Q2 2024 Commentary
It feels like we have been here before.
In the first quarter of 2021, a relentless rally in risk assets pushed the S&P 500 to a Price/Peak Earnings multiple of 27.5 – a level not seen since the days of the dotcom bubble.
The Covid-19 vaccine was being rolled out, life was returning to normal, and massive amounts of monetary and fiscal stimulus were working their way into the economy, with more set to come. Most importantly for markets, quarterly corporate profits had fully recovered from their pandemic declines.
We had long believed that combined monetary and fiscal stimulus measures have the ability to fuel multi-year bull markets. The pandemic-era stimulus, which was comprised of unprecedented global government spending, sub-1% yields on domestic 10-year treasuries and negative interest rates in several developed economies, certainly fit the bill. Given the extraordinary magnitude of the stimulus, there was no certainty about how far or how long the rally could go.
The massive liquidity also fueled the speculative hype that grew into sensations like the SPAC boom and the ARK innovation ETF – investment movements ambivalent to corporate profits. This aspect of the rally allowed for parallels to the dotcom bubble, which had seen the Price/Peak earnings ratio approach 35.
When faced with the choice of following an uncertain rally or selling at historically unsustainable prices, we chose the more conservative path. The speed and magnitude of the recovery had allowed our strategies to capture significant profits from our pandemic-era purchases, bringing our core client accounts to 100% cash allocations. That was the first time that accounts following these strategies had been fully allocated to cash since 1998 (prior to the incarnation of this firm).
In our Q1 2021 commentary, we discussed our conservative positioning while acknowledging the uncertain upside potential, citing the performance of markets after 1998. Our qualified take proved warranted. Earnings grew throughout the year as the economy recovered, price multiples grew at nearly the same rate, and the S&P 500 rallied nearly 20% over the final nine months of 2021. The move brought the price/peak earnings ratio north of 30, making the market’s earlier skeptics look imprudently cautious.
The following nine months were a different story. The S&P 500 saw a peak-to-trough decline of more than 25%, wiping out all of 2021’s gains and then some. It turned out that rampant optimism and historically high P/E multiples were not sustainable after all.
More than three years have passed, and markets are right back where they were in early 2021 – trading at a price/peak earnings multiple that has never before been sustainable.
There are aspects of the recent bubble that set it apart from the fiasco in 2021. This time around, rather than an “everything” bubble with major influences from unprofitable tech companies, the latest gains have been concentrated amongst some of the largest and most profitable companies. To illustrate the dichotomy: the ARKK ETF, the posterchild of the last rally, fell 16% in the first half of 2024, while the “magnificent seven” mega-cap stocks, the torchbearers of the current rally, rose 35%.
While price speculation in higher quality equities seems more rational than speculation in profitless names, it does not inoculate markets from significant downside risks. The dotcom bubble is remembered for the worthless companies whose prices skyrocketed because they added .com to their names, but much of the speculation found its way into the largest companies, with the market weight of the 10 largest S&P 500 companies rising to its highest level since the ”nifty fifty” era. Those high-quality companies were not immune from the dotcom losses. Of the five largest companies in 2000, Cisco famously fell 90%, Microsoft and General Electric lost more than 60%, and even “defensive” non-tech names Wal-Mart and Exxon declined more than 35%.
Though every asset bubble has similarities, every bubble is also different. Those differences are what allow for the speculation to run rampant. This market does not benefit from the monetary stimulus that fueled the 2021 bubble, but it does carry the hopes of the unlimited potential of Artificial Intelligence – which echo the hopes surrounding the dotcom bubble.
Unlike similar moments in 1998 and 2021, Time Overlay strategies are willing to take on some market risk at these levels. The historic concentration among the largest companies has left plenty of relative value elsewhere in our quality universe. We have sought to take advantage of the value disparities, adding to out-of-favor names early in the second quarter. Many of those positions have, so far, failed to meaningfully participate in the concentrated rally, but that is a symptom of this market environment. More than 75% of S&P 500 stocks are lagging the index year to date, and 45% of the largest 1000 stocks posted losses in the first half.
Despite extremely rich valuations, there are reasons for optimism going into the third quarter. Inflation is softening, and investors anticipate that the Federal Reserve will cut interest rates in September. At some point this quarter, S&P 500 earnings are expected to reach a new record high for the first time since 2022. Falling rates should benefit many out-of-favor sectors, and rising earnings could further support the broad advance in equities.
Optimism surrounding renewed earnings growth is another aspect of this market that mirrors 2000 and 2021. Both peaks occurred within a year of markets exiting an earnings recession and climbing to all-time highs. New highs in corporate earnings are not bearish, but markets getting ahead of themselves is. Before peaking, both tech bubbles gave one clear warning sign that prices had moved too quickly (which most investors mistook as good news): multiples began to decline.
Today, multiples continue to expand, and the gap between the strongest stocks and the rest of the market leaves plenty of room for consolidation to the upside. Earnings growth is expected to peak in the fourth quarter, and as long as growth can persist, it may be difficult to break the back of this bull market.
The earnings growth trajectory is not guaranteed, however. Most economic data is fairly resilient, but there are some emerging concerns from the labor market. The unemployment rate has risen by 0.6% over the last year. Increases of this magnitude have, more often than not, been accompanied by recessions and significant market declines. The “establishment” jobs report has been more encouraging, showing persistent labor market growth, but the rate of that growth has now slowed to pre-pandemic levels. The unemployment rate and the rate of job creation are not yet worrisome, but if trends continue, the Fed may find themselves cutting interest rates, not because inflation allows them to, but because economic weakness necessitates it.
Despite our long-term concerns, we are not afraid to participate in this market. Equities have been historically expensive for much of the last eight years, and we have taken advantage of buying opportunities when they have been presented. Time Overlay accounts enter the second half approximately 50% allocated to equities, providing us plenty of flexibility, regardless of the path markets take in the coming months.