Should I Stay, Or Should I Go? Mid-Year Investment Outlook

The first half of 2024 turned out to be pretty good to equity investors, while not so good to  the bond bulls. The performance of the two most popular benchmarks for US stocks and bonds – the S&P 500 index and the Bloomberg US Aggregate Total Return index –  returned +15.3% and -0.72%[1] respectively. However, we should be quick to point out that not all stocks performed equally well. Large cap stocks were the clear winners, while small caps (as measured by Russell 2000 index) returned only +1.6% for the first six months of the year, underperforming T-bills which provided better than 2.6% return for the period. Even within the S&P 500, the disparity of returns has been record-breaking, evidenced by the fact that the equally weighted index returned just over 5.0%. Looking beyond the US borders, the MSCI ACWI index (which includes the US) returned +11.6%, while EM stocks were up a meager 2.4%, also underperforming cash.

So far, so good, but where do we go from here? Usually, in order to peer into the future, it would help to look back and understand how we got here and what drove the performance. Starting with the winners, the US large caps and particularly the magnificent 6 (used to be 7 but Tesla fell out of grace), have had a tremendous run mostly due to earnings growth and some multiples expansion. In other words, fundamentals have more or less underwritten the performance. These stocks benefit the most from the Artificial Intelligence (AI)-related growth and have a lot of pricing power. Also, surprising to some maybe, there is the fact that these stocks are among the largest dividend payers in the S&P 500. According to Capital Group, Microsoft and Apple alone account for 14% of the total index dividends paid in 2023. True, their yields are not very high, but the dividend growth has been rather good. And this is all before any buybacks.

On the other hand, small caps have been struggling due to the fact that they as a group carry higher leverage and have been hurt by the rise in interest rates. They have a lot less pricing power and are more directly exposed to the pockets of weakness appearing in the economy. Their earnings trends have not been nearly as robust as those of the large caps and the shares are simply reflecting that.

Do we expect these trends to continue, or shall we finally get convergence in performance? As long as interest rates remain elevated, small caps are likely to continue to struggle. While their valuations are optically cheap, we are in no rush to buy them yet. We will wait to see lower interest rates and evidence of better earnings trends. Within the large cap universe (S&P 500), we expect the megacaps to chug along as long as the market does not develop doubts about AI in general. The performance gap with the rest of the universe may narrow, however, as the earnings growth differential between them and the rest of S&P 500 should narrow into 2025. We expect this to happen from both ends – slightly lower growth for the megacaps, and slightly better growth for the rest of the universe.

If there is one thing that should give investors a bit of a pause, it is the fact that the S&P index has become extremely concentrated in terms of weights and performance. We have had several instances of that dynamic over the years, and it has usually been followed by a reversal of fortunes for the big winners. These reversals were usually the result of decline in growth prospects, or tighter liquidity conditions, or both. Will this time be different?

As far as growth is concerned, various indicators point at a relatively low chance of a recession in the US in the near term. Ned Davis Research for one, through their proprietary indicator, put the probability of a recession at below 20%, albeit slightly rising. Periods of such low probability historically have been associated with positive equity market performance. Expected earnings growth of 12-13% in 2025 for the S&P 500 index bodes well for continuing gains, although at P/E of 20x, the market seems to have priced quite a bit of that already. We probably should not expect another 15% return in the second half of 2024, but stranger things have happened.

What about liquidity? Since October of 2023 when the market saw its recent bottom, financial conditions have improved dramatically, based on the Goldman Sachs Financial Conditions index. This has been driven by the decline in long-term rates, the equities rally, as well as, what now seems a bit premature, the pivot signaled by Fed Chair Powel in December 2023 towards rate cuts. The market took that message very much on board and ran with it, driving the 15% gain for the S&P 500. Further improvement in the financial conditions in our view will depend mostly on the path of short-term rates (i.e., rate cuts by the Fed) later this year and into 2025. While the most likely trajectory of rates will be down over the next 12-18 months, the speed of travel may not be as fast as the market would like. There is a small risk that rates stay elevated, but this will likely be because growth stays robust and/or inflation (or corporate pricing power) stays elevated. In this case, we would still favor stocks over bonds. Within the fixed income markets, our preference remains for cash and short duration instruments, which has proved to be the right strategy this year. But it would make sense to use potential upticks in longer-dated yields towards the 4.50% and above to extend duration a bit, particularly if we see more evidence of economic slowdown and labor market weakness.

One way to hedge the highly concentrated US market is to diversify away from the US and invest into Europe. The French election has provided a pullback in the Euro Stoxx 50 index, but the market seems to be getting more sanguine about the likelihood that the far right will win an outright majority there. The European equity market  as a whole is cheaper and not nearly as concentrated as the one in the US, plus the ECB has already started its rate cutting cycle. About 11% earnings growth at 12.5x P/E multiple and 3.5% dividend yield strikes as relatively attractive. The one caveat is that Europe does not offer nearly as much exposure to high growth areas such as technology and AI, so don’t expect outsized return potential. Emerging markets are likely to remain challenged in the current environment, but as US interest rates start to go down and if/when the dollar were to weaken, there may be some interesting opportunities to be exploited by the brave of heart.

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