Executive Summary
The first quarter was strong for stocks, building on a very strong fourth quarter of 2023. Most U.S. indices are at new all-time highs breaking the previous records from January 5th, 2022. The U.S. economy remains resilient despite the Federal Reserve efforts to cool it by keeping interest rates elevated. At its last meeting in March, the Fed left rates unchanged and the term “higher for longer” has dominated the recent news and is predicated on the following data points:
The U.S. economy is strong and growing - growth expectations for 2024 increased to 2.0%, in part because of the continuation of solid consumer demand
The U.S. labor market is healthy - the unemployment rate remains low and the four -week moving average of jobless claims has yet to break out of its low range. While we do see headlines of corporate job cuts, workers are finding new jobs quickly
Inflation is lower, but at a slowing rate - Core inflation, as measured by the Personal Consumption Expenditures (PCE) Price Index, edged down to 2.8% year over year in January from 2.9% in December. The Fed target remains 2.0%. The other measure of inflation, the Consumer Price Index (CPI) results for January, February and March were all higher than expected, which has sent bond yields up across longer maturities
The next Fed move is widely expected to be a rate cut and the first cut may be pushed out to the end of the year since the election is in November. The last rate hike was in July of 2023. The Federal government continues large deficit spending, which is making the Fed’s job harder to bring inflation down to the 2% target rate with its monetary policy.
The European Central Bank and Bank of England are likely to start rate cuts ahead of the Federal Reserve, as current expectations are for the first cut in June. The unemployment rate is low in England and the Euro area; however, growth expectations are less than the U.S. economy and stock market valuations reflect it. Growth rates in emerging Asia and all of Latin America look robust but could easily change with any downturn in the more developed economies.
We are cautious due to the high valuation of U.S. stocks but remain optimistic on the global job market and improved productivity from new technologies. We want to remind you we are watching all the developments closely, especially inflation, which is turning out to be more stubborn than expected. We look forward to our planning discussions for the new year and meeting with you, whether in person or virtually.
For those who would like a deeper dive into the details, please continue reading…
World Asset Class 1st Quarter 2024 Index Returns
The first quarter was very positive for U.S. and International Developed stock index returns and most indices finished at new record highs. For the broad U.S. Stock Market, the first quarter return of 10.02% was well above the average quarterly return of 2.4% since January 2001. International Developed Stocks returned 5.59%, also well above the long-term average quarterly return of 1.6%. Emerging Market Stocks returned 2.37%, just below the average quarterly return of 2.5%. Global Real Estate Stocks were negative for Q1 and returned -1.19%, below the asset class’s average quarterly return of 2.2%. Bond yields increased in Q1 after the sharp decline in bond yields during the fourth quarter of last year. The U.S. Bond Market was down -0.78%, below its average quarterly return of 0.9%, while the Global Bond Market (ex U.S.) was up 0.58%, close to its average quarterly return of 0.9%.
Here is a look at broad index returns over the past year and longer time periods (annualized):
For the past year ending 3/31/2024, U.S. stocks led all broad categories with a positive return of 29.29%, International Developed stocks were up 15.29%, Emerging Markets stocks were up 8.15%, and Global Real Estate stocks were up 7.44%. The U.S. Bond Market gained 1.7% and Global Bonds were up 5.92% for the past year. Over the past five years, U.S. stocks were up 14.34% annually, while International Developed stocks were up 7.48% annually, Emerging Market stocks were up 2.22% annually, and Global Real Estate stocks were up 1.21% annually. The U.S. Bond Market was up 0.36% annually for the past five years, while Global Bonds were up 1.03% annually. It has been a difficult five-year period for bonds, due to the increase in interest rates across the yield curve. Over the past 10 years, the U.S. stock market (up 12.33% annually) is well ahead of International Developed (up 4.81% annually), Emerging Markets (EM) stocks (up 2.95% annually) and Global Real Estate stocks (up 3.89% annually). U.S. Bonds were up 1.54% and Global Bonds were up 2.64%, annually over the last 10 years.
Taking a closer look within U.S. stocks during the first quarter, many asset classes had strong returns. At the bottom after two straight quarters as the leading asset class, is Small Cap Value, which was up only 2.9%, while Large Growth led all U.S. asset classes, up 11.41% for the first quarter of 2024. Large Cap stocks (up 10.3%) were above Marketwide results (up 10.02%). There was a noticeable shift back to large cap growth stocks during Q1 as investors increased the valuation of stocks associated with the concept of AI. We will have more to say about the “magnificent 7 stocks” at the end of the commentary.
It is a challenge for small cap value stocks to perform well when the regional banking ETF, symbol KRE, struggles. During the first quarter, KRE was down 6%. Regional banks are challenged by higher interest rates and commercial real estate loans. We still believe almost all banks will make it through a period of higher default rates as lenders and borrowers negotiate new commercial mortgage loans. Small cap value stocks are also stuck in a strong correlation where they under perform when inflation data is higher than expected and outperform when inflation data is lower than expected. During the first quarter, inflation remained stubborn, especially the price of crude oil, which is a manipulated commodity, given the monopoly of supply by OPEC.
If we extend our analysis of U.S. stocks over longer time periods, Large Growth stocks lead over the past year, up an amazing 39% vs. 20.27% for Large Value. Large Growth has been the top returning asset class over the past 5 and 10 years. It is worth noting that U.S. Market wide results for the past 10 years are robust, up 12.33% annually.
The U.S. business cycle continues to slow, but there are signs that a bottom is in. The Conference Board Leading Economic Index, which consists of 12 leading economic indicators has ticked up in February for the first time in 2 years and is 26 months off from its previous peak. On average for the index, there is 10.6 months between a peak and a recession, so the current cycle is well past the average. The 4th quarter GDP growth final reading was revised up to 3.4%, which brings GDP growth for the full year 2023 up to 2.5%, well ahead of GDP growth for 2022 (full year), which was 1.9%. For 2024 GDP growth is expected to slow down to 1.5%, but that is up from consensus expectations of 0.8% growth last quarter. It is difficult to see a heavy recession with the job market still so strong; if you want a job, you can find it. The four-week moving average of initial claims for unemployment insurance remains near the lowest levels in the last year, which means the U.S. job market remains very tight; and until it falters, we are not likely to experience a recession in the near term.
One reason why the jobs market is so strong is the robust fiscal spending, which is adding another $1 trillion to the national debt every 100 days. The pace of fiscal spending isn’t sustainable and is making the monetary policy of the Federal Reserve more difficult in its goal of fighting inflation. The Fed has paused from hiking rates but continues to sell Treasuries and mortgages at a monthly pace of just under $100 billion, which has the effect of increasing interest rates.
Moving on to International Developed stocks, Growth Stocks were up 11.04% in local currency, but up only 6.91% in U.S. dollars, since the dollar appreciated against most foreign currencies during the first quarter. The Euro went from $1.10 last quarter to its current value of $1.08. It is still down from $1.18 per Euro, 2.5 years ago. The currency effect served as a strong headwind, hurting international stock returns during the quarter. The value premium (Value-Growth) was negative -2.7% (4.22% vs. 6.91%), and the size premium was negative -3% (Small Cap-Large Cap, 2.58% vs. 5.59%). Our investment funds are priced in U.S. dollars (unhedged) and benefit from a weakening U.S. dollar:
Over longer time periods, the value premium (value-growth) is positive over the past 1 and 3-year period, but still negative for 5 and 10 years. The size factor premium (small cap-large cap) is negative in the quarter, 1-year, 3-year 5-year and 10-year periods, although just below large cap for the past 10 years (4.54% vs. 4.81%):
Moving the commentary to fixed income, bond market returns around the world were positive during the first quarter, as yields increased for most bond maturities. The bond market is now predicting 2-3 interest rate cuts by the Federal Reserve in 2024, and the Fed’s QT (quantitative tightening) program of selling $90-100 billion of bonds per month is expected to continue for many years. The yield on the 5-year Treasury note increased by 37 basis points, ending the quarter at a yield of 4.21%, down from 3.84%. The yield on the 10-year Treasury note increased by 32 basis points, ending the quarter at a yield of 4.2%, up from 3.88%. And the 30-year Treasury bond yield increased by 31 bps to 4.34%, up from 4.03%. As yields increase, bond prices decrease, and higher borrowing costs make it more difficult for consumers and corporations to use debt, including auto loans and mortgages. Here is the U.S. yield curve, and you can see how yields increased for all maturities longer than 3 months (current yield curve in grey, one quarter ago in blue, and one year ago in green):
Looking at fixed income asset classes, the highest first quarter bond return was for the U.S. High Yield Corporate Bond Index, up 1.47%, which is a sign of a robust economy, while the Government Bond Index Long (long-term Treasuries) was down at the bottom, -3.24%, since longer bonds lose more value than shorter maturity bonds when interest rate increase. The U.S. Aggregate Bond Index was closer to the bottom, down -0.78%, and is up 1.7% in the past year, but down -2.46% in the past three years. Short-term bonds were near the top for Q1, and have positive longer returns for 3, 5 and 10 years. Here are the fixed income period returns:
During the first quarter, the U.S. fixed income markets declined as interest rates climbed due to higher-than-expected inflation readings. Inflation has stopped its decline each month, due to the very strong fiscal spending by the government, which is not likely to end during an election year. The Fed, which was expected to lower rates 6 times at the start of the year, is now expected to lower rates two or three times and may not be able to raise rates until after the November election. We may only see one rate cut toward the very end of the year. The Fed continues its $8 trillion balance sheet reduction (selling bonds) at a rate of ~$95 billion per month or $1.1 trillion annually. Historically, the Fed only lowers the overnight lending rate when the job market looks to be in trouble, since its second mandate is full employment. Job market trouble is usually stock market trouble. However, stocks can continue up with a long pause by the Fed.
The stock market considers hundreds of factors to determine asset prices, some more important than others. One cannot time markets and typically the short term is just noise. Here is a sample of how the world stock markets responded to headline news, during the last quarter and the last year (notice the insert of the second graph that compares the last 12 months to the long term). We encourage you to tune out the financial news, since major news sources have a bias toward negative headlines; and often the headlines of the day have very little to do with the direction of stocks.
CONCLUSION
The positive run for stocks and bonds during 2023 continued into the first quarter of 2024 and the major U.S. stock indices are at new record highs. The strong returns are driven by just seven very large companies known as the magnificent seven: Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia and Tesla, and the valuation of the S&P 500 has increased to a level that some argue isn’t sustainable, while others argue, it is not near the peak of the internet bubble. This argument assumes the AI craze is as big as the internet and it may turn out to be. However, the internet bubble collapse was most painful for the tech sector; and it took the Nasdaq 15 years to regain its peak during the internet bubble. This is the reason we hold globally diversified portfolios. Stock valuations are much more reasonable around the world, and it would be reasonable to expect a shift to international out-performance in the future.
Our recommendation, as always, is to tune out the news and focus on what you can control with your financial well-being in the new year. We are here to help you succeed and look forward to seeing you soon.
Here is a timely piece from our friends at Dimensional:
Some investors attribute the Magnificent 7 stocks’ dominance to a “winner-take-all” environment in which a handful of companies achieve sufficient market share to hinder competition.1 In businesses where gaining users drives success, establishing a strong market share may be like building a moat around profitability. But that doesn’t guarantee these companies can stay on top.
Think about the state of mobile phones 15 years ago. In all likelihood, you would have been reading this on a BlackBerry, such was that device’s entrenchment for mobile business communication. Then, along came iPhones and Androids and suddenly BlackBerry’s foothold was eroded.
History is littered with examples of household names that were usurped by the Next Big Thing. Remember, Sears was a Top 10-sized stock in the US once upon a time. AOL was synonymous with internet access in the 1990s. And in 2003, the most popular social media network starting with the letter F was Friendster.
Even the biggest companies have uncertain futures, highlighting the need for broadly diversified investments. And even if these companies stay at the top of the market, that’s no assurance higher returns will continue if their success is expected.
Standardized Performance Data and Disclosures
Russell data © Russell Investment Group 1995-2022, all rights reserved. Dow Jones data provided by Dow Jones Indexes. MSCI data copyright MSCI 2022, all rights reserved. S&P data provided by Standard & Poor’s Index Services Group. The BofA Merrill Lynch Indices are used with permission; © 2022 Merrill Lynch, Pierce, Fenner & Smith Inc.; all rights reserved. Citigroup bond indices copyright 2022 by Citigroup. Barclays data provided by Barclays Bank PLC. Indices are not available for direct investment; their performance does not reflect the expenses associated with the management of an actual portfolio.
Past performance is no guarantee of future results. This information is provided for educational purposes only and should not be considered investment advice or a solicitation to buy or sell securities. Diversification does not guarantee investment returns and does not eliminate the risk of loss.
Investing risks include loss of principal and fluctuating value. Small cap securities are subject to greater volatility than those in other asset categories. International investing involves special risks such as currency fluctuation and political instability. Investing in emerging markets may accentuate these risks. Sector-specific investments can also increase these risks.
Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed-income investments are subject to various other risks including changes in credit quality, liquidity, prepayments, and other factors. REIT risks include changes in real estate values and property taxes, interest rates, cash flow of underlying real estate assets, supply and demand, and the management skill and creditworthiness of the issuer.
Principal Risks:
The principal risks of investing may include one or more of the following: market risk, small companies risk, risk of concentrating in the real estate industry, foreign securities risk and currencies risk, emerging markets risk, banking concentration risk, foreign government debt risk, interest rate risk, risk of investing for inflation protection, credit risk, risk of municipal securities, derivatives risk, securities lending risk, call risk, liquidity risk, income risk. Value investment risk. Investing strategy risk. To more fully understand the risks related to investment in the funds, investors should read each fund’s prospectus.
Investments in foreign issuers are subject to certain considerations that are not associated with investment in US public companies. Investment in the International Equity, Emerging Markets Equity and the Global Fixed Income Portfolios and Indices will be denominated in foreign currencies. Changes in the relative value of these foreign currencies and the US dollar, therefore, will affect the value of investments in the Portfolios. However, the Global Fixed Income Portfolios and Indices may utilize forward currency contracts to attempt to protect against uncertainty in the level of future currency rates (if applicable), to hedge against fluctuations in currency exchange rates or to transfer balances from one currency to another. Foreign Securities prices may decline or fluctuate because of (a) economic or political actions of foreign governments, and/or (b) less regulated or liquid securities markets.
The Real Estate Indices are each concentrated in the real estate industry. The exclusive focus by Real Estate Securities Portfolios on the real estate industry will cause the Real Estate Securities Portfolios to be exposed to the general risks of direct real estate ownership. The value of securities in the real estate industry can be affected by changes in real estate values and rental income, property taxes, and tax and regulatory requirements. Also, the value of securities in the real estate industry may decline with changes in interest rate. Investing in REITS and REIT-like entities involves certain unique risks in addition to those risks associated with investing in the real estate industry in general. REITS and REIT-like entities are dependent upon management skill, may not be diversified, and are subject to heavy cash flow dependency and self-liquidations. REITS and REIT-like entities also are subject to the possibility of failing to qualify for tax free pass through of income. Also, many foreign REIT-like entities are deemed for tax purposes as passive foreign investment companies (PFICs), which could result in the receipt of taxable dividends to shareholders at an unfavorable tax rate. Also, because REITS and REIT-like entities typically are invested in a limited number of projects or in a particular market segment, these entities are more susceptible to adverse developments affecting a single project or market segment than more broadly diversified investments. The performance of Real Estate Securities Portfolios may be materially different from the broad equity market.
Fixed Income Portfolios:
The net asset value of a fund that invests in fixed income securities will fluctuate when interest rates rise. An investor can lose principal value investing in a fixed income fund during a rising interest rate environment. The Portfolio may also be affected by: call risk, which is the risk that during periods of falling interest rates, a bond issuer will call or repay a higher-yielding bond before its maturity date; credit risk, which is the risk that a bond issuer will fail to pay interest and principal in a timely manner.
Risk of Banking Concentration:
Focus on the banking industry would link the performance of the short-term fixed income indices to changes in performance of the banking industry generally. For example, a change in the market’s perception of the riskiness of banks compared to non-banks would cause the Portfolio’s values to fluctuate.
The material is solely for informational purposes and shall not constitute an offer to sell or the solicitation to buy securities. The opinions expressed herein represent the current, good faith views of Lake Tahoe Wealth Management, Inc. (LTWM) as of the date indicated and are provided for limited purposes, are not definitive investment advice, and should not be relied on as such. The information presented in this presentation has been developed internally and/or obtained from sources believed to be reliable; however, LTWM does not guarantee the accuracy, adequacy or completeness of such information.
Predictions, opinions, and other information contained in this presentation are subject to change continually and without notice of any kind and may no longer be true after the date indicated. Any forward-looking statements speak only as of the date they are made, and LTWM assumes no duty to and does not undertake to update forward-looking statements. Forward-looking statements are subject to numerous assumptions, risks and uncertainties, which change over time. Actual results could differ materially from those anticipated in forward looking statements. No investment strategy can guarantee performance results. All investments are subject to investment risk, including loss of principal invested.
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