Introduction
The second quarter of the year has continued similarly to the first – earnings have remained resilient, inflation has continued its decline, rates have remained elevated, and the labor market and U.S. consumer have stayed strong. The equity advance has remained limited in breadth as advances have been predominantly limited to Artificial Intelligence (AI)-driven mega-cap equities. These AI companies remain our favorite overweight within the broader stock market. Mega cap advances have led headline indices over the last three months and have helped the market continue its run in 2024. In this edition of our quarterly market update, we will cover:
- A Macroeconomic Update: The Continuing Fed-Driven Market
- Inflation and the Labor Market: Coming Back into Balance
- Portfolio Preparation for Rate Cuts
- Why Investing at All-Time-Highs is Still Prudent
- A Quick Note on the Downfalls of Calendar Rebalancing
Macro Update
Beyond the AI megatrend pervading markets, stocks and bonds continue to be dominated by Federal Reserve (Fed) rhetoric and Wall Street’s anticipation of future Fed action. Interest rates have remained elevated as the Fed strikes a balance between its dual mandates of price stability and full employment. As we continue to anticipate the trajectory of the markets, we are focusing on the path of inflation, unemployment, consumer strength, earnings growth, and the Fed’s response to these critical economic factors.
Inflation – Easing but Not Quite to the Fed’s Target
We discuss inflation, in-depth, on a recent episode of the Beckonomics Podcast (click here to watch). The two major inflation gauges the market follows are the Bureau of Labor Statistics’ (BLS) Consumer Price Index (CPI) and the Bureau of Economic Statistics’ (BEA) Personal Consumption Expenditures Index (PCE). Each data point has its merits, and Wall Street waits in anticipation for each of them once per month, but in this article, we’ll focus on the Fed’s preferred inflation gauge – the PCE. PCE inflation has declined steadily over the past couple of years, much to the Fed’s satisfaction. Core PCE inflation is our preferred metric as it removes Headline PCE inflation’s (volatile) food and energy segments. As can be seen in the chart below, Core PCE is steadily moving toward the Fed’s 2% target range, currently sitting at just 2.6% year-over-year. As inflation continues to cool, the Fed should feel comfortable cutting interest rates, providing relief to the economy, the consumer, and broader markets.
Inflation has been hard on the U.S. consumer, particularly in the middle and lower classes, so we agree the Fed should be focused on its mission, but overshooting the inflation target is just as great a risk at this point in the cycle. It is important to note that not all inflation is bad, which is why the Fed targets a 2% inflation rate. However, if inflation soars as it did in 2022 and early 2023, it can create serious issues for the economy.
The Benefits of Inflation – Inflation has a few benefits for the economy, which is why we don’t want to see this figure go to zero (or negative). A few of them are:
- Incentivizes investment – If companies (and consumers) believe the value of their dollars will decline over time, they must invest in projects or other investments to drive future value. This generates fuel for the economy and creates greater wealth and prosperity. We wouldn’t have the technology or products that make our lives so much better today than 100 years ago if it weren’t for investment.
- Benefits to Borrowers – The burden of debt declines as the dollar loses value. Paying back debt in the future is cheaper when inflation reduces the real cost of a loan taken out years ago. This is particularly impactful when it comes to mortgage debt – typically the largest debt item on a consumer’s balance sheet.
- Profits Grow – When businesses can increase the price of their products and services, revenues grow. If margins are consistent or growing, profits will grow modestly as well.
The Downsides of Too Much Inflation – while modest inflation is positive, excessive inflation has serious detrimental effects.
- Stress on Consumers – Perhaps the most obvious negative implication: High inflation erodes the power of savings, especially for retirees and workers whose wages don’t keep up with inflation. This can result in the inability to afford discretionary items as necessities take up a greater portion of one’s budget. This reduces economic growth.
- Lenders Struggle – Banks and other lenders struggle as debt repayment becomes easier (because dollars are worth less). If banks issue debt at interest rates below inflation, their return on capital becomes negative and a detriment to their business.
- Fixed Income is worth less – Bonds and other fixed income instruments are less valuable under periods of high inflation. They do not provide an inflation hedge like equities or real assets; as the value of dollars produced falls, so do the fixed income instruments themselves.
What can we do to protect ourselves?
Equities have historically proven to be some of the best hedges to inflation. As companies raise prices commensurately with inflation, profits grow, and so do valuations. By maintaining stock exposure (in companies that perform well in inflationary environments), we are able to insulate our savings from dollar devaluation. Real assets such as gold and real estate can also serve as inflation hedges during periods of high inflation.
A Strong Labor Market = A Strong Consumer
A positive reason why interest rates have remained elevated is the strong labor market in the U.S. As the Fed balances its dual mandate, the unemployment side of the equation has caused little to no concern so far. If the unemployment rate ticks up substantially, the Fed will be forced to cut interest rates before inflation reaches the 2% target. At this point in the economic cycle, we view unemployment as the more important metric. If unemployment rose precipitously, greater issues than modest inflation would be present in the economy, and market implications would be adverse. The strong labor market (and associated wage market) gives us confidence the U.S. consumer will be able to keep up with inflation for the time being. As can be seen in the chart below, unemployment remains near the lows set before the COVID-19 pandemic.
Earnings – Expectations Continue to Climb
Analysts across Wall Street continue to increase earnings expectations as the year continues. This gives us confidence as stock prices are fundamentally a function of two inputs – discounted future earnings and what investors are willing to pay for them (price-to-earnings (P/E) multiple). P/E multiples have expanded this year as investors gain more confidence in the stability of the economy, but the fact that earnings expectations continue to increase bodes well for the stock market for the remainder of the year.
Earnings growth only increased 1% in 2023, and that year’s market rally of 24% was driven primarily by a combination of P/E multiple expansion and Magnificent 7 (Nvidia, Microsoft, Meta, Amazon, Tesla, Alphabet, and Apple) stock exceptionalism. In 2024 and 2025, analysts predict the S&P 500 will report year-over-year earnings growth of 11.3% and 14.4%, respectively. Earnings-growth-driven price appreciation is much more attractive in our view, as multiples can only expand so far – investors will only pay so much for a dollar of future earnings. An earnings-driven rally has greater staying power and instills more confidence in investors across Wall Street.
Federal Reserve Expectations – Rate Cuts on the Horizon
As mentioned at the top of this article, the market is still very Fed-driven in 2024. Going into the year, the market was expecting 5-6 interest rate cuts of 0.25% over the course of 2024. That expectation has declined to roughly 2 cuts expected for the rest of the year. The reason for this shift is positive – the economy has remained stronger than expected, keeping the Fed comfortable with higher rates as they fight inflation back down to the 2% target range.
The fact that the economy and labor market have remained resilient has allowed rates to remain higher. Still, we would like to see the Fed begin cutting soon as our anticipation is that they risk overshooting inflation to the downside if they do not implement cuts this year. Inflation is on its downward trajectory, and as mentioned, a modest level of inflation is healthy for the economy. Ideally, the Fed would cut three times this year, but we expect two cuts as the likely scenario. As a reminder, the current Fed Funds rate sits in the target range of 5.25%-5.50%, and two 0.25% cuts would bring this rate to 4.75%-5.00%. Interest rate cuts would provide some relief to businesses and consumers currently financing spending at high rates and would provide a tailwind for the economy. Part of that tailwind would be in housing. Current homeowners, who would like to sell, have been hesitant to give up their 2.5% to 3.5% mortgages so they have withheld selling their homes, waiting for lower mortgage rates. The Fed need not cut aggressively, but modest cuts over the next two years will provide ballast for the market and economic development in the United States. As outlined above, a lack of inflation can be detrimental to the market and economy. We’d like to see the Fed begin rate cuts before it’s too late and the economy declines unnecessarily.
Investing at All-Time Highs – Should You Wait for a Pullback?
The S&P 500 is sitting right at all-time highs (ATHs) halfway into 2024, so is it better to wait for a pullback and take money off the table here before reinvesting? Well, history tells us no. We go in-depth into this topic on a recent podcast click here to watch on YouTube. In fact, the data show that depending on the historical period, investing at an ATH is actually better than waiting for a 10% pullback. Why? You may ask. Typically, all-time highs in the market are clustered together. Already this year, the S&P 500 has set more than 30 ATHs. If you were to avoid investing at that first all-time high, you would have missed a 14+% return while just investing in the broad market.
Of course, we understand the fear of investing new or additional dollars when the market is at fresh highs – every market pullback has started from a new high. But, if we are to invest accordingly and maintain a long-term investment mindset, the market is rarely down 10%, even just one year out, and has never been down more than 10% five years from an all-time high.[1]
[1] Past performance is not a guarantee or indication of future results. Investing involves risks, including the loss of principal.
Given what history tells us statistically and by looking at current market fundamentals, we believe it is still a good time to allocate to stocks. While we don’t expect returns quite like the last 18 months over the next year or so, there are tailwinds for the market that we believe will help propel us to new highs in the future.
Preparing for Rate Cuts
As the Fed nears the next stage in its monetary policy cycle, we’re preparing client portfolios by analyzing the market for industries that will benefit or suffer from a reduction in interest rates. The market currently expects about two rate cuts this year, amounting to 0.5% of policy rate reduction. While this isn’t a significant shift from the current policy rate, the stock market is forward-looking and will begin to price in the additional 1-1.25% of cuts expected in 2025, and assets will react accordingly. To get ahead of these market movements, we are analyzing a few rate-sensitive industries outlined below.
Homebuilders
Homebuilders have seen rapid growth throughout the recent, higher interest rate environment, now supplying a significantly larger percentage of total homes sold than they have historically. We discuss this phenomenon on a recent Beckonomics Podcast Click here to view. Major homebuilders have been able to efficiently buy down mortgage rates for their clients and bring much-needed new supply to the market. Because very few existing homes are coming to market due to the lock-in effect of homeowners not wanting to give up low-interest-rate mortgages they locked in years ago, homebuilders have had the upper hand with consumers, given their constant production of new builds. Homebuilders have performed very well since the Fed began its hiking cycle but have recently become less appealing for several reasons:
- Home prices are facing pressure – homebuilders have begun reporting weaker pricing power as sales incentives have increased in recent months. High interest rates have become more expensive to buy down to a comfortable level, and customers are demanding lower prices. While the headline sales price of homes continues to increase slightly, it doesn’t reflect the increase in concessions that homebuilders are making.
- As rates drop, existing homes will begin to hit the market, increasing supply and lowering market prices. In previous newsletters we’ve argued for the Fed to lower rates in order to reduce inflation, and we continue to believe this is the Fed’s best route forward. While it may sound counterintuitive, shelter is the main inflationary pressure keeping the CPI and PCE above the Fed’s target, and lowering rates will likely increase supply and help alleviate that pressure. Once families can trade their three or four-percent mortgage for something in the fives (as opposed to the current 30-year mortgage rate of about 7%), they’re much more likely to feel comfortable entering the market.
New home sales have made up a larger portion of total home sales than ever before. Note that new home sales are plotted on the left axis and are currently about 13% of total sales.
Home Improvement
With high interest rates and low housing turnover, home improvement companies from Home Depot and Sherwin-Williams to furniture companies like Restoration Hardware and Wayfair have been hit with lower demand for their products. Many of these companies saw huge sales during Covid when people fixed up their homes but have since underperformed due to the lack of housing market activity. As rates drop and the housing market picks up, we expect renewed demand for these types of goods and services, creating a boost for these stocks.
Discretionary Spending
In the recent high interest rate environment, consumers have steered away from large, discretionary purchases that are traditionally financed. Purchases such as cars and home improvements like pools, appliances, backup power generation, and solar projects have suffered because high interest rates have made these goods much more expensive to finance. This is especially problematic for projects like solar installations, which are primarily financial decisions versus quality-of-life enhancements. As rates come down, the payback period on solar will begin to make more financial sense, and all financed purchases will be easier for consumers to bear.
We have generally avoided these sectors since the Fed started raising rates and will continue to watch for signs of increased demand as financing becomes cheaper.
Going forward, we expect many industries to benefit from the Fed’s policy shift towards lower rates and are currently building lists of potential investments that will benefit the most. Among these are industrial and solar/electrification companies.
- While rates are high, many companies operate on the least amount of working capital feasible and limit new investments. However, as rates fall, it will become less costly to hold higher levels of inventory and finance new productive assets that industrial companies supply.
Rebalancing
Traditional rebalancing works on a calendar basis to maintain a predetermined allocation to each sector or industry by selling outperforming stocks and buying underperforming ones on a calendar basis (often quarterly). This approach has myriad issues, especially when implemented in an actively managed portfolio.
- Tax inefficient – Calendar rebalancing sells “winners” and buys “losers” on a regular, usually quarterly basis. This approach consistently incurs short-term capital gains and excludes any tax-loss harvesting opportunities.
- Assumes long-term trends will revert at short-term intervals – While some macroeconomic trends fade, others last years before changing or even become a permanent fixture in our lives, like the advent of the Internet. Rebalancing implicitly assumes “reversion to the mean” will happen at short-term inflection points when in reality, this is not always the case.
At Beck Capital Management, we are long-term-oriented investors who take a tax-efficient approach to investing. We aim to realize the majority of gains after at least one year of investment for long-term capital gains tax treatment and strategically harvest tax losses when appropriate.
This means that while we work to keep the portfolio in balance, we allow in-favor companies to grow and often sell losers to offset capital gains taxes. When we trim highly appreciated stock, it is done tactically – when we think it is best and not just because three months have passed. This includes selling the highest-cost tax lots first and taking advantage of long-term capital gains tax treatment.
Tax loss harvesting doesn’t necessarily mean selling a company for a loss and being done with it. Oftentimes, we may still like a company’s future prospects despite poor short-term price action, in which case, we may sell it today and buy it back in 31 days to avoid a wash sale.
For more discussion of rebalancing, see our recent podcast episode on the subject (click here to watch)
Conclusion
It has been an exceptional past 18 months in the stock market. Growing earnings, an easing Fed, and a strong labor market create a tailwind for the markets going forward and should benefit many sectors of the economy. While we don’t believe returns over the next 18 will be quite as remarkable as the past 18, we remain confident that the current market fundamentals combined with our research and analytics, will (likely) give us more satisfying opportunities. We will continue to adjust our portfolios as economic dynamics change – as they always do – and we look forward to seeking more success in the second half of this year.
Disclosures