October 18, 2024

SHARE

By mid-October, the S&P 500 had hit a new all-time high 47 times in 2024. The S&P 500 was up 5.5% in the 3rd quarter, and having gained 21% through September 30th had its best yearly start this century. For stock market investors, there hasn’t been a lot to complain about lately.

Jerome Powell has done his part to fuel the rally on this year. On September 18^th, the Federal Reserve Bank cut the baseline interest rate by 0.50%. This was the first rate cut since March of 2020, and sent a significant message to markets that the Fed believes inflation is well under control. Small-caps, which often rely on more short-term third-party financing, led the market’s broad rally. Interest rate sensitive equities, such as Utility stocks, also benefitted. Bonds were also bid up on the news, and the yield curve “un-inverted” after the longest (10yr vs 2yr) yield-curve inversion in history. The last rate cut was in March 2020. That cut was in response to an economic crisis. This time, the Fed was trying to get ahead of the curve as softer employment data and tepid inflation gave them cover to begin a new interest rate regime.

Here's a brief look at how we got here. After the COVID pandemic, the Fed maintained rates near 0% until March 2022. Realizing the policy error of prolonged 0% rates, the Fed response was to raise rates at the fastest pace in history. Rates increased from 0% to 5.25% in just under 18 months, wreaking havoc on equity and bonds markets. Bonds suffered their worst year in history in 2022, as the Fed attempted to catch up with inflation. The risks to this policy action were significant, as higher rates reduce liquidity within the economy and increase the odds of a recession. However, as inflation stabilized so did the markets, and we have seen a significant rally off the 2022 market lows.
While last year the market was led higher by a select few stocks, namely the “Magnificent 7”, this year the breadth of the market has been much healthier. What has changed? With tepid inflation, softer employment (leading to less pressure on wages), and lower anticipated financing costs, the earnings backdrop for the other 493 stocks that aren’t as levered to Artificial Intelligence has improved significantly. Does all this good news mean stocks are set up for more gains? Let’s look at both the bull and the bear market case from here.

First, the optimist case.

1. Don’t fight the Fed. This is a Wall Street axiom that the liquidity created by Fed policy ultimately impacts the money available to buy equities. With the Fed now on a path to lower rates, this could provide a bid to stock prices. After all, cash becomes less valuable as the interest paid for it declines. As rates move lower, that “cash on the sidelines” may find its way into stocks. The current rate cut cycle could be characterized as a “slow cycle” given the Fed’s anticipated trajectory. Take a look at market returns during a slow cycle as depicted below:  



2. The bull market is young. On October 12^th, the current bull market turned two years old and had a return of about 62%.  Yet the average bull market from 1950 has lasted 5.5 years and had an average cumulative return of 191.6%.  The only bull market that was shorter than two years? The last bull market, which was born in COVID and ended in 2022 when the Fed rapidly raised rates. The longest bull market lasted 12.3 years from 1987 through the Technology bubble in 2000. (source: Carson Investment Research, YCharts @ryandetrick)

3. It’s not timing the market, it’s time in the market!  Owning equities has historically been shown to be one of the greatest ways to build wealth. Just look at some of these numbers. Over the past twelve months, the S&P 500 Total Return (gross, through 9/30/24) was up an incredible 19.75%! Over the past 10 years? An amazing 16% annualized! From inception in 1957 through year-end 2023, this broad-based index has averaged 10.26% per year- spanning nearly 70 years! (source: S&P Global) This suggests that stocks may be at all-time highs, but, yes, that is what stocks are supposed to do.

Ok, what could go wrong?

1. Stocks are expensive! Stocks can stay expensive for a long time, but there is no doubt that stocks are well above their traditional valuations. But, when you look under the hood there are some reasonable explanations for valuations. The increase of higher valuation technology stocks may account for part of the higher price/earnings ratios over historical norms. After all, the S&P “493”, those stocks not included as part of the Magnificent 7, are trading fairly close to historical averages. An additional explanation could be falling interest rates, with lower rates generally supporting higher valuations. At Cutler, we are biased to value-stocks, but we don’t think investors should abandon the markets because of high valuations.

2. What about the election? Economic policy matters, and ultimately impacts economic growth. However, as we mentioned above, stocks have a great historical track record. And stocks have accomplished this under various political administrations. The nearby chart shows the results of partisan investors who sell their portfolio when the other party holds power in Washington. The historical results paint a very clear picture; the stock market has provided value under various administrations, and investors have been best served by ingoring the short-term political winds.  



3. Geopolitical risk. There are certain risks that cannot be quantified but that do represent a real risk for stock market investors. These are often referred to as “Black Swan” events. War in the Middle East is an example, as it is impossible to know the full risk that this represents. The current Isreal-Hamas war has the ability to impact oil prices globally, especially if the war expands to the greater Middle East.

So how should we invest in markets at these levels?

At Cutler, we believe the optimistic case holds the more compelling argument. Looking at the historical value provided by investing in stocks is a bedrock of our investment philosophy. However, we also believe that there are pockets of opportunity that investors can look for. While the US stock market may look expensive, that doesn’t mean that all stocks look expensive. There are asset classes, such as small-cap stocks or developed market international stocks, that are trading at reasonable levels. We also believe that dividend stocks continue to provide great long-term value at today’s levels. Our advice is that investors maintain diligence and that they don’t chase market risk. Equity exposure is appropriate but look for quality and consider valuations.

We all know that stocks won’t always be at all-time highs. The S&P 500 won’t always have returns that look this rosy. There will be turmoil, recessions, and wars. In recent years we’ve seen a pandemic and numerous economic calamities. When a pullback inevitably comes, try to keep in mind the long-term value that stocks have provided. We advise our clients to keep what they need in the near term in less volatile investments, but with their stock portfolios to try and weather the storm. And remember, in a diversified portfolio, not everything is trading at an all-time high. While the S&P 500 has led the way, there are other asset classes that can do well under changing economic circumstances.

Tags: