2024 Quarter 1 Commentary

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"As Ben Graham said: ‘In the short-run, the market is a voting machine — reflecting a voter-registration test that requires only money, not intelligence or emotional stability — but in the long-run, the market is a weighing machine." - Warren Buffet

Warren Buffett’s quote, citing his mentor’s view of short-term market movements versus longer-term trends, seems apt to describe the current mode of markets. Recent moves in stock prices have been impacted by short-term judgements - not so much on the inherent values of the underlying companies whose stocks trade in the market, but on the question of when the Federal Reserve might cut interest rates. Looking back to the end of 2023, confidence and sentiment were running very high due to the three primary soft-landing conditions of:

1) slowing-but-positive economic growth

2) cooling-but-robust labor markets, and

3) declining inflation. 

The data seemed to set the stage for the Fed to cut interest rates sooner rather than later. Indeed, recent data releases continue to suggest that the economy is moving towards the soft landing scenario, in which those three conditions are met.

For example, the chart to the right shows that economic growth is still expected for 2024 and 2025, but expected growth is lower than the previous two years. In addition, while monthly nonfarm payroll numbers have been strong (more than 200,000 jobs created in February), they have not been as hot as they had been in 2023 and 2022. Finally, the Fed’s preferred measure for inflation, Core Personal Consumption Expenditures, is at 2.8%, with a trend that appears on its way to the Fed’s long-term goal of 2% inflation. Together these readings provide the Fed a level of comfort that inflation is being tamed, thus allowing the Fed to cut rates because it can, rather than because it must, which is what happens when the Fed cuts interest rates to stave off a pending recession.

But while the data shows that progress is occurring, that impetus has been slowed by slight ‘misses’ versus expectations. For example, when the Department of Labor came out with the latest Consumer Price Index reading for February, the overall change was trending in the right direction with a 3.2% increase versus the previous year. However, it was considered a disappointment when compared to expectations that it would be up 3.1%. Another example is the February Nonfarm payrolls release, which gives an estimated number of jobs created in the economy. For February, it showed 275,000 jobs created versus an expected level of 200,000 jobs created. Does that mean the labor market is still “too hot,” or is it a temporary blip? These items may seem small, but these slight variations from expectations can cause market participants - the ‘voters’ in Warren Buffett’s quote - to become worried about the timing of rates cuts. Indeed, Fed Chairman Jerome Powell has indicated that the Fed wants to see more evidence that inflation is falling sustainably back to its long-term 2% target before it begins cutting the Fed Funds rate. Thus, the hope of some market participants that the Fed might cut rates in March has faded.

It is understandable for the market to become anxious in the current situation. This period of tight monetary policy, which began in 2022 with increases in the Fed funds rate, is the fastest and highest increase in the last 35 years. In addition, it is becoming one of the longest periods of time in which interest rates remain elevated since the last rate increase in July 2023, at 8 months and counting. Only the period from June 2006 through September 2007 saw rates remain elevated for a longer period at 15 months. Of course, during that time, the Fed Funds rate was a solid 1% lower than today’s rate. Regardless of when the rate cut cycle begins, it will be considered a positive for stocks. Companies can borrow more cheaply as rates fall, they can take on new projects with lower hurdles rates and the business values grow as rates decline due to the methodology used in business valuation. Simply put, lower interest rates lead to higher business values.

For the first quarter of 2024, equity markets increased, although not at the pace of the last quarter of 2023. The market is clearly trying to assess the timing of interest rate cuts by reading the tea leaves of each and every economic data release. There is a high degree of certainty that rates will go down. The question remains as to the exact timing of when it happens. Nonetheless, for the first quarter of 2024, U.S. markets were up 5.18% for the Russell 2000 Small Cap Index, 8.6% for the Russell Mid Cap Index, and 10.3% for the Russell 1000 Large Cap Index. Markets outside the U.S. were up 4.7% as measured by the MSCI All Country World Index ex-U.S. In all, it has been a very good quarter for equity markets. As a matter of fact, it has been among the top first calendar quarters in the last 14 years.

Returning to Buffett’s quote at the top of the letter, another factor could lead to the longer-term “weighing machine” aspect of the market: growth in company earnings. 2023 was a spotty year for earnings growth for many companies. According to FactSet, earnings per share growth for S&P 500 stocks was approximately 2%. That is expected to improve over the next year, as the chart to the right shows. And it is not just the larger companies of the S&P 500 that are expected to grow in 2024. According to Russell Investments, smaller company stocks fared even worse in 2023 with an average earnings decline of -9.5%. That decline is expected to reverse. Analysts that cover small cap stocks are expecting earnings growth into 2024 of 23.9% - more than double the earnings growth of large cap companies. This is typical for smaller companies, which can show greater variations in earnings growth rates because they are growing (or shrinking) from a smaller base of earnings versus larger companies. In either case, earnings growth can support underlying stock prices, because as earnings grow, so grows the value of the business. As the business values grows, stock prices should theoretically increase. However, earnings growth, which is reported quarterly, takes time to show through. Thus, the idea of stock price appreciation by way of fundamental improvement in earnings growth is more of a weighing machine (long-term) than a voting machine (short-term).

Beyond the timing of interest rate cuts and corporate earnings growth, another major event this year which could impact markets is the November election. In previous letters and webinars, we have discussed how the market impact after the election seems to be muted, regardless of outcome. However, the level of uncertainty before elections can lead to higher levels of volatility. This chart displays the returns in the S&P 500 Index from November 30, 1950, through November 14, 2023. The years represent the 12-month periods from November 30th to November 30th following a U.S. presidential election.

Each year shows the average return, with a minimum and maximum return for the category. There are a few major takeaways from this chart. First, the average return in all years is positive, which makes sense given that the long-term return for the S&P 500 over an extended period is positive. Second, the wider the range, the higher the dispersion of returns for the given year. It is no surprise then that the 12 months leading up to the presidential election have the greatest dispersion of outcomes, with the 12 months prior to midterm election having the second largest range of outcomes. Simply put, greater election outcome uncertainty leads to a greater possible range of outcomes. This election will likely provide no shortage of “excitement” (i.e., volatility). For additional context, the worst return for the pre-election Year 4 category was almost -40%. That return occurred in 2007-2008, which coincided with the Great Economic Crisis and start of the Great Recession. The current economic environment is quite different from that period.

Shifting focus to bonds, fixed income has continued to remain volatile to some extent, even after an encouraging market run-up at the end of 2023 in which some securities managed to wrangle positive returns out of what seemed like a lost year for bonds.

If we use the S&P U.S. Aggregate Bond Index as a benchmark for domestic fixed income returns, domestic bonds have returned less than 2% over the past year, as indicated in the first line of the above graphic. This return may seem generous given that in October of last year when the fixed income markets were at their nadir these funds were seeing lows of -5%. Some analysts have suggested that these mediocre returns are largely in part due to performance differences between shorter maturity and longer maturity bonds.

On the short end of the spectrum, not only have shorter term government bonds (generally referred to as ‘T-Bills’) yielded over 5% over the past year, but they have done so with very little underlying volatility. In October 2023, when long term bond holders would have been underwater, T-Bill holders were able to liquidate without loss of capital. Similarly, corporate high yield securities, which tend to be short maturity bonds, performed relatively well. The difference between corporate high yield and T-Bills is the prevalence of credit and default risk – the idea that high yield bonds’ credit rating could decrease, or the counterparty could fail to pay back the loan. However, those willing to take on the risk tend to find a fixed income product that is more closely correlated with equity markets. Since we did see such tremendous returns in equity over the past year, it is no surprise that we also saw an almost 8% return for high yield securities over the last year.

Whereas T-Bills and high yield securities performed well, investors still holding on to longer-term securities felt more volatility as yields continued to increase and prices continued to plummet as economic data continued to meet or beat expectations. In fact, at the end of March investors saw the ten-year yields hit highs for the year (the 10-year treasury yield almost hit 5% in 2023, but reversed trend in October).

It’s important to note that maturity and interest rate risk is only part of the overall picture when it comes to fixed income – It’s also important to consider credit risk and credit spreads. Spreads are the difference in yields between two different types of securities. For instance, the spread between treasury securities and investment grade corporate bonds is a commonly cited data point for investors. Spreads will typically widen during times of financial crisis – indicating investors flocking to ‘safer’ government securities and narrow during good economic times. Right now, as indicated by the spreads on the previous page, credit spreads have become incredibly low.

Another winner in the current year has been gold, which reached highs in 2024. Some economists tout gold as a good hedge against inflation, and the increase in price has some analysts speculating that anticipating rate cuts later this year might be lead to subsequently higher inflation. That being said, in anticipation of higher inflation, or a rebound from the recent drops in CPI and PCE, real estate is often looked at as another inflation hedge as well. Coincidently, the real estate market as a whole has performed incredibly poorly year to date. In fact, in terms of equity, REITs have been outclassed by every other sector. There have been many concerns about commercial real estate performance in particular, with remote work weighing in on office building owners, and of course higher interest rates as well.

On the other end of the spectrum, we’ve seen great performance from the communications, technology, and energy sectors. The energy sector in particular has had a surprise boost from oil and gas price increases in recent months, with some of the best performances year to date seeing double digit returns (meanwhile, some Magnificent Seven stock returns haven’t looked quite as magnificent YTD).

Thank you and stay safe and healthy!

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