Quarterly Market Letter- Q2 2024

By Bruce Thompson on July 12, 2024

July Client Letter

“It’s an election year, and candidates can’t stop speaking about our country’s problems which, they would have you believe, only they can solve. As a result of this negative drumbeat, many Americans believe that their children will not live as well as they do,” and hold a pessimistic view of our economic future.

That message, written by Warren Buffet in his 2016 Letter to the Shareholders of Berkshire Hathaway, is just as relevant today. He goes on to state, “That view is dead wrong: the babies being born in America today are the luckiest crop in history. Today’s politicians need not shed tears for tomorrow’s children.”

Buffet backs up his opinion with some compelling math:

American Real GDP per capita is now about $56,000. In real [after inflation] terms, that is a staggering six times the amount [$8,825] in 1930, a leap far beyond the wildest dreams of my parents.

Some bemoan our current 2% per year growth in real GDP, but using some simple math, that growth rate delivers astounding gains. Our population is growing about .8% per year (.5% from net births and .3% from net immigration). Thus 2% of overall growth produces about 1.2% of per capita growth. In a single generation of 25 years, that rate of growth leads to a gain of 34.4% in real GDP per capita, and a staggering $19,000 increase in real GDP per capita for the next generation. Were that to be distributed equally, the gain would be $76,000 annually for a family of four.

Though the pie to be shared by the next generation will be far larger than today’s, how it will be divided will remain fiercely contentious. Clashes of that sort have forever been with us– and will forever continue.

The good news, however, is that even members of the “losing” sides will almost certainly enjoy– as they should– far more goods and services in the future than they have in the past. The quality of their increased bounty will also dramatically improve. Nothing rivals the market system in producing what people want– nor, even more so, in delivering what people don’t yet know they want. My parents, when young, could not envision a television set, nor did I, in my 50s, think I needed a personal computer. Both products, once people saw what they could do, quickly revolutionized their lives.

U.S. citizens are not intrinsically more intelligent today, nor do they work harder than did Americans in 1930. Rather, they work far more efficiently and thereby produce far more. This all-powerful trend is certain to continue; America’s economic magic remains alive and well.

For 240 years it’s been a terrible mistake to bet against America, and now is no time to start. America’s golden goose of commerce and innovation will continue to lay more and larger eggs. And, yes, America’s kids will live far better than their parents did.

Only time will prove Buffet’s math but, so far, his projections actually have been conservative as Real GDP Per Capita has grown by $11,748 to $67,748 in less than 8 years. This is all the more remarkable given that the economy has endured serious challenges brought by Covid, the erstwhile spike in inflation and interest rates, and two equity bear markets.

Moreover, to Buffet’s underlying message, the increase in GDP Per Capita since 2016 was evenly split between the last two administrations, which more or less has been the case for both the economy and stocks over time.

In his recent article, Stock Investors Have Already Won the Election, Morningstar’s head of research John Renkenthaler points out that the elections of the last several decades haven’t brought significant differences for the economy. “There is much sound—Democrats promise reform and redistribution, while Republicans protest about government interference and offer tax cuts—but there is little fury. No matter who wins [the upcoming election], the economic underpinnings remain largely intact. And those underpinnings have been very, very good for stock prices for several generations.”

He goes on to quip, “Good luck getting either side to admit that it assigns presidential responsibility for the economy only when doing so proves convenient.”  According to research from Forbes, from 1946 to 2020, stocks have returned 8.3% annually — 9% with Democrats and 7% with Republicans in the White House. But it is spurious to draw conclusions from that data, partly because it is impossible to separate the results during one administration from inherited economic policies and conditions, and partly because control of Congress is at least as important.

Assigning credit or blame also ignores numerous external factors over which presidents and political parties have little influence. A partial list includes management of credit conditions by the independent Fed, the state of global markets, population trends (think of the benevolent impact of the post war baby boom on markets), as well as the successive waves of innovation seeded long before by investments in education, science and technology. It also discounts the labor, ingenuity, and productivity of American workers on which our success has been based.

It’s important to remember that the success of our economy also is grounded on the strengths of our financial, legal, and democratic systems, built over two centuries by forward thinking people too numerous to name. Those institutions bend from time to time but have withstood many tempests. The integrity of and global trust in those institutions is critical to our economic success and underpins our influence and national security. That trust, for example, underwrites the position of the US dollar as the world’s reserve currency, allowing us to borrow so heavily in our own currency, leveraging the wealth creation cited by Buffet. It also affords the ability to gradually inflate away our debts and economic flexibility to recover more quickly from financial crises.

We also give credit to countless brave Americans, many of whom made the ultimate sacrifice to win and preserve our institutions and freedoms, and whose names we can never forget.

Perhaps the most confuting commentary on the relative economic sway of presidents is that, in that post WWII period, the stock market returned 12.9% annually when there were split governments, compared to 7.4% when a single party held both the Presidency and Congress. That’s too large a difference to be a coincidence; it speaks to the collective wisdom of the electorate, the strengths of our sometimes chaotic but ultimately effective systems, and the productivity of the American people.

It also suggests that we should guard against letting political beliefs and emotions around elections color our investment decisions, except perhaps at the margins. It’s easy to get caught up in the “negative drumbeat” during election years. But due to “recency bias”, as discussed in our June 2024 Client Letter, it often isn’t so easy to recall the challenges the country has experienced and overcome in the past, and that our system nevertheless has produced staggering growth across political and socio-economic changes.

As Renkenthaler writes, “There are many reasons to vote this November, but the performance of equities is not one of them.” That doesn’t mean there might not be emotion driven volatility, and that sector bets might not change with polls, but volatility is an ever-present risk in the markets which, in fact, underwrites the higher than riskless returns sought from equities over the long run.

Stick to the time-tested principles of diversification and investing within your risk capacity and the requirements of your financial plan. Above all else, don’t hesitate to call with questions. Our committed team of advisors are experts in guiding clients through uncertainties.

Market Update

Seinfeld fans might recall the episode, The Opposite, in which Jerry was forever “Even Steven.”  Whenever he lost something, a $20 bill, a comedy gig, a girlfriend, he gained something else of equal value. Economic policy and markets often involve tradeoffs like that as well, in which a positive in one area triggers a negative in another, and vice versa.

At the outset of 2024, many anticipated that the Fed would begin to cut interest rates by now. However, “stickiness” in inflation and resilience in employment and economic growth data have prompted the Fed to keep rates steady for now. Nevertheless, the headline stock market has reacted quite positively, perhaps because the underlying data show some signs of weakening, particularly in the all-important consumer sector. A negative is taken a positive!  

Moreover, investors may believe that if the economy weakens too much, the Fed now has ample room to respond by lowering rates. Headline inflation, which has declined significantly after the post-Covid spike, remains above the Fed’s preferred 2% target. Prices for many consumer goods and services have cooled. But, as emphasized in our recent letters, housing-related costs, which make up 45% of CPI, have remained stubbornly high.

Housing is an area in which Fed policy has had contrary effects. Higher mortgage rates have crimped both new home building and the supply of existing homes on the market, resulting in higher rents and property prices. Moreover, this indirectly affects the ability of the economy to adjust to tight labor conditions, as people are more reluctant to move to fill job openings.

Of course, clients who already own homes might feel sort of “Even Steven”! While general inflation over the last few years means living expenses are higher, increased real estate values have bolstered balance sheets. (Plus, if you’re not paying rent and you have a fixed mortgage, your personal inflation rate is probably a lot lower than CPI suggests.)

But for the next generation and for those who don’t own homes, the high cost of housing represents a significant challenge to Buffet’s premise. You don’t hear candidates talking about it much, maybe because it’s a bipartisan issue, but national policies designed to address housing shortages and costs will be crucual if the American dream is to be a reality for the next generation.

While investment returns for Q2 and the year to date have been positive, there were marked differences which you’ll want to be aware of. The MSCI ACWI, which LWM focuses on as most representative of globally diversified equity portfolios, notched a gain of 2.5% for the quarter and 10.5% so far this year.

For domestic stocks, the CRSP Total Market Index, which covers all capitalizations (large to small cap stocks) and selection styles (growth and value), returned 13.3% year to date. Uncertainty about the economic backdrop and interest rates led to uneven index results, however. As you can see in the table above, large company and growth stocks significantly outperformed small company and value stocks, which tend to be more sensitive to interest rates.

For example, as of mid-year the S&P 500 Index is up 15.3% while the Dow Jones is up just 4.8%. Over the very long run, those two indexes (the construction of which is explained here) have had similar returns. The S&P 500 is, on the face, more reflective of the broad market since it contains 500 stocks vs 30 for the Dow. But because it is capitalization weighted, this means that over the last several years the index has become more concentrated and skewed to the performance of a handful of large technology companies, dubbed the “Magnificent 7”.

While these companies have indeed experienced strong earnings growth, the growing popularity of indexing has resulted in geometrically bigger portions of dollars flowing into the largest companies’ stocks, and their valuations have grown faster than the market’s. According to JP Morgan Q3 2024 Guide to the Markets, so far in 2024, the Mag 7 stocks have returned 33% while the rest of the S&P 500 index is up just 5% (similar to the Dow).

Let the buyer beware — this also means that their stock prices are more negatively impacted when money flows out of the index. For example, during the 2022 bear market, as a group the “Magnificent 7” stocks dropped 40% compared to a decline of just 8% for the remainder of the S&P 500 Index! (JP Morgan Q3 2024 Guide to the Markets).

Maintaining diversification across various types of stocks (and asset classes), as reflected in your portfolio, is a “least regret” approach to balancing the risks we face and the returns we seek. At some point though, price does matter. The good news is that, as noted in Blackrock’s Q3 2024 Outlook, the largest 7 stocks in the S&P 500 Index are currently valued at 34x earnings, while the remaining 493 stocks are valued at a more reasonable 17x earnings.

This isn’t a foregone prediction, but if interest rates do eventually trend lower, overlooked value and smaller cap stocks may outperform the market. That includes financial companies, which make up a big part of the Dow, and Real Estate Investment Trusts (REITS), where has been most impacted by higher rates.

Beyond our shores, through the first half of the year, the international stock MSCI ACWI ex USA Index returned 5.7%. International stocks have been impacted by a strengthening dollar as British and European central banks have cut rates while the Fed has held the line. Adjusting for currency, foreign stocks returned 11.1% through mid-year.

Again, if price is any object, the MSCI ACWI ex USA Index trades at a relatively attractive 13.5x, a 36% discount to the S&P 500 Index, and a 60% discount to the Mag 7 stocks. Foreign stocks also provide superior dividend yields at 3.2% vs 1.4% for the S&P. Given the currency dynamics, any shift to lowering rates in the US would be a beneficial catalyst.

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