Q2 Letter - 2024
Q2’2024 Recap: The Rally Continues
The US equity markets remained strong through Q2, fueled by inflation continuing to glide down which subsequently decreases the risk that the Fed will have to keep rates higher for longer. As a result, investor and consumer confidence has improved in anticipation of rate cuts, which has translated through to US consumer data remaining resilient. June retail sales surprised to the upside (0.9% growth versus expectations for 0.2% growth) plus April and May were both revised higher by 0.2%. Furthermore, the manufacturing sector finally showed a spark in activity, rising 0.4% month-over-month in June. These better-than-expected data point in retail sales and industrial production have boosted estimates for US GDP growth in Q2’24 to likely come in at the high-end of estimates, which analysts have called for roughly 1.9% - 2.3% GDP growth. GDP growth above 2.0% would be indicative of an economy that has cooled from last year, but is still healthy as it is expanding modestly.
We’re now in the middle of Q2 2024 earnings reports, and while the forward 12-month P/E ratio for S&P 500 companies is at 21.2x, above the 5-year average of 19.3x, it can be justified given the earnings growth for this quarter is expected to be 9.7% year-over-year, which would be the highest growth rate in over 2-years (Q1’22 = 9.4%). We believe year-over-year growth in earnings will be at or above 10.5% for the second quarter given analyst estimates are often conservative. Over the past ten years, actual earnings reported by S&P 500 companies have exceeded estimated earnings by 6.8% on average, and 74% of companies have reported actual EPS above the mean.
This reacceleration in earnings growth is obviously bullish and at least partially explanatory for valuations to be above their 5-year average P/E multiple. When adjusting for growth and looking at each sector, we can see that the largest sector in the S&P 500, Information Technology, is trading in the 73rd percentile for its price-to-earnings growth ratio, only slightly elevated against the last 30 years, but very low for the communications sector in the 13th percentile (see graph below). Knowing this makes valuation much more justifiable when considering the growth that these companies are expected to produce. While important to be aware of and monitor closely, valuations are not signals for timing the market. Wouldn’t it be nice if stock-picking was as easy as buying the stocks with the lowest P/E multiples?
What about picking the stocks with the highest earnings growth rates? It is well-known that the large technology stocks, the Magnificent Seven, have been largely responsible for the returns of the S&P 500 since 2023. There’s a good reason for this; their earnings have also increased much more rapidly than the majority of the other stocks in the S&P 500. This quarter, Nvidia, Amazon, Meta, and Google will report 56.4% year-on-year earnings growth while the other 496 companies will report growth of approximately 5.7%.
However, even those seemingly invincible, large technology companies can't defy the law of large numbers, making it increasingly difficult to sustain their current growth rates. Next year, they will face tougher comparisons due to the significant benefits they have reaped from the booming AI-driven capital expenditure cycle. Meanwhile, the growth rate for the other 496 companies is projected to rise from 5.7% in Q2 2024 to 15.6% by Q4 2024. In contrast, the growth rate for Nvidia, Amazon, Meta, and Google is expected to decline from 56.4% to 28.4% (see below). To be clear, we firmly believe in the transformative impact AI is going to have on our economy through the foreseeable future. But we have conviction in the AI theme benefiting not just tech, but across sectors that are responsible for the buildout of infrastructure and the heightened energy demand driven by AI proliferation, thereby opening up opportunities outside of tech alone.
Breadth Breakout – Welcome to the Show!
The markets are now pricing in a 94.0% chance that the Federal Reserve will cut the Federal funds rate by 0.25%, which is the interest rate at which banks lend reserve balances to other banks overnight (short duration borrowing). Changes in the federal funds rate can lead to changes in the prime rate, which banks use as a base rate for consumer and business loans, and thus has significant impacts across the global economy. As the Fed embarks on a rate-cutting cycle, markets typically cheer it initially. Even if they are cutting rates for the wrong reasons (growth concerns) markets will likely remain favorable even for a short period after the cuts begin. Since essentially the beginning of July, we have seen the smaller companies be bigger beneficiaries from rates dropping precipitously; 10-year Treasury yields have fallen from 4.46% to 4.20%; likewise, 2-year yields have fallen from 4.76% to 4.45%. Smaller companies are generally more rate sensitive than large-caps because they tend to carry more leverage and are more likely to be financed with floating rate debt. As such, a move down in rates can have more dramatic effects on small-cap sentiment and thus price momentum.
We believe the labor market remains strong due to improving sentiment and structural dynamics, despite the unemployment rate rising from a cycle low of 3.4% to 4.1%. It's likely that labor market dynamics will stay tight compared to historical standards and not exceed 4.5%, well-below the last ~30-year average of 5.8%, especially if the Federal Reserve begins loosening financial conditions in September. Importantly, market price action also suggests this outlook. The broadening stock market rally has triggered a rare bullish signal, the Whaley Breadth Thrust Indicator, due to a sharp increase in stock participation outside of the mega tech names, indicating the potential for significant gains ahead. It's the 15th time the indicator has flashed since the S&P 500's inception in 1950, and stocks returns have been positive 100% of the previous 14 times on a 12-month forward basis, and 13/14 times on a 6-month forward basis. The indicator has delivered an average one-year return of 23% for the S&P 500, as well as an average six-month gain of 17.4%.
The indicator is triggered when the number of five-day advancing stocks in the market exceeds the number of five-day declining stocks by roughly 3-to-1. Essentially, the rally has expanded from extremely narrow to very broad in a short period of time. The last time the Whaley Breadth Thrust signal triggered was November 3, 2023. Since then, stocks have surged roughly 20%. See below chart of S&P 500 returns over various time periods after this indicator has been triggered.
This phenomenon could be attributed to behavioral factors such as investor psychology and the tendency to chase winners (herding), leading to momentum that may not yet be justified by earnings. However, momentum is a well-documented and significant factor in returns. Coupled with the forecasted increase in earnings expectations and the attractive valuations of small-cap stocks relative to mega-cap technology companies, this small-cap rally and rotation could be just the beginning. While price momentum provides valuable insights and can enhance investment strategies, it is crucial to recognize its limitations and the potential for reversals. Therefore, it is only one component of our risk-management framework.
Responsible portfolio risk management requires constant vigilance to potential shocks, a proactive reduction in portfolio volatility as the likelihood of external threats rises, and a keen awareness of events and data that influence markets to understand what is already priced into various asset classes, not just stocks. A trend we’ve already mentioned and are monitoring closely is the recent increase in unemployment, which could raise concerns about consumers’ ability to spend and drive growth. However, we believe the labor market is normalizing, not breaking. Demographic tailwinds remain strong, consumer balance sheets are all-time robust, and sentiment appears more likely to improve than deteriorate into the 2nd half of the year. Additionally, it is difficult to get negative on the market when breadth finally begins to get going, as that has historically been a very encouraging sign when there’s notable strength from many of the lagging sectors.
As has always been the case, we will continue to remain in the "ready position" to act if risks materialize such as if the labor market showed signs of weakening beyond a normalized level. It’s important to note that the Fed is acting from a position of strength given they can loosen financial conditions quickly if they believe the labor market is beginning to deteriorate. Consequently, even if inflation remains around 3%, that’s not high enough for the Fed to ignore unemployment concerns. In such an environment, owning assets like stocks is crucial as the value of cash decreases. There’s an argument to be made that asset prices are likely to be supported even if demand cools, given the Fed's ability to lower interest rates from their current levels. In that scenario, certain companies will benefit more than others which makes our job as asset allocators even more valuable.
We are grateful for the trust that you have placed in us to monitor these conditions affecting the financial markets, and we look forward to continuing to serve as your partner in achieving your financial goals. If you have any questions or concerns, please do not hesitate to contact us.
Information presented reflects the personal opinions, viewpoints and analyses of the employees of Mirador Capital Partners, LP, an SEC-registered Investment Adviser. The views reflected in the commentary are subject to change at any time without notice. Nothing herein constitutes investment advice, performance data or any recommendation that any particular security, portfolio of securities, transaction or investment strategy is suitable for any specific person. Any mention of a particular security and related performance data is not a recommendation to buy or sell that security. Mirador Capital Partners, LP manages its clients’ accounts using a variety of investment techniques and strategies, which are not necessarily discussed in the commentary. Investments in securities involve the risk of loss. Past performance is no guarantee of future results. Visit us at miradorcp.com for more information.