At the midpoint of the year, the financial market, as measured by the S&P 500 continues to look solid, up over double digits on June 30, 2024. However, dig a little deeper and we are seeing signs of strain. The small cap index, the Russell 2000 (IWM), which should grow faster due to the smaller companies in the index is only up 1% year to date, while other widely followed benchmarks such as the Dow Jones (DIA) and S&P 500 equal weight indexes are both up under 4%, and the income producing Vanguard REIT Index (VNQ) and Bond Fund Index (AGG) are both down on the year, as of June 30, 2024. In this midyear market commentary, we will discuss why the S&P 500 is up as well as go into more detail on the problems we see brewing in narrow market leadership, high valuations, slowing economy, and geo-political headwinds.
The market is off to a strong start in 2024, but most stocks are not participating in the rally. According to Barron’s Magazine just five stocks- Nvidia, Meta Platforms (Facebook), Alphabet (Google), Microsoft, and Amazon have accounted for 61% of the S&P 500’s return this year1. All of these companies are benefitting from expected boom in Artificial Intelligence applications that companies are racing to develop. We think that Artificial Intelligence is going to happen, and it will be transformative, but the market is pricing in the valuations of growth that has not happened yet, which makes the market susceptible to a pullback. Indeed, the S&P 500 Tech sector's price to sales ratio has pushed all the way up to 9.8 times sales, which is well above its past high in 2021, and a very aggressive valuation number (Bloomberg). Keep in mind many companies trade at 10 times earnings. While speaking of earnings, JP Morgan stated in March of this year that absent the large technology stocks, the S&P 500 showed negative earnings growth last year of -4%, which shows how skewed the market has become.
Outside of the strong Artificial Intelligence Technology related stocks, the economy has been slowing down as the year has progressed. Retail sales in May increased 0.1%, less than the 0.3% economists had expected. In April, retail sales ticked down 0.2%, according to revised data from the Commerce Department. Capital Economics chief North America economist, Paul Ashworth, noted May’s retail sales reading adds to "signs that consumers are struggling a little." "Consumer spending is slowing because real income growth is moderating and because some consumers are becoming credit constrained amid elevated interest rates and rising credit card utilization," Oxford Economics Deputy Chief US economist Michael Pearce wrote in a note to clients.
According to First Trust, while overall retail sales are up 2.3% in the last year, they are no longer keeping up with the pace of inflation; “real” (inflation-adjusted) retail sales are down 0.9% in the last year after inflation and have remained stagnant for three years after peaking in April 2021. Sales were down at a 0.1% annualized rate through the first five months of 2024, a sign that U.S. consumers are finally starting to bend under the strain of higher borrowing costs after depleting their artificial stimulus saved up during the COVID years.
Bank of America is also coming to the same conclusion. Being one of the largest banks in the world and either having banking or credit card relationships with almost 50% of U.S. consumers, Bank of America has a unique insight to U.S. consumer spending. In their June credit card spending report, Bank of America shows discretionary spending on entertainment is down -14% year over year, furniture is down -13.8% and home improvement spending is down -11.5% year over year. Spending for necessary items is holding up better. (see chart below)
The most recent July 5th, 2024 jobs report also suggests a slowing economy. The overall jobs growth was still a healthy 206,000 new jobs for the month, but 70,000 of those jobs were government related jobs which suggest the private sector of the economy is not as robust as the overall numbers suggest (U.S. Labor Department). Moreover, the all-important unemployment rate ticked up to 4.1%, which is the highest since October 2021, and up from the cyclical low of 3.4% as more people reported to be actively looking for jobs. Furthermore, the number of job openings to unemployed persons has settled back down to pre-pandemic levels of 1.25 jobs open for every unemployed person. This indicator had jumped to two open jobs for every unemployed person during COVID and was a leading cause of wage inflation.
Digging even deeper into the unemployment report it also suggests a slowing economy. The Bureau of Labor Statistics actually tracks unemployment through two surveys, the Establishment Survey where the Department of Labor interviews businesses on the number of jobs they have at their establishments, and the Household Survey where they call households to check on their employment status. Historically, there has been very little difference in the numbers, but over the last two years the two surveys have moved apart and now show two very different scenarios. The Household Survey has shown no growth in full time jobs for over a year. The Establishment Survey paints a different picture of a job market that is still healthy but slowing as employers continue to hire workers. The Household Survey shows almost no growth in employment. On closer inspection it appears that many of the jobs that have been created are actually second jobs that workers are taking on to keep pace with inflation, or they are jobs that are going to newly arrived immigrants and are not showing up in the Household Survey.
On the geo-political front, the conflicts going on around the world continue to grow more intense. Starting with the Ukraine war, the “West” so far has successfully provided more assistance (first financial aid, second military aid, third more advanced weapons systems, tanks, aircraft, and fourth allowing targeting of military targets within Russia using Western equipment) without triggering a broader conflict. While we are not commenting if this is good or bad, we are making note that the risk of the conflict spreading is increasing. Moreover, the pace of assistance is also increasing. According to CNN (6-25-24), U.S. military contractors will now be headed to Ukraine to help with U.S. provided weapons systems, the first time the U.S. has acknowledged having Americans on the ground in Ukraine. Traditionally, U.S. contractors are trained special forces.
Russia has countered these actions by signing a mutual defense agreement with North Korea and signed military deals with Iran. In North Korea, Russia has agreed to give North Korea advanced military and nuclear technology in exchange for North Korean troops to fight in Ukraine, as well as supply arms to Western adversaries because the West was providing high precision weapons to Ukraine and giving it permission to fire them at targets inside Russia.
In Iran, according to analyst Gregory Brew at Eurasia Group, Russia has agreed to buy Iranian ballistic missiles, drones, artillery, and ammunition in exchange for more security cooperation and advanced weaponry, particularly modern aircraft. This is problematic because it builds up Iran’s military industrial complex and supplies it with more advanced technology at a time when Iran is directly supplying its proxies attacking Israel.
In addition, we continue to believe that the situation in the Middle East continues to slide. While Hamas has largely been defeated, the situation on Israel’s northern border with Hezbollah continues to escalate. As of the end of June, more than 60,000 Israelis are still evacuated from the northern border with Lebanon and Secretary of State Blinken said Israel had “effectively lost its sovereignty there.” As a result, ABC News reports that the Israeli military is preparing a phased pullout from Gaza and quietly pressing the government to broker a truce with Hamas as quickly as possible, as the military works to clear the decks ahead of what officials say could be a withering war with the powerful Iranian-backed Lebanese militia Hezbollah. Kamal Kharrazi, Iranian foreign minister and top advisor to Iran’s supreme leader, issued a stark warning that a conflict in Lebanon could result in a regional war involving all Arab nations. "All Lebanese people, Arab countries and members of the Axis of Resistance will support Lebanon against Israel," he said in an interview with the Financial Times. "There would be a chance of expansion of the war to the whole region, in which all countries including Iran would become engaged." Even without a wider war, a conflict with Hezbollah would be far more difficult than the conflict with Hamas. The Pentagon estimates that Hezbollah has over 100,000 trained fighters and that Hezbollah's total rocket count ranges from 40,000 to 120,000 which is considerably more than most countries, all of which are right on Israel’s border. Moreover, as the map below from Institute for the Study of War reveals, much of Hezbollah’s vast military infrastructure is embedded within civilian society, which makes military strikes more difficult.
For financial markets, a widening of the Middle East conflict or even just a direct conflict between Israel and Hezbollah would cause oil prices to rise which in turn would create inflationary pressures undoing many of the gains the Federal Reserve has made in bringing inflation back towards their long-term goal of 2%. The financial markets are currently expecting at least one rate cut before the end of the year. If war in the Middle East flares up and inflation spikes with higher oil prices the expected interest rate cuts will not happen and the market rally we have enjoyed will likely reverse.
In conclusion, the last six quarters have seen strong stock market gains, but we are now seeing issues that concern us. Equity valuations have risen, the stock market is increasingly concentrated in just one sector, and the U.S. government’s ability to come to the rescue in a future crisis has been diminished due to the governments growing debt load. While we do not expect a recession this year before the election due to the large amounts of government stimulus, next year could be tougher. However, we think the over $6 trillion dollars on the sidelines in money market accounts will help cushion any market sell-off, especially if the Federal Reserve starts to lower interest rates and that money gets reinvested into dividend paying stocks. As a result, we continue to favor large capitalization, brand name equities who are providing goods and services that consumers and businesses need on a daily basis and who are returning cash back to investors as the best risk adjusted returns.
Thank you for your continued support.
Sincerely,
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