During the second quarter of 2024, the S&P 500 Index delivered a return of 4.3%, and this increase brought returns for the Index to 15.3% on a year-to-date basis. The market’s advance was not broad. The S&P 500 equal weighted Index generated a return of -2.6% for the quarter, and the S&P Small Cap Index returned -3.1%. The S&P Growth Stock Index rose 9.6%, while the S&P Value Index fell 2.1%.
In the recent quarter, investors favored a small group of large cap growth stocks as they have for much of the last two years. The five largest stocks in the S&P 500 Index were growth stocks, and they comprised more than 27% of the Index on a capitalization weighted basis: Microsoft, Apple, Nvidia, Amazon, and Meta Platforms. These stocks generated returns substantially above that of the Index as a whole. For example, the year-to-date return for Nvidia, not including dividends, is above 150%. The five largest stocks are responsible for roughly half of the Index’s return year-to-date.
The large growth stocks have extremely high valuations, Nvidia had a price-earnings ratio (PER) of about 74 times trailing twelve-month earnings at the end of the second quarter. The S&P 500 also carried a high PER of 29 as well, when the quarter closed. This measure was up from the level at the end of the first quarter and was well above the long-term average of 18. The rise in the PER from about 25 to its current level of 29 over the last twelve months has been a significant driver of returns. Corporate profits are expected rise at about an 8% to 9% rate over the near term, and without a further expansion in PER’s from their already elevated levels it is unlikely stocks returns will be as high in the next twelve months as they were in the last twelve months and year-to-date. The high PER’s reflects a generally optimistic outlook with respect to the economic environment and corporate profits and leave little or no tolerance for disappointment with respect to either earnings or changes in economic conditions. Even small disappointments are likely to produce large reductions in valuations.
The short-term outlook for corporate profits includes earnings increases of roughly 8% or 9% in the second quarter. Further increases in profits will depend in large part on economic conditions. The current consensus for economic conditions includes real GDP growth of slightly over 2% in the second quarter. Growth at this level would represent a significant increase over the estimated 1.4% growth in the first quarter of 2024, but a decline in the rate of growth when compared to the estimated 3.4% growth in the fourth quarter of 2023. GDP growth in the next few quarters is expected to average 2% or slightly less.
One of the primary sources of volatility in the growth rate of GDP is consumer spending. Current data show real disposable income not growing over the last quarter. In addition, the recent unemployment reading shows an increase in unemployment to 4.1% at the end of the second quarter. The unemployment rate would have been higher by about 0.5% if the labor force participation rate remained at pre-pandemic levels. The growth in jobs has been insufficient to produce a significant decline in the unemployment rate. Since January of 2020, the number of new jobs has grown at an anemic 1.4% per year. In recent months, government sector jobs have been, on average, about 40%, of all new jobs.
Readings of current economic conditions presage a slowdown in economic activity and rates of inflation above the Fed’s targeted rate of 2%. There has been a slight uptick in initial unemployment claims. New homes sales are declining, and the median price of new homes is falling. Industrial production has been flat since March of 2023. The level of sales of new automobiles is declining, and the latest measure of real disposable income shows an increase at a low 1% annual rate. The latest reading on inflation showed prices increasing at a 3.3% annual rate. Prices are increasing at a faster rate than is real growth. This condition is like that of the 1970’s, a period characterized by slow economic growth, rapid and rising inflation, and negative real returns for the stock market.
The Fed has stood fast in its efforts to lower inflation to its target of 2%. However, the Fed’s ability to reach that goal will face a new challenge soon. Investors have focused on the Fed’s evaluations of the level of inflation, with the expectation the Fed will lower short-term interest rates and stimulate economic growth once inflation falls to a level it finds acceptable.
While the Fed has been trying to control inflation by manipulating intertest rates, liquidity has been increasing. The Monetary Base, a measure of high-powered money, has been rising at an approximately 3% annual rate most recently. The Base was increased by almost $5 trillion in response to the sub-prime mortgage market collapse in 2008/2009, and the base increased further as the fed tried to prop up economic activity in the face of a COVID 19 driven set of policies which shutdown of the economy in 2020. Much of the $5 trillion remains in place. The Fed appears to have given up the effort to reduce the enormous increase in liquidity put in place over the last 15 years.
As the Fed attempts to control inflation, the yield curve has risen. The curve remains inverted, interest rates on short-term obligations are higher than rates on long-term obligations. The yield on one-year government obligations was about 70 basis points higher than the yield on ten-year obligations. Rates have risen along the curve. As a result of this change, bond returns have been negative year-to-date. The Bloomberg US Aggregate bond index has produced a -0.7% over the first two quarters of 2024.
While the Fed is trying to curb inflation, the Treasury is running an estimated $1.9 trillion debt in 2024. The latest Congressional Budget Office (CBO) estimate of the deficit shows an increase of $400 billion over the previous estimate. Expenditures in 2024 are expected to total $6.8 trillion and revenues are expected to be $4.9 trillion. The CBO estimates tax revenues in 2024 will be 10.1% higher than revenues in 2023, but expenditures will increase by 12.4%.
By the end of 2024 Debt held by the public will total 99% of GDP. Interest on the debt will be 3.1% in 2024 and will rise to 4.1% of GDP by 2034. Interest on the debt with be nearly the same amount as that budgeted for national defense in 2024. Treasuries expenditures averaged 21.0% of GDP over the period from 1974 to 2023. The CBO scoring of President Biden’s budget forecasts the expenditures will rise to 24.9% of GDP by 2024. The primary drivers of expenditures are social security and Medicare. There are no plans to change the trajectory of these expenditures; deficits will be large and growing for the foreseeable future.
Since 1971, when the Fed has been called upon to monetize deficits, it has done so frequently. The Fed’s efforts to reduce inflation may have produced favorable results in the short term, but the enormous deficits the treasury has put in place will bring with them calls for the Fed to step up and increase liquidity. Inflation will likely rise from the current relatively low levels in the near future.
The performance of the stock market has been driven by very few stocks concentrated in one market sector, and with high PER’s. Should one of those stocks falter because of a disappointing earnings report, or revenues below expectations, or any metric favored by holders of those stocks, the market’s decline will be sudden and substantial.
Sources: S&P Dow Jones Indices, US Bureau of Labor Statistics, CBOE, Bureau of Economic Analysis
The information contained in this commentary represents the opinion of Affinity Investment Advisors, LLC and should not be construed as personalized or individualized investment advice. The analysis and opinions expressed in this report are subject to change without notice. The information and statistical data contained herein have been obtained from sources, which we believe to be reliable, but in no way are warranted by us to accuracy or completeness. This report includes candid statements and observations of economic and market conditions; however, there is no guarantee that these statements, opinions, or forecasts will prove to be correct.
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