Q2 Market Update 2024: Multi-Factor Analysis of the Economy and Markets
For a brief explanation with only the essentials, you may read the initial summary. For a more detailed analysis of the economy and markets, you may read the entire article following the summary.
Summary
Domestic large and mid-sized companies led total returns in the last twelve months and through the initial two quarters of 2024 (although emerging markets were about 1.6% higher than mid-sized companies on a year-to-date basis). Large companies generated a positive total return in the second quarter with mid-size and small companies contracting a couple percent, but on a year-to-date basis all three categories have generated positive total returns. Considering the 11 different sectors on a year-to-date basis, Technology, Financials, and Utilities have provided the largest double-digit returns. Conversely, Telecommunications and Real Estate have been the lone losers of a few percentage points through two quarters.
The handful of largest companies, especially Nvidia, dominated the S&P 500 to produce slightly more than a 15% return year-to-date and company concentration has become more of a concern than it has ever been as the top 10 stocks represent nearly 38% of the S&P 500. However, the valuation of the entire S&P 500 is not excessively overpriced for long-term investors. Interest rates have risen about 0.40% this year when considering all rates at or above the 1-year maturity while short rates (< 1 year) have remained steady. The 12-month unadjusted core inflation rate was 3.3% for June compared to 4.80% in June of last year as housing and vehicle insurance were the primary sources of higher prices. The change in monthly inflation in June indicates at least a short-term decrease in the pace of inflation until additional months confirm or disprove the downward trend.
Seasonally-Adjusted Unemployment reported by the rate was 4.1% of the labor force in June, which is higher than the 3.6% unemployment rate in June of last year and 0.10% higher than the unemployment rate of 4.0% in the prior month of May. Despite the higher unemployment rate this year, the total number of employees on seasonally-adjusted non-farm payrolls increased by 206,000 on a preliminary basis in June relative to May and increased by approximately 2.6 million from June of last year.
Additional optimism is provided by the excess demand for labor as indicated by the combination of the employment level and non-farm job openings of 169.22 million in May versus the 167.73 million civilian labor force. The excess demand for labor of nearly 1.5 million has contracted roughly 50% from a higher excess of nearly 3.2 million last May, but has slightly increased from the 1.43 million excess labor demand in April.
The markets have treated investors well over the last 12-month period while being fairly kind through the first half of 2024. We continue to remain alert to the various aforementioned economic factors to optimize the rationality of our investment decisions and associated investment results for the countless individuals and families that depend on us for their financial security and prosperity. To trust us is your careful decision. To validate your trust is our purpose and pleasure.
Returns by Sub-Asset Classes
Using the weighted average of total returns according to assets under management from 3 major providers of exchange-traded funds and mutual funds - StateStreet, BlackRock, and Vanguard - we will analyze total returns across sub-asset classes in the second quarter, year-to-date, and on a trailing twelve month basis. In the second quarter, emerging markets generated the highest total return near 4.68%, while the S&P 500 (large companies) generated a total return near 4.56%. The weakest performance in the second quarter resulted from mid-size companies losing near 2.36% and small companies losing near 2.92%.
On a year-to-date basis, large companies produced the highest total return near 15.27% while emerging markets followed with near a 6.96% total return. Broader fixed-income, conveniently represented by aggregate bond indices (approximately 45-50% government, 25% corporate, 22-27% securitized, and 1-4% cash), is the only discussed sub-asset class that depreciated near 0.62% on a year-to-date basis.
On a year-over-year (trailing twelve month) basis, large companies also dramatically outpaced the alternative sub-asset classes by more than 10% via providing near a 24.59% total return over the last year at the end of the second quarter, while mid-size companies generated near a 12.43% total return, and emerging markets followed close behind at near a 11.59% total return. Broader fixed-income produced the lowest total return near 2.57% in the past year through the second quarter with short-term and intermediate-term investment-grade corporate debt respectively providing approximately 5.83% and 5.53% total returns in the past year.
Returns by Company Size
Regarding performance according to company size, large companies generated the highest total returns in the second quarter of 2024, followed by mid-size companies losing roughly 2.36%, and small companies losing near 2.92%. On a year-to-date basis, large companies continued to lead in total return near 15.27%, followed by approximately 5.34% for mid-size companies, and 1.48% for small companies. On a trailing twelve month basis ended in June, large companies produced roughly 24.59% in total return to exceed mid-size companies at 12.43%, and small companies near 10.30% in total return during the past year.
Returns by Sector
After considering the performance of sub-asset classes and companies by size, we turn to performance by sectors. In the second quarter of 2024, technology produced a 11.09% total return, followed by utilities at 4.94%, and the broad S&P 500 at a 4.56% total return. For the notable losers, basic materials declined 5.03% in the second quarter with industrials depreciating 3.90% and energy falling 3.41%. On a year-to-date basis, technology produced the highest 22.74% total return while financials followed considerably lower at 11.44%. Telecommunications and real estate both lost a little more than 3% through the end of June this year for the negative side of performance. On a trailing twelve month basis, technology provided a massive 38.78% total return while financials also followed behind technology at a 28.88% total return over the past year. Telecommunications and consumer staples were the most depressing across sector performance, respectively, at 0.64% and 1.30% of total return.
Returns of Concentrated S&P 500 vs. Equal-Weight S&P 500
The S&P 500, represented by a weighted average of three major ETF providers according to assets under management, produced a total return of 15.27% through the end of the second quarter in 2024. The 15.27% total return for the market-capitalization weighted S&P 500, which uses the market value (size) of companies to determine position sizing, was substantially higher than the 4.96% year-to-date total return provided by the equal-weighted combination of S&P 500 companies.
Four companies - Microsoft, Apple, Nvidia, and Amazon - represent approximately 25% of the S&P 500 for all three major ETFs (BlackRock, Vanguard, StateStreet). The top 10 companies (roughly 2% of the total companies in the index) represent around 38% of the index, while 25-30 companies (around 5-6% of the total) represent 50% of the index. Although there is seemingly adequate diversification provided by investing in the S&P 500, less than 1% of companies are representing 25% of the index and roughly only 5% of the companies providing “diversification” are representing 50% of the index.
From the perspective of an isolated portfolio, the top 4 companies representing approximately 25% of the S&P 500 - Microsoft, Apple, Nvidia, and Amazon - are valued at 64 times 2023 earnings adjusted for non-recurring items and at 49 times the last twelve month earnings. The top 25-30 companies constituting 50% of the S&P 500, also viewed within the context of an isolated portfolio, are valued at nearly 51 times 2023 earnings adjusted for non-recurring items and at 42 times the last twelve month earnings.
When considering the valuation of the S&P 500 based on forward-looking earnings forecasted by a group of qualified analysts, including and excluding the top 10 companies, we obtain a better understanding of valuations. The top 10 companies are currently valued around 34 times the next 12 month earnings, yet the remaining 492 companies are valued around 17 times the next 12 month earnings. The combination of the top 10 companies with the remaining companies results in a valuation of approximately 21 times next 12 month earnings (about 30% above the average) for the S&P 500 overall. While 21 times the next 12 month forecasted earnings is not a super expensive price to pay, it also is not a bargain. Despite the somewhat higher valuation than average - I believe long-term investors will continue to prosper in our highly-respected equity market if they have competence and rationality on their side.
Evolution of Interest Rates
Transitioning the focus to the government yield curve to consider the evolution of interest rates this year, we find that the ultra-short 3-month rate remained fairly stable with a minuscule increase from the starting point of 5.46% in January, remaining at 5.46% in March, and finishing at 5.48% at the end of June. The short 1-year rate began the year at 4.80%, but increased 0.23% by the end of March to 5.03%, and slightly continued the upward trend to 5.09% to end the second quarter.
Moderate rates (in the 3-year to 10-year range) all experienced increases between 0.25% to 0.30% by the end of March, while they continued to elevate another 0.10% to 0.15% in the second quarter to end June roughly between 4.3% and 4.5%. Long rates, beginning at the 10-year maturity point, also increased from the beginning of the year. The 10-year rate started the year at 3.95% before increasing to 4.20% ending in March, and continuing the ascent to 4.36% to end June. It is a natural consequence that higher government risk-free rates relative to the beginning of the year have generally increased the cost of risky borrowing for consumers and businesses.
Inflation: Developments and Major Sources
The consumer price index (CPI) and personal consumption expenditures (PCE) are both used as inflation measurements for the economy of the United States. The U.S. Bureau of Labor Statistics reports both seasonally-adjusted inflation and unadjusted inflation via the consumer price index. Seasonally-adjusted inflation is used to eliminate the influence of any expected seasonal changes that typically occur in approximately the same amounts at the same time(s) throughout the year, therefore providing a more accurate measurement of the true short-term change in inflation not resulting from seasonal changes (production cycles, holidays, etc). Seasonally-adjusted inflation measures the unexpected change in prices to better reveal the true trend of inflation, while unadjusted inflation reveals the actual prices for consumers when they pay for their goods and services in the current market.
It is important to remember that the different weights of goods and services used to calculate the consumer price index may not be representative of your unique proportions of monthly expenditures, so be cautious if relying on the assumption that the consumer price index is indicative of your unique inflation rate.
There are two common measurements of inflation according to the consumer price index - “headline” inflation (which includes all expense categories) and “core” inflation (which excludes the volatile categories of food and energy costs that may distort the broader trend of inflation). For a look into the inflation rate on an annual (year-over-year) basis for the month of June this year relative to June of last year, the 12-month unadjusted headline inflation rate was 3.0%. When removing the commonly volatile food and energy prices, the 12-month unadjusted core inflation rate was 3.3% for June compared to 4.80% in June of last year.
The 3.0% unadjusted annual headline inflation rate for the month of June is 0.40% higher than the 20-year average of 2.60% including outlier data, but essentially 0.70% higher compared to the 2.31% 20-year average when removing outliers from the historical data (IQR x 1.5 method). The 3.3% unadjusted annual core inflation rate for June is approximately 0.90% higher than the 20-year average of 2.42% including outliers and roughly 1.30% higher than the 20-year average of 1.96% when excluding outliers. It is apparent from the unadjusted 12-month core inflation rate of 3.3% compared to the 4.80% 12-month core inflation rate of last June, that inflation is converging towards the 20-year average core inflation rate of 1.96% when excluding outlier months.
When deconstructing the 3.0% unadjusted annual headline inflation rate into the major sources, shelter (housing) increased 5.2% in isolation and contributed 1.80% to the 3.0% headline rate, followed by motor vehicle insurance increasing 19.5% and contributing 0.51% to headline inflation and hospital services increasing 7.1% and contributing 0.16% to the headline rate. When switching the focus to sources of deflation, used cars and trucks were the largest reduction to unadjusted annual headline inflation with prices decreasing 10.1% for a reduction of 0.27% in overall headline inflation.
The one-month seasonally-adjusted headline inflation, for the first time within the last year, declined 0.10% in June. The 0.10% decline in June was quite different from the usual 0.20% to 0.40% monthly price increases in the past year - a positive signal for the trend in costs experienced by consumers. The one-month seasonally-adjusted core inflation rate increased at a relatively slower rate of 0.10% in June relative to May.
When deconstructing the 0.10% seasonally-adjusted monthly headline deflation rate into the major sources, gasoline declined 3.8% in June compared to May to subtract around 0.13% from the monthly inflation rate, while airline fares decreased 5.0% to diminish the monthly inflation rate by nearly 0.04%, and used cars and trucks fell 1.5% in June relative to May for a reduction of nearly 0.03% from headline inflation. Shelter (housing) was the primary source of inflation at 0.20% in June for a 0.07% contribution to monthly headline inflation.
The monthly seasonally-adjusted headline deflation rate of 0.10% and seasonally-adjusted core inflation rate of 0.10% - both below their typical recent monthly increases ranging mostly between 0.20% and 0.40% - indicates at least a short-term decrease in the pace of inflation until additional months confirm or disprove the trend.
Employment Conditions
Seasonally-Adjusted Unemployment by number of people (which removes distortions from changes in unemployment not representative of sincere change) was 6,811,000 in June compared to 5,997,000 in the same month of June 2023. Since January, unemployment rose from 6,124,000 to 6,811,000 by the end of June.
Seasonally-Adjusted Unemployment reported by the rate was 4.1% of the labor force in June, which is actually 0.50% higher than the 3.6% unemployment rate in the same month of June last year and 0.10% higher than the unemployment rate of 4.0% in the prior month of May. Approximately 60% of the 0.50% increase in unemployment since last June has occurred in the last three months (25% of the time), thus indicating recent upward momentum in unemployment that requires awareness as 2024 progresses towards completion.
Seasonally-Adjusted Unemployment for those unemployed 27 weeks or more increased from 1.35 million people in May to 1.52 million people in June. The percentage of people unemployed 27 weeks or more relative to the total unemployed increased to 22.2% in June compared to 20.7% in the prior month of May and 18.8% in the month of June last year. The 22.2% June 2024 figure is below the 10-year June average of essentially 23% when removing 2020 & 2021 outliers and is also below the 10-year average of 23.9% across all months when excluding outliers.
Despite the increases in unemployment variables implying a concern for labor conditions, the total number of employees on seasonally-adjusted non-farm payrolls increased 206,000 on a preliminary basis in June to 158.64 million relative to 158.43 million in May and increased approximately 2.6 million relative to the total employees on non-farm payrolls of 156.03 million in June of last year. While the unemployment rate may be increasing lately, there are a couple more million employees contributing to the output of the economy this June compared to last June. The preliminary 206,000 addition to non-farm payrolls consisted of a 136,000 payroll addition within the private sector and 70,000 addition within the government (public) sector. Considering major influences to the net increase in private payroll in June, health care added 49,000 employees to payroll, social assistance added 34,000, Construction added 27,000, professional and technical services added 24,000, and temporary employment services subtracted 49,000 from the net non-farm payroll growth.
While adding a couple million employees to payroll in the past year is a positive for economic activity, additional optimism is provided by the excess demand for labor as indicated by the combination of the employment level and non-farm job openings of 169.22 million in May exceeding the civilian labor force of 167.73 million in May by nearly 1.5 million. The excess demand for labor of nearly 1.5 million has contracted roughly 50% from a higher excess of nearly 3.2 million last May, but has slightly increased from the 1.43 million excess labor demand in April. An economy offering slightly more opportunities than the labor force can support is a better “problem” than an economy with more labor supply than opportunities to employ that labor. To have and not need opportunities to earn income is more desirable than to need opportunities to earn income and not have them.