Second Quarter 2024 Market Review

Independence Day 2024 Edition

While it’s now more than a few days past the 4th, we think it would be a wonderful thing if all our clients, and actually all Americans, took a moment to ask God to bless our great nation.

Stock Market Developments

The quarter recently ended was a bumpy ride for the stock market with the major indices finishing the quarter mixed as the Nasdaq reclaimed the top spot with a gain of over seven percent while the Dow 30 ended slightly lower than it started.

Year to date, all indices are up, although the Dow substantially lags the S&P and Nasdaq.

This divergent performance is similar to what occurred in 2021 when the cap-weighted S&P 500, driven by the “Magnificent 7”, NVIDIA, Amazon, Apple, Meta, Google, Tesla, and Microsoft, outperformed the equal-weighted index.

Similarly, 2024’s rally has been concentrated in a small number of names even though the earnings results reported during the early part of the quarter were positive overall.

Economic Observations

Looking at the economy, the Conference Board Leading Economic Index® (LEI) for the U.S. decreased by 0.5 percent in May 2024 to 101.2 (2016=100), following a 0.6 percent decline in April. Over the six-month period between November 2023 and May 2024, the LEI fell by 2.0 percent—a smaller decrease than its 3.4 percent contraction over the previous six months.

The May numbers were driven primarily by a decline in new orders, weak consumer sentiment about future business conditions, and lower building permits,

According to The Conference Board; “While the Index’s six-month growth rate remained firmly negative, the LEI doesn’t currently signal a recession. We project real GDP growth will slow further to under 1 percent (annualized) over Q2 and Q3 2024, as elevated inflation and high interest rates continue to weigh on consumer spending.”

Speaking of inflation, the May Consumer Price Index (CPI) remained flat over April and rose 3.3% over the prior year — a deceleration (not a drop) from April’s 0.3% month-over-month increase and 3.4% annual gain in prices. Both measures came in lower than economist expectations and had the lowest monthly headline reading since July 2022.

A decline in energy prices, led by a drop in gas prices, contributed to further downward pressure on headline CPI.

The “core” index, which strips out costs of food and gas, showed prices in May climbed 0.2% over the prior month, the lowest monthly core reading since June 2023, and 3.4% over last year, again lower than economist estimates.

Of course, “official” government numbers don’t always reflect the experience of the average citizen. Several years ago, the “Big Mac” index was developed to measure the impact of inflation on lifestyles across the globe as McDonald’s has restaurants throughout the world. The website Fastfoodmenuprices.com has taken the Big Mac Index a step further.

While these numbers will have no influence on Fed policy, they certainly do have an influence on our current spending and perhaps even retirement planning decisions.

In fact, a new study published by Northwestern Mutual found that the “magic number” Americans believe they need to retire comfortably hit $1.46 million this year, the highest level on record. The figure represents a nearly 15% jump from the $1.27 million that Americans said they needed in 2023, thereby easily surpassing the current official 3% inflation rate.

Over the past five years, Americans’ “magic number” has surged 53% from the $951,000 reported in 2020, according to Northwestern Mutual. We don’t know how those surveyed derived those numbers and it’s likely many of them haven’t had the benefit of a Financial Review. Still, it is telling that people are feeling the impact of rising prices and that impact is weighing on their views of retirement.

And Then There Was One

Unlike 2023, the “Magnificent 7” were spotty performers versus the S&P and Nasdaq during the first quarter. Only three significantly outperformed while two not only lagged but turned in losses for the quarter.

That turned around in Q2 as the Magnificent 7 rode again with five of the seven besting both indexes. NVIDIA returned another 36% on top of the prior quarter’s 82% gain for a total year-to-date of just under 150%. That’s over 100% more than the next best performance from a Magnificent 7 member (and Tesla was down over 20%).

Can NVIDIA defy history?

What we are seeing today is very similar to what we saw in the late 90’s when it became clear that the internet would have a growing presence in our economy. Powered by an army of online day-traders using platforms like E-trade, ScottTrade, and Ameritrade, internet-related companies saw their stock prices soar to unsustainable levels. Many of these companies were not profitable and eventually prices came into alignment with fundamentals. This derating led to an approximate 77% drop in the NASDAQ Composite Index and many of the dot-com companies went bankrupt. To be fair, rising interest rates and the onset of a recession in Japan also played a part in triggering the downswing.

Source: Wikimedia Commons

It is often said that history doesn’t repeat itself, but it often rhymes. Unlike many of the “Internet Unicorns” of the late 1990s, NVIDIA is growing and profitable. It has reported triple-digit year-over-year sales growth in each of the last four quarters. and earnings grew by 790% over the past year. Still, by many measures, its price has gotten ahead of the performance of the company.

For example, NVIDIA’s Price to Sales ratio (P/S), is presently around 38 but had been in the 40s before the latest pullback. Price to Sales is a simple ratio that tells us how much investors are paying for a dollar of sales. So, anyone buying NVIDIA stock today is paying $38 for every dollar of sales NVIDIA generates. By comparison, here are the current P/S ratios for the other members of the Magnificent 7:

• Alphabet: 7.4
• Amazon: 3.5
• Apple: 8.6
• Meta: 9.2
• Microsoft: 14.0
• Tesla: 6.6

The P/S ratios of the other six average out to 8.2, which implies that if NVIDIA were to trade in line with the other six companies, its price would have to drop to around 80% from where it’s trading today. (Although it’s worth noting that these P/S ratios are backward looking. If we accept the sales growth estimates currently in place for Nvidia, the P/S ratios grow much closer looking out as little as two years into the future.) As we have quoted before, in the short term the stock market is a voting machine, but in the long term it’s a weighing machine and eventually the scales will be brought into balance.

To be sure, there are other metrics involved in the valuation of the stock of any company. Our own favorite valuation metric, Cash-Flow Return on Investment, indicates that the stock price could go higher. Still, artificial intelligence is an investment meme right now. NVIDIA’s current rates of sales growth won’t last forever, and it may only take one bad quarter to turn the Fear of Missing Out into the Fear of Loss and send the stock price lower.

Growth investing is exciting when it’s working but it can be devastating for people counting on annual portfolio growth to keep up with their spending. This is a concern that we have echoed repeatedly since we started composing our client letters.

Per Investopedia:

The (S&P 500) index has returned a historic annualized average return of around 10.26% since its 1957 inception through the end of 2023. However, while these statistics can make it seem like the stock market marches higher almost every year, stocks tend to move sideways quite a bit of the time. Averages of any kind can be deceiving and a 10% average return for an index doesn’t mean you make 10% each year. Some years you are making 20% or 30%. In other years, you watch your account drop, and in other years all you get are dividends with no gains.

Source: NYU Sloan School of Business

As highlighted in the graph below, most of the progress in the stock market over the last 150 years has come in three big moves: mid-40s to mid-60s, 80s-2000, and 2010 to now. The rest of the time stocks moved sideways, with little growth, sometimes for decades. During such times, dividends would be the primary source, if not the only source, of investment returns.

Larger view: Historical Average Stock Market Returns for S&P 500.

Over the long term and depending on when you started, U.S. stocks might return 10% a year on average. But in any given year, as shown previously, their performance could diverge from that average quite dramatically. The table below lists some of the market’s biggest annual wins and losses during the modern era.

Imagine needing to withdraw some of your money at a time when your portfolio has lost a third of its value, or just simply sitting through a period when your portfolio loses a third of its value. Many people have found out the hard way that they’re not able to stomach market volatility and they end up pulling chunks of money out of the stock market and locking in those losses for good.

Nobody can predict the length or severity of a downturn. In 2020, we believed that the sell-off was panic-induced, not helped by the various experts and news outlets who seemed to contradict themselves hour by hour. Once the general public figured out that COVID was not going to end life on earth and that oceans of government stimulus were flooding the world economy, stocks quickly recovered and headed to new highs. Downturns like the 2008 Housing Bubble lasted a lot longer and the recovery was much slower led by the Nasdaq 100 in the “new normal of ultra-low interest rates (green line) that lasted until 2022.

All three indices dropped in 2022 but started to turn around in October of that year after the Fed announced a “pause” in their interest rate hikes and has since recovered to new all-time highs in 2024 with great fanfare.

There’s just one inconvenient fact that these celebrations ignore.

Back to Inflation

Above, we spoke about the impact of inflation on our daily cost of living, but we also have to consider the impact of inflation on our investment strategies.

Looking again at the history of the S&P 500, this time over the last 40 years, we can adjust returns for inflation:

Source: NYU Sloan School of Business

Annualized Nominal Rate of Return: 11.23%

Annualized Inflation Adjusted Rate of Return: 8.18%

In other words, inflation has reduced annual returns by more than 300 basis points (3.00%) over the last forty years. While a 3.0% difference may not sound like much at first, the graph above shows how devastating inflation can be over longer time frames. In our example here, it comes out to a difference of $6.4 million based on an initial $100,000 investment.

As an investor, therefore, inflation must be considered. That’s why we inflation adjust all the numbers that we use in our Financial Reviews. And the irregularity of returns is why we stress test with the Monte Carlo simulations.

Having a solid mix of different assets can help smooth out the annual ups and downs of the various markets, give you liquidity no matter what’s happening, and with proper management, can keep your wealth growing.

There are three general threats to financial independence and a comfortable retirement, longevity, inflation, and market volatility. This is why we start with the Financial Review so that investment allocations can be better aligned with both short and long-term cash flow needs.

Like most endeavors, the pursuit of financial independence is a balance of paying attention to what is happening now while preparing for what will happen next. Most individual investors are solely focused on what’s “hot” now:

dot com

pot stocks

Blockchain

electric vehicles

AI?

This is one reason why the average investor underperforms the market by a wide margin.

Recent findings indicate that 56% of American workers feel behind where they think they should be on their retirement savings, including 37% who feel “significantly behind.”, in this, arguably the most prosperous nation on the planet.

While we all “know” of someone who put all of their money in XYZ stock and became a multi-millionaire “overnight”, very few of us actually know someone who’s done that. Building wealth and achieving financial independence begins with “What’s Next” as opposed to “What’s Now” to position yourself for managing through future uncertainties.

Our goal is not to beat a market index in any given year but to help our clients achieve their financial goals over the long term.

Many thanks for letting us play a part in helping you to achieve your investment goals.

God bless,

Tom

Post from: Insights