3rd Quarter, 2024

A quick way to measure market risk is to follow trends in financial leverage.

THE MARKETS

The third quarter was another stellar, yet volatile, period for US equity market returns, with the S&P 500 adding 5.9%. This broad gauge of large US businesses is now up 22.1% through the end of the third quarter.

While these return numbers are impressive, they do not tell what we believe to be the most interesting story from the markets. The context of how the market produced these returns tells the story of where we are now.

Through the end of the second quarter, market returns were largely driven from impressive growth in technology businesses focused on semiconductor manufacturing, artificial intelligence (AI), and cloud computing services. In the third quarter, this leadership position fell apart. The Technology sector was among the worst performers in the quarter, while the Utilities and Real Estate sectors took up the mantle of market leadership, gaining 19.4% and 17.1%, respectively. Utilities are now the best performing sector of the S&P 500, returning 30.5% year to date.

Although this dramatic reorganization in market leadership can be explained by either long-term (AI applications will require vast increases in electrical generation and massive investments in physical data centers) or short-term factors (an accommodative Fed policy), we favor the simpler explanation that lower interest rates are the driver. Utilities and real estate businesses are essentially financial assets whose valuations are a direct reflection of interest rates.

As global geopolitical tensions continue to roil, leverage builds in complex trading strategies, interest rate policies change, federal deficits widen, new tax structures are proposed, elections are held and economic growth prospects are reconsidered, investors are likely to continue to adjust their willingness to pay for businesses with uncertain cash flows. Easier credit leading to additional risk-seeking leverage will reduce the margin for error in the economy and could result in more volatility. Therefore, it follows that these bond proxies would serve as a suitable landing spot for investors seeking a safe haven.

THE ECONOMY

Against the backdrop of uncertainty, it is easy to understand why investors are cautious. Pockets of inflation that are due to structural supply constraint, like housing, have remained stubbornly high leading to an increased risk that broader inflation could be reignited if general demand for goods and commodities rises quickly.

In general, prognosticators’ economic outlooks for the balance of 2024 and 2025 are middling as they anxiously wait for a shoe to drop. Threading the needle on inflation while still allowing for growth will be tricky as the global economy is now sufficiently complex to reduce any one central bank’s ability to tame or spark economic activity.

As always, bright spots in technological progression give cause for optimism over the long-term. The R&D and infrastructure investments necessary to make the future a reality provide investors with many opportunities to deploy capital, but the price at which those investments are made will be the determinant of the ultimate returns on that capital earned by those providing the funding.

Exogenous events are always a risk to economic activity. While it may appear that we are living in a time of heightened threat to the global order, it is important to remember that this could have been said at numerous times over the preceding decades.

Fortune favors the prepared. In an investing context, preparation comes in the form of a portfolio that is well allocated, properly diversified and provides for near-term cash needs. This will allow an investor to weather a storm and take advantage of opportunities that arise as a result.

INVESTMENT STRATEGY

As of now, it is rare to find clear opportunities in the equity market. This may lead some to seek to reduce market exposure. The tremendous gains in equity prices this year have led to stretched valuations. Prior to the start of the third quarter the rich valuations were mostly confined to growth-oriented sectors, however the broadening of market performance to traditionally defensive sectors has resulted in pervasive valuation premiums.

In general, this dislocation in share prices from what we would consider fair value is nothing more than a passing curiosity. Equity investments are the long-term component of a portfolio, protecting purchasing power and compounding value over years, not quarters. Reallocating a portfolio away from equity holdings due to near-term valuation concerns is likely penny-wise, pound-foolish. Over the long-term, we continue to view equity exposure in the form of well-managed, cash generative businesses as the best path to wealth creation.

With its 50 basis point cut in rates in September, the Fed has clearly embarked on a path of accommodation. Although the Fed’s impact centers on maturities two years and in, the broader bond market has signaled its comfort with the way events are unfolding by normalizing the yield curve with a slight upward slope out the maturity horizon. With Treasury rates on 2 to 10 year maturities in a tight range of 3.7% to 4.0% against a backdrop of an inflation rate of 2.5-3.0%, the bond market is serving its desired role of reducing portfolio volatility while preserving real value.

Portfolio risk is better considered as a strategic decision that takes into account cash flow needs and general risk appetite. We recommend always being cognizant of the cash needs from a portfolio and not having any cash needed in the next five years subject to market risk. Those assets are better housed in liquid bonds paying satisfactory yields to protect against the drag of inflation. 

Allocating a portfolio in a sensible manner that allows equity holdings to continue to be held undisturbed and without the drag of taxes will result in far more attractive long-term returns than the alternatives.

CONCLUSION

We live in trying times, but that is to be expected. It has never served to bet against ingenuity, creativity and value creation. Volatility may continue as we deal with the challenges of an election season, interest rate changes, federal deficits, leveraged investment strategies and global conflict. We strive to protect and grow our clients’ capital in real terms and equity exposure remains the best way to do that. Great businesses managed by competent people will continue to respond to risks, adapt to challenges and invest for the long-term.