Q1 2024: PFM Quarterly Commentary
746 days can sound like an unbearably long time depending on your perspective. Remember counting down the days until you received your driver’s license? Receiving that ticket to freedom seemed impossibly distant even when only months away. For the cosmologists and geologists among us, we’re confident that they’d say 746 days is barely a blink of an eye. Meanwhile, when it concerns investments – in particular when it involves your hard-earned savings from work – 746 days may as well be an eternity.
That is precisely how long it took the S&P 500 to make a new all-time closing high. Its previous high was attained on Monday, January 3rd, 2022.[1] Since that day, we often have espoused the long-term wealth generating abilities of investment markets, noting regularly that major indexes like the S&P 500 are previously undefeated and eventually should make new highs as they participate in economic growth. That’s been the experience since 1896 when the Dow Jones Industrial Average was conceived and 1923, when the S&P index was created. These new highs followed declines wrought by world wars, depressions, and you guessed it, pandemics. Sometimes investors must wait uncomfortably long to realize those gains, but past market movements indicate that patience when investing more often than not pays off. This last bear market proved no different.
While this period between all-time highs proved unpleasantly lengthy, it contained another story worth telling. In recent letters, we discussed the narrow market participation; basically, a handful of oversized technology companies drove nearly the entire performance of the S&P 500 because the stocks within the index are weighted by market capitalization.[2] This means that a few large companies exert outsized influence on the overall performance of the index. This weighting methodology can allow the performance of the S&P 500 to obfuscate the health of the underlying stock market. For example, last year, just seven stocks (i.e., the Magnificent Seven) of the S&P 500 accounted for over 60% of its return.[3] Conversely, a whopping 173 companies in the S&P 500 had negative returns in 2023, with the average loss exceeding 14%.[4] This lopsided impact from the Magnificent Seven was made clearly evident by analyzing the disparity of returns between the S&P 500 and other broad-based domestic equity indexes such as the Russell 2000, the S&P Mid Cap 400, and even the equal-weighted version of the S&P 500. Respectively, they underperformed the benchmark index in 2023 by 9.4%, 9.9%, and 12.4%.[5]
The pretext for our 2023 history lesson is to provide context on why narrow market participation can blur investors’ perceived reality; this is because equity market participants are still taught to judge their portfolio’s performance solely against the well-publicized returns of the S&P 500, even while the index’s composition further distorts. The Russell 2000 Index, which represents 2,000 smaller domestic stocks and is a good proxy for the general health of American companies, remains 13.8% below its all-time high recorded 877 days ago.[6] The S&P 400 Mid Cap Index went 836 days between all-time highs before finally registering a new one last month.[7] The equal-weighted version of the S&P 500 (which eliminates the performance influence enjoyed by larger companies) went 790 days before finally tagging a new high in early March.[8] For other important asset classes such as international developed equities, domestic bonds, and emerging market equities, the drought between new highs continues. As of the time of this writing, they last enjoyed new highs 940, 1,335, and 1,138 days ago, respectively, and sit well below their previous high-water marks.[9]
Such lopsided returns have occurred before. History suggests that narrow markets do not continue indefinitely and are typically resolved through underperforming sectors catching up during the next bull market. In late 2000 for example, the S&P 500 technology sector’s weighting in the S&P 500 crossed above 30% for the first time while conversely the utilities sector’s share hit an all-time low of 2.2%.[10] From when the next bull market began in October of 2002 to its end in October 2007, the utilities sector experienced an epic run, appreciating 229% on a total return basis.[11] As the old saying goes, “history doesn’t repeat, but it sometimes rhymes.” Therefore, it’s worth contemplating that the technology sector’s percentage weighting in the S&P 500 once again crossed 30% for the first time in twenty-four years and the utilities sector’s weighting in the S&P 500 has coincidentally registered a new all-time low of just under 2.2%.[12]
This last point isn’t meant as a recommendation to buy utility stocks, but rather, to serve as reminder that no trend lasts forever and that the market’s inherent cyclicality ensures that what underperforms today may very well outperform tomorrow. Changes to stubbornly embedded conditions take time. Entrenched trends don’t go quietly, and an alarm doesn’t conveniently sound when major shifts are at hand. In the ten years following the Great Financial Crisis, historically low interest rates and subdued inflation was such the norm that it became difficult for investors to see a time when that environment wouldn’t prevail. In late 2017, we began writing about what we then thought may be a coming surge of inflation; we realize this may have sounded impossible to believe at the time. This wave didn’t happen overnight, but eventually inflation skyrocketed to the highest levels in four decades and interest rates now sit at twenty-year highs; a situation that a few short years ago would have been deemed unlikely if not impossible. Long-time readers may remember other contrarian points of view we expressed during the bear market in 2018 and in the depths of the Covid crisis.
Going against the grain is never easy which explains why many investment professionals simply repeat consensus opinions. Instead, we analyze information and let the data speak for itself. All the while, we maintain a deep appreciation that markets can act erratically and unexpectedly. To that point, we’re noticing a subtle change in behavior of several sectors that have underperformed for some time. Many of these sectors were previously leaders during the aforementioned 2002-2007 bull market; however, since then mostly they have lagged. These areas of the market occupy space at the value end of the spectrum rather than growth. Value companies traditionally operate in stable, mature industries and their stocks tend to trade at a discount when applying traditional valuation techniques.[13] They generally focus on generating high free cash flow and often place greater emphasis on distributing dividends over capital reinvestment. This forgotten corner of the market includes utilities, financials, energy, industrials, materials, and consumer staples.[14] For most investors, it is difficult to imagine a market not led by mainstream technology companies. In fact, there is a whole generation of investment professionals who literally don’t know of any other type of environment. But there was a time not too long ago when markets were led by steel producers, industrial machine manufacturers, miners, telecommunications companies, chemical providers, electricity generators, and major money center banks. After more than a decade of technology dominance, perhaps we could see those days again.
Some might be asking what catalyst could affect such a change to the long-term status quo. Naturally, the answer is the Federal Reserve, which in our opinion, could be on the verge of a policy shift. During their March meeting, the Central Bank held interest rates steady at 5.5% and choreographed their tentative plan for three rate cuts this year; this by itself was widely expected. What was entirely surprising, was Fed Chairman Powell’s response to a question during the press conference. To paraphrase, the reporter congratulated the Fed for successfully bringing inflation down from nearly 10% to 3%, but noted they seemed be having great difficulty further reducing inflation to their target of 2%, despite employing the most restrictive monetary policy in four decades. Powell suggested that the Fed would be comfortable with inflation at this elevated level “over time” provided there is evidence of progress that it will eventually return to their mandated 2% target.[15] For anyone who watches the Fed closely, this statement is seems to be a reversal from their decades-long disciplined commitment to reaching their 2% inflation target quickly and at all costs.
If Powell is telegraphing that we are entering a period of structurally higher inflation, then companies that are more capable of passing along higher costs to the end users of their products and services should outperform. In that environment, consumers will preference goods and services they are unable or unwilling to cut from their budgets, regardless of their financial situation, while purchases of discretionary items might be reduced or eliminated. Many of the sectors listed above fit this description.
In addition to interest rate cuts, Powell also teased that the Fed would unveil a plan to begin tapering its quantitative tightening (QT) program as early as April. Like interest rate increases, QT is another mechanism they can use to tighten monetary policy to help curb inflation. Cutting interest rates while also ending the QT program will certainly provide stimulus to the monetary system. Beginning new stimulative measures before the Fed has reached its 2% inflation target while seemingly simultaneously abandoning that goal could mean that higher inflation is here to stay. That might explain why gold, long considered an inflation bellwether, has recently moved vigorously to new all-time highs.
During this unsettled time, we appreciate your trust in our investment philosophy and process. Do not hesitate to be in touch – we’d love to hear from you.
Regards,
Peak Financial Management
Disclosures:
The views expressed represent the opinions of Peak Financial Management as of the date noted and are subject to change. These views are not intended as a forecast, a guarantee of future results, investment recommendation, or an offer to buy or sell any securities. The information provided is of a general nature and should not be construed as investment advice or to provide any investment, tax, financial or legal advice or service to any person. The information contained has been compiled from sources deemed reliable, yet accuracy is not guaranteed.
Additional information, including management fees and expenses, is provided on our Form ADV Part 2 available upon request or at the SEC’s Investment Adviser Public Disclosure website – https://adviserinfo.sec.gov/. Past performance is not a guarantee of future results.
[1] Bloomberg L.P. 2024.
[2] S&P Global, “S&P U.S. Indices Methodology”, March 2024. https://www.spglobal.com/spdji/en/documents/methodologies/methodology-sp-us-indices.pdf
[3-12] Bloomberg L.P. 2024.
[13] Charles Schwab, “Value Stock Investments: Build a Durable Portfolio”, March 2023. https://www.schwab.com/learn/story/value-stock-investments-build-durable-portfolio
[14] ETF.com, ETF Basics, “Growth Investing vs Value Investing: What’s the Difference?”, https://www.etf.com/sections/etf-basics/growth-investing-vs-value-investing
[15] Federal Reserve, FOMC Press Conference Transcript, March 2024. https://www.federalreserve.gov/mediacenter/files/FOMCpresconf20240320.pdf