Do the Markets Reflect a Widespread Suspension of Disbelief?

Equity markets continued to move higher during the second quarter, with U.S. Large Cap stocks boosted by rising earnings expectations and expanding valuations. During the quarter, the S&P 500 rose 4.28 percent, closing at 5,460.48, just off its record high set on June 18, 2024. While this generated media and investor excitement, a closer look shows weakness for stocks overall as nearly every other measure of the entire U.S. equity market fell during the quarter. For example, U.S. Mid Cap and Small Cap stocks fell 3.45 percent and 3.11 percent, respectively, during the quarter. More importantly, a deeper look at the S&P 500 index reveals that the broad index was propelled higher by a select few companies. While the S&P 500 advanced 4.28 percent, an equal weighted version (i.e., each of the 500 companies weighted the same) actually declined by 2.63 percent. 

Throughout history, market environments that feature broad-based participation tend to have higher forward returns with less volatility versus those where market breadth is as weak as it is today.

The six largest companies in the S&P 500 (Microsoft, Apple, Nvidia, Amazon, Meta and Alphabet) combined were responsible for all of the S&P 500’s strong quarterly gain, and then some. These mega-cap stocks generated a 17.1 percent return during the quarter. Due to their massive 31 percent weight within the S&P 500, they were collectively responsible for 110 percent of S&P 500 index return. For illustrative purposes, consider that an investor who held 70 percent of their assets in cash and invested the other 30 percent in the six largest companies would have still outperformed the S&P 500 despite the massive drag on performance from holding all that cash. Simply put, both the concentration of the market and the concentration of returns during the quarter was remarkable. 

We don’t view this level of concentration as a sign of a healthy market given that it has led to a material deterioration in overall market breadth. Consider that a historically meager 30 percent of the companies in the S&P 500 outperformed the overall index return during the quarter—the lowest number since the dot-com bubble in the late 1990s. Throughout history, market environments that feature broad-based participation tend to have higher forward returns with less volatility versus those where market breadth is as weak as it is today. We believe that the current concentrated environment makes the market vulnerable to downside risk if the narrow source of strength experiences a hiccup in performance. 

The economy and the markets 

While we don’t believe the current market concentration is healthy or sustainable, we do believe it is explainable. During the second quarter, overall economic growth weakened. We believe this weakening explains the deteriorating breadth of stocks generating strong returns during the quarter. Simply put, as the economy weakens, investors are focused on companies that they believe will be insulated in an economic slowdown. This approach has led them to potential beneficiaries of the long-term theme of artificial intelligence, which is helping to drive those six names higher. We acknowledge that some of this performance was driven by the reality that during the quarter these companies saw their forward earnings expectations rise by 9.2 percent versus 2.8 percent for the other 494 companies in the S&P 500. However, the biggest driver of the six winners was the change in what investors were willing to pay for these expected forward earnings. The earnings multiple expanded by 7.2 percent for the top six, while it fell 3.8 percent for the rest of the S&P 500, resulting in a negative 0.6 percent return for the other 494 companies (the S&P 500 excluding the top six companies). We believe that the perceived economic insensitivity of these stocks and the valuation multiples that investors are willing to pay for them will be tested in the coming quarters as economic weakness broadens.  

Signs of a weakening economy 

During the quarter, overall economic growth surprised to the downside, with the Citigroup economic surprise index falling sharply and hitting its lowest level since August 2022. In a sign of broadening economic weakness, the Institute for Supply Management (ISM) Manufacturing PMI, which has been in contraction for 19 of the past 20 months, was joined by the larger and previously robust services sector of the U.S. economy with the ISM Services PMI slipping into contraction in both April and June. This is an important development given that the combination of these two reports often provides clues to the overall health and strength of the U.S. economy. Indeed, if we weight these reports by their relative contribution to the U.S. economic growth, the combined reading of the two was at a contractionary level (below 50) for two of the three months during the quarter. While the ISM services survey only goes back to mid-1997, we note that as the chart below shows, there have been only two times when this indicator has been below 50 and a recession has not ensued: two months in early 2003 and one month at the end of December 2022, when the economy was moving past the post-COVID oddities.  

While these are only two indicators, it's worth noting that retail sales, business capital spending and housing also slowed during the quarter as the impact of higher rates continued to work their way into the economy. The impact of Fed rate hikes has long and variable lags, and while it may seem like an eternity since the Fed started its aggressive rate hike campaign—boosting rates 5.25 percentage points, the third quarter of 2024 will mark only the 10th quarter since the rate hike campaign began. During the past eight recessions, this is the average time from the start of a rate hike cycle to the beginning of a recession.  

Just as economic growth weakened during the quarter, indicators of future economic growth continue to point to trouble on the horizon.

While inflation did slow toward the end of the quarter, the Federal Reserve continues to point to higher rates for longer, which we believe will continue to weigh on U.S. economic growth. The reality is that the Fed wants to have greater confidence that inflation is put to rest for the foreseeable future. And as we noted in the past, the easing inflation that emerged late in the quarter happened as we saw signs of a slowing economy. The question now is whether the Fed can magically pull back inflation further without the economy sliding into recession. We believe it is possible but unlikely.   

Just as economic growth weakened during the quarter, indicators of future economic growth continue to point to trouble on the horizon. The Conference Board’s Leading Economic Index (LEI) continued its descent during the quarter and has now been negative in 26 of the past 27 months—the sole exception being a 0 percent reading in February of this year. The LEI peaked in December 2021 and has been consistently under pressure since, resulting in a 14.7 percent drawdown, the fourth largest on record and surpassed only during the recessions of 1973, 1982 and 2007-09. This index is an example of the oddities and often confusing signals that have occurred post-COVID, when previously reliable economic indicators have pointed to an impending economic recession, yet one has not materialized. This begs the question: Are these indicators broken, or is it just taking longer for the economy to fall into recession given the torrent of fiscal and monetary stimulus unleashed during COVID?

Is the Fed listening? 

Despite increasing signs of economic weakness, the Federal Reserve has strengthened its comments around higher interest rates for longer. Indeed, at the Federal Open Markets Committee (FOMC) June meeting, policymakers pulled back their expectations for rate cuts this year from three to one, with four members now expecting no cuts this year. While inflation data in May and June was generally favorable, the prior reports this year pointed in the wrong direction As such, the Fed wants to wait until it has stronger conviction that inflation is trending sustainably back to 2 percent. 

The Fed is likely wondering if the unexpected uptick in inflation early this year came as a result of the optimism it expressed late last year that inflation was slowing and set to continue to ease. We note that late in an economic cycle inflation sensitivity is generally higher, largely because increases in economic growth come against an economy that is low on slack to create the needed supply. Consider that after members of the Fed forecasted late in 2023 that it would cut rates by just 50 basis points in 2024, investors extrapolated nearly 175 basis points of cuts for 2024. This not only spurred optimism among consumers and corporations but also caused a sharp market rally that may have led to a wealth effect that helped push inflation higher. Taking it one step further and tying this to our opening comments, when rate cut expectations evaporated in early 2024, it coincided with the market beginning to narrow. Before that, the market had broadened on hopes the rate cuts would create a soft landing.   

Various inflation measures and three- to six-month trends of some of these measures remain above where the Fed would like them to be before they declare “mission accomplished.” Most notable are wages, which we have previously referred to as the Fed’s final inflation frontier. While wages cooled some to end the quarter, they remain up 4 percent year over year, which is above the 3.0-3.5 percent pace the Fed has stated it believes is consistent with sustainable 2 percent inflation.

It’s the labor market, but which measure?  

The Bureau of Labor Statistics (BLS) Nonfarm payrolls report remained strong during the quarter, showing an average of 177,000 new jobs added each month during the quarter. However, the BLS’s other measure of the labor market—the unemployment rate—rose from 3.8 percent to 4.1 percent during the period. Add this to the list of historically odd economic divergences that have occurred during the post-COVID period. Year to date, the Nonfarm payroll report has shown 1.334 million employees added to payrolls, while the household employment report, which is the basis for the unemployment rate, has shown just 16,000 new jobs. The monthly difference between the two measures results in the Nonfarm payroll data showing 2.661 million new jobs created in the past 12 months through June 30, compared to a meager 195,000 for the period according to the Household report. In data going back to 1957, this 12-month difference has been eclipsed only during the COVID-impacted month of April 2020 and is the second largest gap in the history of the reports.  

With inflation still above the Fed’s target, it makes sense that a weaker job market would be required for the FOMC to cut rates. And while overall employment metrics appear to be weakening, they are still too strong for the Fed to feel rate cuts are an option at this time. While we have seen signs of weakness, the conflicting data is likely creating difficulty for the Fed to judge the overall labor market strength, and with wages and inflation still elevated, the Fed has been waiting for more definitive signs of labor weakness.  

As the Fed waits, the clock appears to be ticking. The unemployment rate has risen from 3.4 percent to 4.1 percent as companies respond to softer demand conditions. This rise has not yet triggered the closely watched Sahm Rule, which looks at the change in the three-month average of the unemployment rate. A rise of 0.5 percent or more in the three-month average in the unemployment rate triggers the Sahm Rule, which has a perfect track record going back to at least the 1940s in signaling recessions. We are now at 0.43 percent on the rule, but a rise of 0.1 percent in July to 4.2 percent in the unemployment rate would trigger the rule.  

While the national data is trending toward triggering the Sahm Rule, 22 states have already moved past the 0.5 percent demarcation line. Our analysis based on data going back to 1976 shows that this has never happened without a recession occurring. The 22 states in agreement with the Sahm rule make up 48 percent of the total U.S. population, and, importantly, we note that the number of states currently in this group is nearly twice as many when compared to the soft landing the U.S. economy achieved in 1995.  

The bottom line

We continue to believe that a recession still is the most likely outcome for the economy. Could a soft landing occur? Perhaps. But the reality remains that the U.S. economy is later in a business cycle, and historically, the only way a late-cycle economy has gained substantial slack is through a recession. Certainly, the current cycle could go into economic overtime as was the case in the late 1990s, but we believe it’s unlikely. Furthermore, we note that the Fed has cut rates before each of the past four recessions (COVID included), yet the economy still fell into recession. We continue to remind investors that this doesn’t mean they need to dramatically change their asset allocation. Instead, we believe they should make sure they are comfortable with the level of risk they have and be prepared to stick with their asset allocation.  

The market 

Despite some downside momentum developing in the economy during the second quarter, forecasts call for the S&P 500 to see 10.6 percent earnings growth for 2024 and 13.3 percent growth in 2025. Against those elevated earnings expectations and economic risks, investors are willing to pay historically elevated valuations (top decile) valuations of 22x and 20x forward earnings, respectively.  

In the years since COVID, we have often heard that investing is more about themes and that valuation is an outdated investment relic. We disagree but concede that valuation is often a poor short-term indicator of performance. As you can see in the chart on the left below, over the last 70 years, there has been little correlation between current earnings multiples of the S&P 500 and performance during the next 12 months. However, as the chart on the right shows, there is a clear trend of stocks trading at higher price-to-earnings multiples underperforming during the subsequent 10-year period. Starting valuations drive more than half the returns during the period. Simply put, we expect below-average returns for the S&P 500 given the current elevated valuations and the elevated downside risk to consensus earnings expectations given our mild recession forecast.

While our expectations for the S&P 500 may come across as concerning, they shouldn’t discourage investors. Much like our opening discussion of digging deeper to reveal what is happening, we continue to believe there are plenty of opportunities for those willing to look past the six largest names in the market. Many parts of the U.S. and world markets have already been trading as if a recession is likely to occur. This is where we think there are opportunities for intermediate- to long-term focused investors. Ironically, we believe these opportunities will start appearing when the economic environment changes; we again point to our research that shows every economic cycle has had different leadership and that the last economic cycle’s winners often become the next economic cycle’s laggards.  

First, the S&P 500 equal weight index trades at a more historically normal 16.3x forward 12-month earnings. We also see much more attractive valuations in value stocks as well as U.S. Small and Mid-Caps. Focusing on U.S. Small Cap, we note that the S&P 600 small cap stock index trades at 8.1x trailing 12-month cash flow. As the chart below shows, over the last 25 years, this type of valuation discount has been seen only when the economy was coming out of a recession. We believe this discount shows that investors have been worried about an economic downturn and as such have been avoiding this area of the market.  

We also note that on a relative basis, U.S. Small Caps trade at less than 15x forward 12-month earnings that are expected to grow only 1.6 percent. When you contrast that with U.S. Large Caps trading at more than 22x earnings, the relative discount is 30 percent, a level that last occurred in the late 1990s, a period of time when the market was similarly concentrated and driven by a few large stocks in the S&P 500.

History doesn’t always repeat, but it often rhymes. We've noted that the current economic and market cycle reminds us in many ways of the late 1990s, when a few mega-cap stocks drove the market cap weighted S&P 500 to new highs while the rest of the market languished as a late-cycle economy was being buffeted by previous Fed rate hikes. Not only is the current market more concentrated than it was then, but as we showed in our opening chart, the market breadth is as bad as it was then. Similarly, the equal weighted S&P, value stocks, Small and Mid-Cap stocks were dramatically underperforming. Today, we also hear echoes from the 1990s that valuations don’t matter, and indeed, current market valuations overall are nearing but not yet to the elevated valuations then.   

Ironically, in late 1999, when it became apparent that a recession was on the way and interest rates began to falter, the economically sensitive but cheaper parts of the market began to outperform and did so into and through that recession. While those groups saw negative returns on an absolute basis in the early stages of the recession, they outperformed on a relative basis and eventually posted positive absolute performance as the economy pulled out of the recession and began to expand. While many investors often refer to this time period as a lost decade, we note that it was lost only for the narrow part of the market where investors had previously pushed stocks to excessive levels.  

We continue to believe that there is light on the horizon with many opportunities for intermediate- to long-term investors to harvest. Recessions and corrections are natural features of the economic and market cycles. Sticking to a long-term plan and staying invested and diversified, even in areas that haven’t done well, remain the core tenets we believe create and maintain financial security for investors.  

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