The second quarter was mixed for stocks, after two strong quarters of positive returns (4th quarter of 2023 and 1st quarter of 2024). Most U.S. indices are at new all-time highs, thanks to the bull run since the end of the quarter (as of July 11th). The U.S. economy continues to grow, although at a slower rate. The Federal Reserve Board (Fed) is keeping interest rates elevated but has cut the amount of bond selling in half from just under $100 billion to $50 billion per month, which puts less pressure on interest rates going higher.
The next Fed move is expected to be a rate cut and the first cut may be in September (87% chance at the time of this writing), although it could easily be pushed out to the end of the year or even next year. The last Fed move was a rate hike back in July of 2023. The Federal government continues large deficit spending, which is likely making the Fed’s job harder to bring inflation down to the 2% target rate with its monetary policy.
The European Central Bank (ECB) cut its rate for the first time in five years on June 6, 25 basis points, along with the central banks of Canada, Sweden and Switzerland. The ECB rate is now 3.75%. The Bank of England has kept its rate steady at 5.25% due to strong wage growth. International developed stocks struggled during the second quarter but have also picked up since the quarter ended.
We are cautious due to the high valuation of U.S. stocks but remain optimistic on global economic growth and the strong momentum of stocks. If inflation continues to cool, it may provide the catalyst for U.S. small cap stocks to outperform, since they are at a 25-year low in relative valuation compared to U.S. large cap stocks. We look forward to our planning discussions and hope you enjoy the remaining summer months.
For those who would like a deeper dive into the details, please continue reading…
World Asset Class 2nd Quarter 2024 Index Returns
The second quarter of 2024 was positive for U.S. and Emerging Market stock index returns and negative for International Developed and Global Real Estate stock index returns. For the broad U.S. Stock Market, the second quarter return of 3.22% was above the average quarterly return of 2.4% since January 2001. International Developed Stocks returned -0.6%, below the long-term average quarterly return of 1.6%. Emerging Market Stocks returned 5.0%, above the average quarterly return of 2.5%. Global Real Estate Stocks were negative for Q2 and returned -1.48%, below the asset class’s average quarterly return of 2.2%. The U.S. Bond Market was up a very small 0.07%, below its average quarterly return of 0.9%, while the Global Bond Market (ex U.S.) was up 0.11%, below 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 6/30/2024, U.S. stocks led all broad categories with a positive return of 23.13%, International Developed stocks were up 11.22%, Emerging Markets stocks were up 12.55%, and Global Real Estate stocks were up 5.1%. The U.S. Bond Market gained 2.63% and Global Bonds were up 5.26% for the past year. Over the past five years, U.S. stocks were up 14.14% annually, while International Developed stocks were up 6.55% annually, Emerging Market stocks were up 3.1% annually, and Global Real Estate stocks were up 0.65% annually. The U.S. Bond Market was down -0.23% annually for the past five years, while Global Bonds were up 0.51% annually. It has been a difficult five-year period for bonds, due to the increase in interest rates across the yield curve, as the Federal Reserve started raising the overnight lending rate in the beginning of 2022. Over the past 10 years, the U.S. stock market (up 12.15% annually) is well ahead of International Developed (up 4.27% annually), Emerging Market stocks (up 2.79% annually) and Global Real Estate stocks (up 2.94% annually). U.S. Bonds were up 1.35% and Global Bonds were up 2.45%, annually, over the last 10 years.
Taking a closer look within U.S. stocks during the second quarter, Large Growth took the top spot, up 8.33%. Large Cap stocks (up 3.57%) were slightly above Marketwide results (up 3.22%). At the bottom was Small Cap Value, which was down -3.64%. This was the second quarter in a row that large cap growth stocks led as investors increased the valuation of stocks associated with AI. Within large cap growth, the leaders continue to be the “magnificent 7 stocks”, all mega cap companies. We will have more to say about this small group of stocks at the end of this blog.
It is a challenge for small cap value stocks to perform well when the regional banking ETF, symbol KRE, struggles. During the second quarter, KRE was slightly negative -0.6%. Regional banks are challenged by higher interest rates and commercial real estate loans against properties that have declined in value. 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. The relative valuations of small-cap stocks compared to large-cap stocks are near their lowest levels in 25 years, which makes small cap stocks attractive.
If we extend our analysis of U.S. stocks over longer time periods, Large Growth stocks led over the past year, up 33.48% vs. 13.06% for Large Value. Large Growth has been the top returning asset class over the past 3, 5, and 10 years. It is worth noting that U.S. Market wide results for the past 10 years are robust, up 12.15% annually.
The U.S. business cycle continues to slow. The first quarter GDP growth initial estimate was 1.3% (annual rate), much lower than Q4 of last year, which was revised up to a final reading of 3.4%. GDP growth for the full year 2023 was 2.5%. For 2024, GDP growth is expected to slow down to 1.5%, the latest consensus expectation for 2024 Q2 is for 2.1% growth. It is difficult to see a heavy recession with the job market still strong. The four-week moving average of initial claims for unemployment insurance is heading up but 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 and has now cut in half the value of Treasuries and mortgages it sells from a monthly pace of just under $100 billion, to $50 billion.
Moving on to International Developed stocks, which were positive in local currency but negative for the quarter, due to currency movements. Value stocks led the second quarter, only down -0.17%, after currency adjustment (up 1.23% locally). Growth Stocks were down -0.94% in U.S. dollars, up 0.43% in local currency, since the dollar appreciated against most foreign currencies during the second quarter. The Euro went from $1.08 last quarter to its current value of $1.07. The exchange rate has slowly moved down from $1.19 per Euro, 3 years ago. The currency effect served as a strong headwind, hurting international stock returns during the second quarter. 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 slightly 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 (4.04% vs. 4.27%):
Moving the commentary to fixed income, bond market returns around the world were just above break even during the second quarter, as yields increased for most bond maturities, but coupon interest payments were high enough to offset market price declines. The yield on the 5-year Treasury note increased by 12 basis points, ending the quarter at a yield of 4.33%, up from 4.21%. The yield on the 10-year Treasury note increased by 16 basis points, ending the quarter at a yield of 4.36%, up from 4.2%. And the 30-year Treasury bond yield increased by 17 bps to 4.51%, up from 4.34%. 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 slightly 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 second quarter bond return was for the very short 3-Month Treasury Bill Index (up1.32%), followed by the 1-year Treasury Index (up 1.11%), then the U.S. High Yield Corporate Bond Index (up 1.09%), which is a sign of a robust economy, while the Government Bond Index Long (long-term Treasuries) was down at the bottom, -1.8% for the quarter; and down -10.45% annually for the past three years. The U.S. Aggregate Bond Index was near the middle, up 0.07% for the quarter, and up 2.63% in the past year, but down -3.02% annually 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 second quarter, the U.S. fixed income markets were positive at the short end and negative at the long end of the curve as interest rates climbed due to stubborn inflation readings. The Fed, which was expected to lower rates 6 times at the start of the year, is now expected to lower rates one or two times. We may see a rate cut at the September FOMC meeting and one rate cut toward the very end of the year; or none at all. The Federal Reserve changed its QT (quantitative tightening) program from selling $90-100 billion of bonds per month to a cap of $50 billion per month, which started in June.
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
After two strong quarters of returns, fourth quarter of 2023 and first quarter of 2024, the second quarter was positive for U.S. and Emerging stocks; and negative for international developed stocks. Thanks to a continued upward movement of stocks this month, the major U.S. stock indices are now at new record highs. The strong returns continue to be 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 after the internet bubble burst. This is the reason we hold globally diversified portfolios. Stock valuations are much more reasonable for small-cap stocks and international stocks, and it would be reasonable to expect a shift to small-cap and international out-performance in the future.
Our recommendation is to stay disciplined with investments, tune out the news and focus on what you can control with your financial plan. We are here to help you succeed and look forward to seeing you soon.
Here is a timely piece from our friends at Dimensional on the Magnificent 7:
It is unlikely any stock has an expected return of 100% per year. That seems too high to be the cost of equity capital for a company, and it’s doubtful anyone would sell a stock with an expected return 10 times the historical stock market return.1 A realized return that big likely means the company surprised investors in a good way.
The Magnificent 7 stocks returned on average more than 111% in 2023, exceeding the S&P 500 Index by over 85 percentage points. While it’s hard to say what cash flow expectations were built into their stock prices, comparing analyst earnings estimates to actual earnings suggests these companies exceeded expectations for the year. All seven reported earnings exceeding average forecasts. For example, Nvidia posted an earnings per share 37.4%bhigher than the average analyst expectation. Contrast this with 2022, when five of the seven companies’ earnings fell short of analyst expectations. The average Magnificent 7 stock return that year trailed the S&P 500 Index by 28 percentage points.
Expecting Mag 7 outperformance to continue is to bet on these companies further exceeding the market’s expectations. Simply meeting expectations may result in returns more in line with the market, consistent with the history of top US stocks.
The S&P 500 Index had an annualized return of 10.3% from January 1926 to December 2023. S&P data © 2024 S&P Dow Jones Indices LLC, a division of S&P Global. All rights reserved.
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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