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Correction or Collapse?

By May 10, 2024No Comments
After 10% returns in the first quarter and on the heels of the late 2023 rally, the S&P 500 gave up almost half of the year-to-date gain in April.  As we have entered May, earnings reports are generally on or above target, and stocks have rallied from their April lows.  At this point, the recent sell-off feels more like a correction than a course change.  Nobody should expect 10% quarterly gains to continue.  However, we can at least enjoy the five months of steadily increasing returns without much volatility.  That is not how markets typically behave, and we will likely see a considerably more choppy pattern in the months to come.

Part of the sell-off was related to slowing progress on inflation, causing the Federal Reserve Board to be significantly more cautious in cutting interest rates.  Inflation is declining, but not fast enough nor broadly enough.  Unemployment has ticked up, with most of the increase coming from white-collar jobs.  However, the labor market is still tight, especially for hourly workers in services and construction.  Interestingly enough, wage growth is now again exceeding inflation, which should positively impact consumer sentiment.  The chart below could help explain negative economic sentiment when inflation exceeds wage growth. Consumer confidence could potentially increase as income growth once again exceeds inflation.  The big caveat is whether the Federal Reserve will manage to react appropriately with interest rate/monetary policy.  If rates stay too high for too long, it could trigger a recession.

Part of the issue facing the Federal Reserve is extraordinary Federal government spending.  The current deficit is running at 6.1% of GDP.  This is not sustainable and is significantly above expected economic growth.  Government spending is contributing to the outperformance of the U.S. economy vis a vis the rest of the world.  At some point, spending will have to be reduced, and taxes will have to be increased.  And that day of reckoning may be coming as the 2017 tax cuts expire at the end of 2025.

Given the current investing climate, we have not seen significant changes in what is working in the markets.  Some key generalizations:

  1. Large companies continue to outperform small companies, particularly mega-cap technology firms.  A large part of this performance is coming from companies related to artificial intelligence, including semiconductors like NVIDIA, Microsoft, and Google, among others.  Earnings growth in the last quarter was very strong and exceeded analysts’ expectations.  One company of note that has not participated in this strength is Apple.
  2. Industrials continue to outperform as the reshoring of U.S. manufacturing continues.
  3. Defense and aerospace, highly correlated with manufacturing, is doing well and likely to continue to do so with current large scale global conflict.
  4. Banks have shown resilience since the early 2023 scares, although many regional banks remain overexposed to the apocalypse of office real estate due to the work-from-home movement.
  5. Energy stocks may be attractive, particularly given unrest in the Middle East and continuing restrictions on Russia’s energy sales.  In addition, energy has a strong seasonal pattern, with much of the annual return being realized in the second quarter of the year.
  6. Fixed income returns are attractive.  The yield curve is still inverted (short-term rates are higher than longer-term rates).  CDs and money markets still yield 5% or more, and this trend will likely continue until the Federal Reserve starts cutting rates.
  7. Both developed and emerging international markets have had positive returns but still generally lag U.S. markets.

We continue to make portfolio adjustments, but there has not been a significant shift over the last six months.

We are also paying attention to what changes may be in store as we approach the election.  While the policies are different, neither presidential candidate addresses spending.  Both are still relatively close on China policy.  We are expecting much higher volatility leading into the election.  By volatility we mean higher daily or weekly movements, not necessarily negative returns.

Please contact us with any concerns or changes in your situation.