August 2024 Market Update

August 1, 2024

John Browning, MBA and CSA? | CEO, Principal

Are You Running Scared??

There is a "scare prank" that my daughter showed me on her social media where one person acts as if they see something scary, causing the person they are with to react the same way. The prank is amusing albeit maybe not to the one being pranked.? It reminded me of the markets and how many react based on short-term news. An earnings report comes out, a news service or an analyst highlights a single number within many, and novice investors react violently in one direction or another.??

Earlier this year, the meme stock investor known as "Roaring Kitty" leaned forward and backward in his chair, holding a gaming system, sending a company stock from around $10 per share to nearly $50 and then back down to $18.? Over the past several weeks, a single comment from a political candidate has sent many company stocks and asset classes moving violently in different directions.

As the summer heats up, the stock market is experiencing a heat wave of its own in the form of rising volatility. Market uncertainty has climbed as investors rotate out of large-cap technology stocks and into a broader array of sectors and styles, including small caps. Since their respective peaks in mid-July, the Nasdaq and S&P500 indices have declined significantly. Meanwhile, the Russell 2000 index of small-cap stocks has increased over the same period. What’s driving this rotation and how might you consider positioning yourself to profit?

We believe that the market as a whole is anticipating a rate cut by the Federal Open Market Committee (FOMC) in September and that these cuts will continue for some time into the future. While the higher rates have hurt smaller businesses that rely more heavily on floating-rate debt than larger ones, lower interest rates should positively impact these companies. Further, it is hard not to notice that the larger companies' P/E or price-to-earnings ratio has continued to increase this year.? For this reason, we see investors taking some of their gains off the table and moving back into smaller capitalization names. We anticipate that this will continue but would not write off those larger cap companies with innovative and profitable pipelines just yet.? We are not in the camp that suggests Artificial Intelligence is done moving higher.

Investors are rotating away from large-cap technology stocks:

Stock market swings are part of everyday life for those of us who have been involved in the markets on a daily basis for decades, and yet we understand that for people who do other things, these swings can be unpleasant.? There are different types of swings in the market long-term and short-term.? Which ones are worse all depends on your perspective.? We look for the speeches and antics of the election period combined with rate cuts and geopolitical events in the Middle East to move the markets around quite a lot in the coming months.? Positioning yourself to profit, in my opinion, remains firmly rooted in a balanced approach, making incremental changes to adapt but, in general, sticking with profitable, innovative companies that consistently treat their shareholders and clients well.??

Last month we showed that what some had called the "everything rally" really was not an everything rally and had largely been concentrated in a fairly small number of companies.?? We believe that will now broaden out which may mean this rotation out of those names which have done extremely well over the last several months could continue to see a decline.? We have started to see this during this earnings season where even the slightest hint of bad news from one of these companies has resulted in immediate and harsh punishment of their share price.? This is another great reason to make sure you have your "portion control discipline" firmly in place.? Never rely too much on any one company or sector to support your portfolio, no matter how much you believe yourself to be right, and that includes those of you who rely on a single index like the S&P500, which may be unduly punished due to its overweighting of the so-called "Magnificent Seven" companies.???

There are many reasons to be optimistic about the overall market. In the long run, bull markets are driven by earnings growth and corporate earnings, and these are still showing up strong as a general rule this season.

Economic growth is healthy:

If solid earnings drive market rallies, those earnings are, in turn, driven by a healthy economy. According to the most recent Gross Domestic Product (GDP) report, the economy grew at 2.8% in the second quarter, exceeding consensus expectations of 2.0%. This is a significant acceleration from the first quarter’s 1.4% growth rate. As shown in the accompanying chart, jumps in consumer spending, business investment, and government spending helped drive the headline number, with trade reducing it slightly. Despite high interest rates and fears of an economic slowdown, consumer spending was resilient, contributing 1.6 percentage points to overall GDP.

Other data support this view as well. The Personal Consumption Expenditures index is the Fed’s preferred measure of inflation, and the latest report showed that price pressures continue to improve. Overall prices rose only 0.1% in June or 2.5% year over year, slightly decelerating from the prior month, while core inflation increased 2.6%. Across various inflation measures, including consumer and producer prices, there is evidence that inflation could be on track to return to the FOMC's target of 2%.

It’s crucial to maintain a level head during volatile periods:

As is always the case, investors need to maintain a longer-term perspective when facing market volatility to the downside. Short-term pullbacks and market rotations are normal and expected as investors evaluate new facts and data.

For example, the accompanying chart shows that the largest decline this year was only 5%. This is quite low by historical standards, especially compared to the solid year-to-date gains by the S&P 500 and Nasdaq. Most years experience far more significant intra-year pullbacks yet end in positive territory.

This highlights the importance of being emotionally prepared and having a balanced portfolio for stock market volatility. Pullbacks are an unavoidable part of investing. How investors deal with these periods is often far more important than the market movement itself. The current rotation is also a reminder for investors to maintain diversification across a number of market areas and not focus only on whatever is performing well at the moment. In our opinion, sticking to these long-term principles is still the best way for investors to achieve their long-term goals.

The bottom line? The market rotation from large caps, especially technology and artificial intelligence stocks, and into other areas such as small caps, has driven market uncertainty higher. Rather than overreacting to these moves, investors should instead maintain a long-term perspective and focus on their strategic asset allocations.

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