July 2024 Commentary

Key Observations & Outlook

• July saw a significant rotation in the US stock market with investors shifting away from mega cap, technology, and growth style factors in favor of smaller to mid-cap and value stocks.

• Small caps, as measured by the S&P 600 Index returned 10.79% in July vs. 1.22% for the S&P 500 Index, marking a substantial reversal in the performance of large vs. small caps.

•  The Federal Reserve signaled that the inflation rate continues to decline, increasing the probability of Fed Rate cuts at the September Fed meeting.

• Bonds also rallied during the month driven by increasing expectations of a rate cut.

• Economic data continues to indicate slowing growth with ISM Manufacturing report coming in below market expectations.

Market Commentary

With so much noise in the markets in the first few days of August, the events and market movements in July already seem like old news. That said, there are several key themes that we saw beginning to play out in July that continue to play roles in the early August market volatility. First, July experienced the first major rotation out of the mega cap technology names, favoring small and mid-cap stocks as well as more value-oriented stocks. Small cap stocks, as measured by the S&P 600 Small Cap Index, returned 10.8% during the month with the S&P 500 Large Cap Index returning just 1.2%, while the technology heavy NASDAQ 100 Index fell 1.5%. Many of these stocks were due for a breather after the strong run over the last year and a half. Extended valuations and lofty expectations heading into earnings season, combined with concerns that the expenses associated with artificial intelligence (AI) build out may exceed the associated revenues on AI-oriented companies in the short run.

Employment and manufacturing data have also been pointing to a slowdown in the US economy. The early August stock route was largely due to the publication on August 2nd of the July employment statistics from the Bureau of Labor Statistics which showed another uptick in unemployment in July to 4.3%. While unemployment rate still sits within the range that most economists consider “full employment”, the critical non-farm payrolls report also reflected much slower than expected job creation, indicating that the upward trend may persist, thus further slowing economic growth.

The Institute for Supply Management released the Manufacturing Purchasing Managers’ Index (PMI), showing a decline of 1.7% down to 46.8%. Readings below 50% indicate a contracting economy. Nearly all segments of the manufacturing sector pointed to a slowing of the manufacturing economy at a faster pace than was previously anticipated by the markets.

Source: Institute for Supply Management

Bad news that was good news is now bad news

Over the past two years, markets have been hanging on every move from the Federal Reserve (the Fed) in hopes of seeing lower interest rates to promote growth. In many of the past instances, bad news, such as weaker unemployment data or slowing GDP, have resulted in a bump in the stock and bond markets as investors interpolated the negative news as an indication the Fed would move quicker to begin lowering interest rates. The current bout of market volatility, however, seems to have put the economic data at the forefront as the bad economic news is being digested as bad news.

As markets began accepting the possibility of a recession, the “flight to quality” trade resurfaced with bonds regaining their role as a diversifying hedge against stock market volatility. From the recent peak of the S&P 500 on July 16th through August 5th, the S&P 500 dropped nearly 8.5% with the Bloomberg Aggregate Bond Index rising over 2% during the same period.

The Bottom Line

The rotation in the markets away from mega cap technology stocks as well as the renewed negative correlation between stocks and bonds supports the argument for diversification within portfolios. For the past few years, diversification has not been a popular concept as heightened correlations between stocks and bonds resulted due to the hyperfocus from investors on Fed policy. We continue to be in favor of maintaining a diversified approach within equity markets which would include allocations to mid and small cap as well as non-US securities.

In contrast to pre-pandemic investing, the relatively higher yields in bonds allow them to play not just a diversifying ballast to equity returns but also allow investors to get paid a modest amount of income for that diversification. With that said, there is room for further volatility in the bond market as new data may sway expectations of what the Federal Reserve may do with rates in the coming months. Currently, the market is predicting, with 100% confidence, a significant rate cut in September. However, even as inflation mitigates, it still remains stubbornly above the Fed’s preferred target and while it is likely that the recent bout of volatility in the equity markets might spur the Fed to make a cut, we have seen expectations fail to materialize in the past.
Anytime there is a distinct negative market action, it is natural for investors to be caught up in the emotions of the moment. Our job, as advisors, is to bring discipline and consistency to our client’s investment portfolio in a way that focuses on the long-term goals of each individual and family. By diversifying portfolios and incorporating strategies that have less exposure to traditional stock and bond markets, we can help insulate each client against making emotional decisions, stay focused on the long-term objectives, and maintain discipline through any volatility inducing event.