Navigating the markets: Insights from our Q2 Economic and Market Review

Executive summary:

• Momentum continued in the second quarter, with U.S. equities still led by the large technology stocks known as the Magnificent 7
• History shows that a strong first half of the year often leads to a strong second half
• There will be presidential elections later this year and that likely will have an impact on markets and on infrastructure spending
• With the Magnificent 7 dominating market performance, small cap stocks have lagged significantly over the past several quarters. We look at what the future holds for this asset class.

The momentum we've seen in U.S. equity markets over the past year continued in the second quarter of 2024. With large technology stocks leading the wave, the S&P 500 index has risen 23% in the 12 months ended June 30. Can this continue?

Well, I don't have a crystal ball so I can't answer that question. But I can say that even if markets change direction in the short term, their long-term trend is up. We've also found that strong market performance often leads to more strong market performance. More on this shortly.

The rally has led to the S&P 500 setting a series of new all-time highs in the first half of this year. Many observers are worried that this could lead to a major pullback, especially with presidential elections in November, and signs of a spotty economy. There's a lot of debate over whether the U.S. will have a soft landing, a hard landing or no landing at all  – that is, no recession, just ongoing economic growth.

But with the jury still out and the political landscape in turmoil, you may have clients who want to crystallize the gains of the past year and step back from the market. Once again, I'm going to show you why they should stay true to their investment plan and remain invested. And I am going to give you some tools to help you convince them.

A promising start to the year

It's encouraging to see the strong market performance we've enjoyed so far. It bodes well for the near future. Historically, when the first half of the year is strong, the trend often continues into the second half, as the chart below shows.

It may appear that the market has been volatile, but the truth is that volatility has been relatively subdued. You may think it's been volatile because of the many headlines related to upcoming elections, and persistent inflation concerns. While we continue to monitor inflation numbers and the U.S. Federal Reserve's reaction to them, the reality is that the market has moved steadily higher with only a few small dips. it's important to let your clients know that what they are seeing on the news is just short-term noise. And as the chart below indicates, momentum often leads to more momentum.

Balanced Index Portfolio: 60% Russell 3000 Index, 40% Bloomberg U.S. Aggregate Bond Index (1986-2024) linked to Bloomberg U.S. Gov/Credit Bond Index (1984-1985). Index returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment. Indexes are unmanaged and cannot be invested in directly.

The "Magnificent 7" keep on roaring

U.S. stock market headlines in recent years have largely been focused on what are commonly referred to as the "Magnificent Seven" stocks. This group includes Microsoft, NVIDIA, Apple, Alphabet, Amazon, Meta and Tesla -- the largest technology-oriented companies in the S&P 500 Index.

Boosted by the changes in how most people work and live amid the Covid pandemic that began in March 2020, technology stocks now represent nearly one-third of the S&P 500 index – up from 10% in 2014.

In NVIDIA's case specifically, the company has gone from just a 0.1% weight in 2014 to the second largest company in the index at 6.6%. While the recent returns from these names have been attractive, rarely do each of these names represent the top-performing companies in any given year. Additionally, taking a look back at 2022 when these names represented some of the worst overall returns in the index highlights the risk of a concentrated market.

It's important to maintain global diversification as market leadership can change suddenly and unpredictably.

Source: Morningstar, Russell Investments and FactSet. As of 6/30/2024. Alphabet weight represents A&C shares. Index weights based on each calendar year end. Yearly return ranks based on start of period index components. Index returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment. "Magnificent 7" refers to Apple, Microsoft, Alphabet, Amazon, NVIDIA, Tesla and Meta.. 

Small cap investments: Doubts arise, but history suggests rebound potential

Currently, small cap stocks [market capitalization ranging from approximately $300 million to $2 billion] make up a little under 5% of the S&P 500 Index. The last time their weighting in the index was this low, there was a significant rebound. Small cap underperformance has been a hot topic lately, as these stocks have significantly lagged their large-cap counterparts. But as we discuss in this blog, that doesn't mean you should write off small cap exposure altogether.

Small caps are a great area for active management. This topic frequently comes up in meetings, and I believe small caps need interest rates to start decreasing for them to perform well, as small companies often rely on borrowing to fund their operations. As long as rates stay high, small caps may struggle, but if the U.S. Federal Reserve (Fed) cuts rates later this year or next year, it could be a good time to invest in this asset class.

This chart effectively illustrates these points.

• After strong returns from U.S. large cap stocks, relative performance and allocations for small cap has fallen to levels last seen in the 1990s.
• In previous similar experiences, this trend reversed as small cap stocks outperformed in future periods.
• Markets tend to move in cycles. Maintaining exposure to small cap stocks can benefit portfolios as leadership reverses.

Source: Morningstar and Russell Investments. As of 6/30/2024. Large Cap represented by Russell 1000 Index; Small Cap represented by Russell 2000 Index; U.S. Stock Market represented by Russell 3000 Index. Index returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment.

Infrastructure spending is supporting economic growth

Infrastructure is key to the effective functioning of our society. We all depend on transportation networks to get around and to manage the import and export of the goods we use in our daily lives. We rely on reliable utilities and the efficient transmission of wireless signals. And our future may depend on sustainable infrastructure, such as projects focused on renewable energy and eco-friendly transportation systems, which contribute significantly to reducing carbon emissions and minimizing environmental impact.

Taking a proactive approach to infrastructure maintenance and upgrades offers long-term cost savings by preventing deterioration and reducing the need for expensive repairs.

The comparison to a report card makes this topic intriguing. Imagine you are a parent and your child received a report card highlighting their shortcomings. That would likely be cause for concern. So should the report card our infrastructure received from the American Society of Civil Engineers (ASCE). We are mindful of the state of our infrastructure and the substantial funds allocated or already expended in this area. Infrastructure remains a robust asset class that garners significant attention, especially during election seasons.

Source: American Society of Civil Engineers, Statista.

Election year results

Sticking to the plan has historically provided solid returns in Presidential election years as the chart below shows. The story and message remain consistent: election years tend to have similar capital market returns compared to non-election years.

You'll notice the average return for the 12 election years is 9.1%, shown at the bottom middle of the page, compared to the overall average of 9.7% for the 1976-2023 period. The 60 basis-point difference is mainly due to the 22% drop in 2008. Spreading that over 12 years has a much larger impact than over the entire nearly 50-year window. Excluding 2008, year-to-year performance is quite similar whether it's an election year or not. Remember, 2008 was marked by the Great Financial Crisis and the housing bubble. I say it in every election year, don't mix your planning with your politics.

Source: The American Presidency Project & Morningstar Direct: 60/40 Portfolio: 60% U.S. Equity / 40% Bonds. U.S. Equity: Ibbotson U.S. Equity Index (1976-1983), Russell 3000 Index (1984 – Present). Bonds: Ibbotson Intermediate Bond Index (1976-1985) linked to Bloomberg U.S. Aggregate Bond Index (1986-Present). Indexes are unmanaged and cannot be invested in directly. Returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment.

Cash vs. a diversified portfolio – Who will win the gold?

The 33rd Olympic Games are starting in a few days so we decided to look at which asset class could win a gold medal. Well, everything depends on the asset class and the time frame.

We started with the 1984 Olympics in Los Angeles and looked at a 40-year time horizon. In the upper left-hand corner, you'll see that cash is positive 100% of the time over a one-year period. Bonds are positive 87% of the time, and stocks and bonds are positive 86% of the time. Using the Olympic podium analogy, cash takes the gold for short-term performance.

However, when you look at longer-term scenarios, moving past the sprint to middle-distance and long-distance horizons, a diversified portfolio consistently outperforms in almost every category. This serves as a reminder that while cash may be a good short-term solution, it is not the long-term answer for building wealth in a portfolio.

Source: Returns periods from July 1984 through June 2024. 50/50 : 50% Russell 3000 Index, 50% Bloomberg Aggregate Bond Index (1986 to Present) linked to Ibbotson SBBI US Intermediate-Term Government Bonds Index (July 1984-1985), Bonds: , 50% Bloomberg Aggregate Bond Index (1986 to Present) linked to Ibbotson SBBI US Intermediate-Term Government Bonds Index (July 1984-1885), Cash: Citigroup 3 -month T-bill Index Returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment.

Our Q2 2024 Economic and Market review provides crucial insights and analysis necessary for anyone navigating the complex financial landscape. Just as athletes study game plans and training routines, you can use this document to put the current economic and political landscape in context and ensure your clients remain on their chosen financial journey.

Keep watching for further updates and insights as we navigate these dynamic financial currents. Remember, making informed investment decisions is crucial for maintaining long-term growth and stability.