2024 Quarter 2 Commentary

“There is a tendency in many armies to spend peace time studying how to fight the last war.”

- Lt. Colonel J.L. Schley, Corps of Engineers

While the above quote was written about military matters, it is a truism that can be applied to human nature. In investments, the adage is “past performance is no guarantee of future results.” Whatever the phrase, it is natural to look back in history- whether recent or long ago- to extrapolate what the future might hold. The very same element in human nature can also be seen in the Federal Reserve’s approach to inflation today.

In the case of the Federal Reserve, one can see that monetary policy has been held in a restrictive stance since July 2023 through the setting of the Fed Fund rate, which has been held at the 5.25% - 5.50% level. Through many rounds of data releases, Fed Chairman Jerome Powell has maintained that the Fed will maintain restrictive policy until they see clear evidence of a sustainable path to “price stability,” which is Fed parlance for inflation measures which are at or near 2%.

The chart on the following page shows the two primary measures of inflation: the Personal Consumption Expenditures Index (PCE) and the Consumer Price Index (CPI). While each has a slightly different methodology, both move together when viewed over a long period. Of note is the post-Covid inflation spike when the economy re-opened. Demand was up significantly, but supply chains were either shut down or thrown into chaos. While supply issues were a critical problem that contributed to inflation, massive spending on the part of governments also led to the classic inflation problem: too many dollars chasing too few goods. Both measures of inflation were at multi-decade highs by late 2021. Yet the Federal Reserve erroneously clung to the notion that the inflation spike was transitory because they focused too much on the supply issues only. The net result was that the Fed was slow to respond to inflation, but respond they did, raising the Fed Funds rate from almost zero to today’s level in less than 18 months.

This chart also shows that inflation is now trending quickly back down to more normal levels, but the Fed is still reluctant to cut rates at all. This gets back to the original quote at the top of the letter. The Fed is very influenced by its own slow footedness in dealing with inflation a few years ago, so today it would appear that it fears an inflationary resurgence brought about by a rate cut more than it does the potential for an economic slowdown caused by maintaining high rates. We can already see the impact that higher rates have had on the economy as expressed in GDP growth. Economists see continued growth, although the pace of that growth is expected to be lower. However, the longer the Fed keeps rates high, the more that could impact those forward economic growth expectations.

While rates remain high today, the market is constantly attempting to gauge when rates might be cut. Just the expectation of a rate cut is enough to move the market, as it did in the last two months of 2023. The fact that we have now gone through 6 additional months of 2024 without the Fed signaling a rate cut has altered the market’s expectations. Look no further than the chart below, which shows the market’s changing attitude to the probability of where rates would be by March 2025. In February of this year, the market assumed - with near certainty! - that rates would be a full percentage point lower by March 2025. With each passing Fed meeting, in which Chairman Powell reiterated the need to see ‘sustainable evidence’ of falling inflation and a cooling labor market, it became apparent that the first rate cut would be delayed. Expectations for lower rates by March 2025 have dropped. As a matter of fact, those expectations bottomed out by May. But one can now see that the probability of lower rates is beginning to creep upwards once again. To put it another way, the notion of rates remaining higher for longer has been priced into the market.

From the market’s perspective, having higher rates appears to be primarily benefitting large cap stocks. That basic narrative is that, with higher rates come higher borrowing costs, which are more punitive for smaller companies, because they rely on debt financing more than their well-capitalized larger cousins. And while there is a kernel of truth in that narrative, it does not fully explain why large cap stocks are outperforming as much as they are. At quarter end, the S&P 500 was up 15.3% for the first six months of the year, while the Russell Mid Cap Index was up 5.0% and the Russell 2000 Small cap index was up just 1.7% in the same period. But is that disparity driven by borrowing costs, or are the gains seen in large caps more of a concentration effect from investors plowing into a handful of mega cap tech stocks?

For the first half of the year, the S&P 500 Index outperformed the equal-weighted version of itself by more than 10 percentage points. The difference between the two indices is that the standard S&P 500 is market cap weighted, meaning that the biggest stocks have the biggest impact on the index, whereas the S&P 500 equal-weight index is more of a measure of the average stock performance. When the standard S&P 500 index outperforms, it is because the largest stocks are doing much better than the average stock. Put another way, the market gains are more concentrated in the biggest companies. This would appear to have less to do with borrowing than it does with the tech-preference among investors today. While we remain positive about the current economic outlook and broad fundamentals for stocks, we do advocate prudence in remaining diversified across market caps.

Returns for large cap stocks - including many aforementioned technology stocks - continue to outperform in 2024 as they have for past sixteen months, delivering returns of over 14% year to date as seen in the below graphics. Growth stocks have also continued to accelerate as the year progresses, bouncing back from their 2022 performance, which saw some outsized volatility for that particular size and style.

Source: Morningstar, May Barnhard Investments LLC

Meanwhile, small cap returns have been understated year to date compared to large cap performance, with small value stocks the only style and sector combination with negative returns year to date. Some of this discrepancy can be explained by the outsized contribution to returns that some large cap stocks in particular are having – for example, NVIDIA. However, high interest rate environments also aren’t particularly kind to smaller caps, who generally may rely on higher financing costs to fund expansion.

When markets have been performing as well as they have, we often receive questions about the current valuation of equities. These questions typically fall in the vein of whether the market is overvalued or whether someone should modify our target allocation to contain fewer equities and instead move towards larger fixed income or alternative asset allocations. When considering rebalancing portfolios, there are several ways to address these questions and take these into consideration when investing clients’ assets.

The first thing to consider is that historically, from a market perspective, when equities have performed well in the first half of the year, in the second half of the year momentum has carried and equities tend to continue to do well. In the chart to the right, for instance, we see that returns for a dollar invested when markets are at an all-time high tend to outperform in the long term than funds invested on any other day. We also often share data and articles regarding why investors that over-invest in cash have underperformed the market, even when seemingly trying to time their trades. While seemingly counterintuitive, many aspects of the stock market are driven by momentum – the idea that if this security performs well, it will continue to perform well.

Another factor is to consider the fair values for companies. We can compare them to their current value and use the resulting ratio as a metric for being overvalued versus being undervalued. For example, Morningstar publishes their fair value for many publicly traded domestic equities, using modeling techniques to ascertain what they believe is the actual value of a security, based on future cash flows, macroeconomic trends, etc. We can then divide the fair value by the actual price and can get a ratio where the large the number the more over valued it’s considered.

In the graph to the right, we can see that according to these Morningstar valuations, the U.S. market is somewhat fairly valued compared to past prices. Although, it’s important to remember that subjectivity can play into these fair value analyses, it is interesting to note against the backdrop of times where markets were considered undervalued.

When considering fair value, we can also look at past equity run ups, and see times when equities entered a bear market, and compare them to the most recent market run ups. Most notably, for the 1929 stock market crash that led to the Great Depression (denoted in orange) as well as the 2001 stock market crash (denoted in blue), returns over the most recent prior five-year period (denoted in pink), have been considerably lower.

An important consideration when evaluating time periods is to differentiate the varying regimes that these markets performed in – meaning, interest rate and monetary policy may be different, housing markets and labor markets may look different, political situations could be different, and so on and so forth. Given this, it would be foolish to look at this metric or any one metric to consider whether the market is clearly overvalued or clearly undervalued.

Instead of focusing exclusively on these valuation metrics, prudently following best principals for investing can lead to success. For example, by using diversification we can look to diminish some of the risk associated with investing primarily in one asset. In addition, fixed income has acted as the ballast against equities in the case of market volatility. When withdrawing funds in the instance of a market downturn, investors don’t want to be liquidating equity funds at lower values. While in recent years we’ve seen a move away from the two asset types of equities and fixed income being correlated, by delving down into different fixed income types, and delineating each by category (T-Bills, Asset Backed Securities, TIPS), we can look to continue diversification in client portfolios as necessary.

In July, we are busy rebalancing client portfolios as necessary and returning any large deviations from policy back to their target allocations. After a year of extended large cap and growth dominance, it’s important to evaluate client portfolio positions versus expected returns. In particular, value and small cap performance have lagged in recent months and we may see a reversal in trends towards year end, specifically if we see a rate cut.

Thank you and stay safe and healthy!