2024 Mid-Year Outlook: A Tale of Two Markets
Highlights
Technology companies continue to propel stocks higher year-to-date; however, concentration risks are high and potential for a valuation adjustment is elevated should optimistic growth forecasts fail to materialize.
Strength in technology has masked underlying market weakness and the “Magnificent 7” continue to have an outsized impact on market returns and investor portfolios.
To reduce exposure to market-cap weighted indexes and improve the valuation profile, we increased the allocation to value and managed strategies in our domestic equity portfolios.
Growth stocks lead the U.S. market higher
The U.S. stock market continued to rally in the first half of 2024, as represented by the Russell 3000 Index, which climbed 13.6%. The broad international stock market, as represented by the MSCI ACWI Ex-US Index, advanced 5.7%. International stocks continued to lag U.S. stocks, partly due to investor concerns about France and the Eurozone outlook. Domestic bonds finished the second quarter roughly unchanged, with the intermediate bond index up a mere 0.5% year-to-date.
Growth stocks once again drove the stock market. On the heels of its 43% rise last year, the Russell 1000 Growth Index gained 20.7% (vs. 6.6% for the Russell 1000 Value Index) year-to-date through June 30th. Mega-cap growth stocks have driven major indices to all-time highs, with technology and communications companies accounting for roughly 44% of the S&P 500 Index constituents (34% technology and 10% communications). Astonishingly, as of June 30th, the top three companies had a combined market capitalization of $10 trillion, and the top five companies accounted for 25% of the index as a whole. As a result, excessive concentration is embedded in the U.S. stock market, posing a significant risk to investors who fail to diversify their portfolios.
This year's growth stock rally is masking weakness in the broader market. Through June 30, the equal-weighted S&P 500 Index (which assumes an equal investment in all companies in the index) gained 5%. In contrast, the market capitalization-weighted S&P 500 Index (which weights the investment in each company based on its market capitalization) is up 15.3% year-to-date.
S&P 500 vs Equal Weighted Index
Date Range: 12/29/2023 - 06/28/2024
Source: YCharts - accessed on July 1, 2024.
What happens to technology stocks during a recession?
Historically, recessions and periods of economic weakness coincided with weak corporate earnings. Stock market performance was driven by economically sensitive sectors tied to the business cycle, such as industrials, financials, energy, and consumer discretionary.
Today, technology companies are driving the market higher. Their rapidly growing revenues and earnings seem insensitive to softening data and near-term economic headwinds. Big tech is flush with cash and generating significant profits, while reinvesting heavily in operations. With 44% of the S&P 500 Index comprised of tech companies, the broad market may appear to be flourishing when many companies in other sectors may actually be treading water or even in decline. The inherent risk for investors today is paying a high multiple for the growth heavy U.S. market, which has seen valuations rise much faster than non-U.S. stocks:
Latest data point is June 18, 2024
Given lofty expectations of the largest tech companies, we believe there is a risk that investors may at some point assign a lower multiple to these businesses, which could cause a broader market pullback. The top ten stocks in the S&P 500 Index are trading at 35 times forward earnings, suggesting that current valuations reflect meaningful growth expectations.
Strategic Repositioning
In the domestic equity portion of client portfolios, we increased the managed strategy target to 50% and maintained our value/growth tilt of 55/45 to help mitigate concentration risk and benefit from the dispersion in equity markets. By allocating more to managed strategies, our goal is to reduce the market-cap weighted bias in the index and add managers that offer differentiated sources of return. Within the international equity portion of client portfolios, we maintained a 55% allocation to managed strategies. With more compelling valuations and greater opportunities available from non-U.S. stocks, we are comfortable with the current positioning.
For fixed income, we remain neutral on the interest rate outlook and are balancing the potential for lower rates in 2025 with concerns about the budget deficit and excessive federal spending. Inflation is cooling, and the risk of an economic slowdown is still somewhat elevated. We are targeting a weighted average duration of five years in client portfolios, near the average of the intermediate-term and aggregate bond index. Duration was increased in 2023, following the end of the Fed’s tightening cycle, where short-term rates rose from near zero to 5.25%. The Fed’s action has improved the risk/reward profile of fixed income going forward.
Our strategic allocation to gold remains intact. As a firm, we have long believed that a 5% allocation to gold can benefit long-term portfolios. Gold has historically reduced portfolio volatility, hedged against inflation and enhanced portfolio diversification given its low correlation with other asset classes. Gold has performed remarkably well in 2024. The spot price of gold has risen 12% year-to-date and 22% over the last year, outperforming most major asset classes. Gold’s performance was driven by central bank purchases, strong investment flows, resilient consumer demand, and ongoing geopolitical uncertainty. We believe that lower interest rates, a weaker dollar and elevated economic risks are factors that may drive the price of gold higher over time.
Conclusion
We believe the unique dynamics of the technology sector may support continued market strength, but also recognize that valuation risks are currently elevated for growth stocks. With inflation trending down, fixed income may be offering attractive yields and relative price stability on a go-forward basis. Given our diversified approach and current tilt toward value stocks, actively managed funds and gold, we believe portfolios are well positioned heading into the second half of the year and beyond.
