and dividend payments and those types of things. There tends to be a little bit of shifting back and forth in the market. When one outperforms for a long enough period of time, the other usually comes back and takes its place. And this graph shows that really well. Going back way to around 1990, you’ll see the line that kind of cuts across the middle of the graph is the zero line. And whenever that blue line is above that zero line that represents out-performance by growth stocks, these technology stocks relative to the boring blue chip value stocks like your Johnson’s & Johnson’s and General Mills of the world.

And you’ll notice that anytime there’s out-performance by one, it usually gets offset later by out-performance by the other. And the only times we’ve seen in the past 40 years such intense out-performance by growth stocks relative to value stocks, there’s been a pretty significant snapback. Once was back in that tech bubble that Sam was just talking about in 2000, 2001 and once again back in the pandemic recovery period, late 2020, early 2021. And in both those cases, value stocks shortly thereafter outperformed growth stocks in the case of the more recent spike by 20% and in case going back to the dot com bubble by 40%. And we’ve already started to see a little bit of a retracement of that number right now.

This could be potentially the time when the rest of the market potentially has an opportunity to catch up with these high-flying growth stocks on one hand. Or on the other hand, if we’re looking at a situation where we’re going to see a snap back in the markets, perhaps the value stocks are going to be less impacted by that.

It’s a great time to not really get distracted so much by what’s been doing well lately, but also look at what historically does well afterwards. There’s a reason why your rear-view mirror is not as big as your windshield in your vehicle, and it’s because we don’t want a major focus on where we’ve been, but where we’re going.

This next slide gives us a sense as to what we might expect from the Fed. The Fed has seemingly stopped raising interest rates. They’ve at least been on a pause for a period of time, and they’re not putting forth a lot of expectation that they see the need to raise interest rates given what they’re seeing now, that can always change, but more what they’re hinting at is the likelihood and what the markets are starting to price in, is the likelihood that we start to see some rate cuts.

So where do we go from there? Historically, once the Federal Open Market Committee starts to cut rates, they tend to do it at a relatively brisk pace and it’s usually a brisker pace than they increased rates at. That’s the good news. The bad news is that if you look at this chart, you see these gray areas, those are recessions and it’s usually, so these rate cuts have been historically in response to the need to prop up a slumping economy. So whereas we might see rates come down at a faster rate than we have historically, you could say that we might actually be rooting for them to come down a little bit more slowly and feed into that soft landing narrative that we were talking about. Another place that we might look for returns that maybe hasn’t been the place to look over the past 10, 15 years is abroad. And I’m going to turn it over to Sam to talk to that point a little bit.

Sam Chaplin:

Yeah, so this is a chart from our friends at JP Morgan of what their expected returns are over the next 10 years or so long-term capital market assumptions, and they are still showing increased return probabilities internationally. It ties a little bit back into what Jim was saying too about market broadening out with value versus growth. These international companies tend to skew a little more value. And something interesting too is that some segments and industries of the market that have traditionally been value-orientated are actually becoming growthier because of AI implications. For example, utilities recently have been doing really well. That’s typically a pretty boring sector, not a whole lot of growth there. You’re just clipping dividends typically. But the applications of AI are actually going to enable more productivity and margin expansion and all that type of stuff. So both geographically areas and industry areas of the market that haven’t been growing as fast recently might be able to do more so with the application of AI.

Still like to have a healthy international diversification, and similar to what Jim said about growth versus value, when domestics outperform international for a long period of time, it tends to revert or vice versa, which is why we don’t try to time too much when it comes to geography.

Elections is another question we get constantly of should I sell because so-and-so is going to be president or because so-and-so is going to be president? And we like to try to downplay that as much as possible. The markets have done well irrespective of what party is in the Oval Office and also in Congress. They’ve done back tests of what if you sold every time that a Republican came in office or Democrat came in office. And in any case, you would do much worse off if you were just playing politics instead of letting the market do the work for you. And even beyond that, we’ve shown before how even industries that you think would do well under a certain administration are hard to predict as well. So not an area that we try to game out at all, just to keep the long-term focus is what we advocate for there. And that’s going to be our final slide for today. Thanks for joining us.

James Bradley:

Next time we see you, it’s going to be the middle of August, so hope you all enjoy some good picnics in the meantime.

Sam Chaplin:

Yeah, enjoy the summer.

James Bradley:

Enjoy your summer. Have a good one, folks. Thanks.

The foregoing content reflects the opinions of Penobscot Financial Advisors and is subject to change at any time without notice. Content provided herein is for informational purposes only and should not be construed as investment advice or a recommendation regarding the purchase or sale of any security. There’s no guarantee that the statements, opinions, or forecast provided herein will prove to be correct.

Past performance may not be indicative of future results. Indexes are not available for direct investment. All investing involves risk, including the potential for loss of principal. There is no guarantee that any investment plan or strategy will be successful.