July 1st, 2024
Despite the headlines and abundance of fear around the presidential election, it seems the two largest determinants in market performance in the latter half of 2024 will rest on the shoulders of two factors: the validity of Artificial Intelligence, and the Federal Reserve’s interest rate policy.
As I’m sure you’ve heard once, twice or perhaps a hundred times in the last month, most of the market gains over the last two years can be attributed to the top 7+ companies in the S&P 500 – coined the “Magnificent 7” (Mag 7). Namely: Nvidia (NVDA), Meta (META), Tesla (TSLA), Amazon (AMZN), Alphabet (GOOG), Microsoft (MSFT), and Apple (APPL). In addition to the Mag 7, other stocks such as Broadcom (AVGO) and Eli Lilly (LLY) have also grown to all-time high market capitalizations, both surpassing Tesla and being key drivers of our largest indexes.
Despite the strong economic backdrop and overwhelmingly good earnings, the market is becoming increasingly unbalanced, as the biggest mega-caps have reached previously unseen valuations, while the bottom 493 companies seem to remain historically undervalued. The top-heavy nature of the market has many investors wondering how this new paradigm will resolve? Will the biggest names continue to get bigger? Or will there be a dramatic “reversion to the mean” moment when the giants fall, and the market returns to a more normal distribution/equilibrium?
The chart below illustrates how “out of whack” things have gotten as the Mag 7+ have grown into uncharted territory, the top 10 stocks now represent over 35% of the S&P 500 – as the index is weighted relative to market capitalization.
The good news for investors using index funds is that they have been rewarded for just owning the index and riding the wave. Investors who tried to tactically tilt towards the equal-weight version of the S&P 500 have underperformed the market-cap weighted benchmark by around 10% year-to-date, and the spread between the market-cap and equal-weight index continues to widen.
The outperformance of large caps over small caps is even more dramatic. Small caps have had a tough run during the Fed’s rate hike cycle and have been stuck in limbo waiting for the first cut to arrive. The Fed’s delayed timeline for rate cuts has triggered significant outflows from small caps and into large caps. The result is around 15% outperformance by the S&P 500 over the Russell 2000 year-to-date. Zooming out to a three-year view shows how vast the outperformance of large caps has grown. Even when small caps (blue line on chart, symbol IWM) lagged in prior years, they moved in a correlated fashion with large caps (black line, symbol SPY). Yet in 2024, small caps have flatlined while large caps have exploded higher.
The Determinants
First – Artificial intelligence (AI) – is it a revolution or an overblown gimmick awaiting a bubble burst?
Aside from Eli Lilly, all other Magnificent 7 stocks are currently betting on the future of AI applications to drive their future revenue growth. The AI boom has drawn comparisons to the dot-com bubble – a valid comparison at the surface since both involved excitement over revolutionary new technologies. Yet, unlike the dot-com bubble – which saw a flood of unprofitable speculative tech stocks soar to massively overbought valuations – the biggest beneficiaries of the AI euphoria are established, extremely profitable large cap companies. During 1999-2000, there were 631 technology IPOs, of which just 14% were profitable, adding to the speculative frenzy. In 2022-2023, there were just 15 tech IPOs. Despite the increase in valuations, the Nasdaq 100 index is trading at a roughly 28x forward P/E ratio, less than half the 60x forward P/E of March 2000.
Moreover, as companies like OpenAi, Apple, Meta and others begin dishing out their AI verticals it is becoming clearer how massively instrumental AI will be to the future of business as usual, and how its tranches of revenue will impact these company’s bottom line.
Lastly, the AI pundit’s conversation often seeks to understand the ethereal nature of the landscape without considering the real-world effect of today, and its cascading demands on our very real-world’s future. In the present, AI may seem like a simple upgrade to Siri, or a chatbot one might converse with while using a banking application. But the real-world effect is its demands on energy, and energy infrastructure.
Energy, namely utilities, have underperformed the S&P 500 since 2023 because of large investor outflows. Outflows, due to investors seeking better, more secure income – in the past, utilities and energy stocks have been a generative space for income (dividends) but as interest rate hikes have emerged one can earn more income in safer securities – such as Treasuries. Having said that, coupling the current and future demand(s) of AI on energy infrastructure as well as the potential future interest rate cuts, energy stocks are looking to make a big come back.
And secondly, the most likely catalyst for the lagging performers (small/mid-caps) will be – no surprise here – Fed interest rate cuts & the Fed’s interest rate policy moving forward. Going into 2024, markets were sold on the prospect of six rate cuts. Since small cap stocks are much more sensitive to interest rates (due to higher borrowing costs and less access to capital), this was viewed as a perfect setup with small caps trading at historically cheap valuations. Yet, as rate cut hopes have plummeted to the potential of just one cut in 2024, small caps have done nothing for investors. Even the recent positive inflation data hasn’t led to any inflows into small cap stocks.
With a rate cut occurring in the latter half of 2024, this may be an opportune time to rebalance your investment strategy to include sufficient exposure to US small and mid-cap stocks while trimming back exposure – and capturing profit – from the Mag 7 and other mega caps. While also leaning into many of the oversold energy stocks – my preference being sustainable and progressively oriented utility companies.
And now, your Monthly Market & Economic Update by the numbers.
Warmly,
Mark S Sauer
Market Update
Global Equities: Stocks found their way to new highs in June, with a +4.19% gain for the S&P 500. The Dow Jones Industrial Average added +1.06% while the Nasdaq Composite led the large cap indices with a massive +7.19% gain. Small caps fell -2.24%, while Developed International stocks were down 2.96%, and Emerging Market stocks ended the month mostly flat, up +0.32%.
Economic Update
PCE Inflation: The latest Personal Consumption Expenditure Index (PCE) report showed inflation was flat in May, bringing the annual rate down to 2.6%, the lowest level since early 2021. Core PCE, which excludes food and energy and is the Fed’s benchmark for inflation, was up just 0.1% during the month bringing the annual rate down to 2.7%. The Fed still needs to see further progress to reach its 2% target, but the data was a positive sign.
Charts of the Month
Core PCE Inflation
Our first chart shows annualized Core PCE inflation measured over three, six, and twelve-month periods. May’s PCE data provided some relief for nervous investors hoping to see inflation return to its downward trend after a first-quarter setback. The Fed often points to the three-month rate as the best indicator of present conditions, and that measure has fallen to its lowest level since December. Yet, the Fed has been vocal in stressing that it needs longer term measures to show sustained declines before it will consider cutting rates.
Charts of the Month
Nasdaq – Market Cap Vs. Equal Weight
Our final chart shows a three-year view of the Nasdaq 100 ETF (QQQ, blue line), which is market-cap weighted, compared to the equal-weight version (QQQE, orange line). The two ETFs typically move in tandem, with QQQ showing slight outperformance in late-2021 to early-2022. The synchronization has greatly deteriorated over the last year, however, as mega-cap stocks such as Nvidia (NVDA), Apple (AAPL), Microsoft (MSFT), Amazon (AMZN), Meta (META) Broadcom (AVGO), and Alphabet (GOOG) have grown to collectively represent nearly 46% of QQQ. These mega-caps have kept the market afloat by consistently blowing away earnings forecasts, while the smaller-market-cap names have languished.
