Enjoy the Silence

Market Update for the Quarter Ending
March 31, 2024

Business Exit Planning

Expectations are for a U.S. presidential election on the first Tuesday of November that will feature two incumbents. The candidates will square off for the second time in four years. With the primary season all but over, the general election has started earlier than ever before. As was the case in 2016 and 2020, we can expect a tight contest ahead, and political party control of the Senate and the House of Representatives are up for grabs. As one would expect, the political headlines are anything but quiet these days.

What has been eerily quiet in recent months, however, has been the volatility of the stock market. The Chicago Board Options Exchange Volatility Index, known as “The VIX”, measures the expectation for volatility of the S&P 500 Index over the next 30 days. Technically, the index tracks various options contracts where traders make bets (or hedges) on various market indices. A higher output implies higher volatility lies ahead, while lower output infers lower expected volatility.

As the most recent 5-year VIX chart shows below, the volatility was especially low during the first quarter and ended the quarter at 13.01. This 3-month period is lower than any time since the 2020 pandemic, meaning that financial markets have been quite calm. Idiosyncratic, company-specific factors have driven results, rather than macro-related events. Participation in the rally has been broader than last year. There have been winners and losers within the same industry, unlike last year when all big tech stocks outperformed. Thus, much of the volatility has been neutralized and offset with less impact on the VIX. Lower volatility correlates with greater returns historically and investors are hoping for more of the same going forward. A better than expected earnings season would bode well in the near-term. However, we would expect volatility to increase at some point and it has been slightly elevated in early April.

Above: The 5-year chart of the VIX Index. The VIX is lower than any point since the pandemic and showing that stock market volatility is down considerably.

Stocks continue to rally while bonds take a breather

The S&P 500 is off to an especially strong start this year and returned 10.5% during the first quarter. It was a first quarter that featured 22 record closes – the most since 1998. The rally that started in November has broadened out to include more than just the biggest technology companies. Traditional value sectors have performed nearly as well as last year’s growth winners. But, smaller companies have trailed a bit recently, with the Russell 2000 up only 5.1%. Concerns that interest rates could remain higher for longer mean that debt could remain more expensive and harder to come by – and smaller companies are more reliant on debt.

Despite the geopolitical events abroad, overseas markets performed well, as the MSCI EAFE Index increased 5.7% for the quarter. (The MSCI EAFE increased 10.1% when the stronger U.S. dollar is not taken into account.) Valuations remain favorable and any rotation from technology broadly favors foreign markets with more exposure to financial services, consumer cyclicals and healthcare. Emerging markets continue to lag, with the MSCI Emerging Markets index up only 2.3% for the first 3 months of the year. A massive reset has been in place with China’s pivot away from their decades-long push toward capitalism, troubling demographics, and an over-valued housing market.

Bonds took a breather and were flat during the first quarter, thanks to rising interest rates that were driven by economic strength and stickier than anticipated inflation. The Bloomberg US Aggregate Bond Index declined -0.7% during the first three months of the year. Nevertheless, yields are higher now than at any point in the last 20 years and fundamentals point to better returns ahead.

Interest rates higher for longer

Investors assumed back in November that the Federal Reserve would be cutting the overnight fed funds interest rate many times throughout this year in response to a steadily declining rate of inflation throughout 2023. However, inflation has been stickier in recent months (mostly due to services rather than goods) and remains slightly over the Fed’s target rate. Moreover, an economy that was forecasted to slow over the last year has continued to beat expectations. The job market remains strong and corporate earnings have reaccelerated in recent quarters. The Fed’s next move is likely to cut interest rates, but any expected cuts have been pushed to the back-end of the year.

It will be hard for the Fed to cut interest rates if inflation remains higher than target and the economy continues to expand. There may be only a couple rate cuts later this year, and the overnight rate could remain the same all year if the economy remains strong. The good news is that the Fed has the ability to cut rates quickly if necessary, which they have not been able to do for most of the last 15 years.

Global Asset Allocation Strategy

The global diversified strategy remains over-weight stocks, as it has since the October 2022 market bottom. Extra stock exposure lies mostly within domestic mid-sized companies. Small and mid-sized company valuation is considerably cheaper than domestic large companies. Also, traditional growth sectors, driven by Artificial Intelligence (AI) and semi-conductors, have expanded and are above target levels at this time.

Given the extra exposure to stocks, the level of bonds remains slightly underweight. The purpose of the bond portfolio is to provide yield and liquidity, and act as a buffer to more aggressive stocks. The threat of inflation showed once again to be fixed income’s worst enemy by pushing interest rates higher and limiting returns. Fortunately, the approximately 5.5% annualized yield has cushioned the bond portfolio sufficiently to absorb much of the damage, resulting in a bond portfolio that was relatively flat for the quarter. The expected return of the bond portfolio is quite favorable based on yield, elevated rates and low defaults.

We will continue to monitor and adjust risk when appropriate. Rebalancing is dictated by valuation, trend and expected returns of the underlying asset classes. The strategy invests with a 5-7 year time horizon and continued stock market upside could warrant a near-term reduction in risk.

Focused Equity Strategy

During the first quarter, the stock strategy sold, or trimmed positions that we felt had simply become too expensive and added proceeds to companies that have more attractive valuations.

In January, we trimmed McKesson (MCK) and added to Johnson & Johnson (JNJ). Both are companies we have owned for a long time. McKesson is a pharmaceutical distribution company that mostly ships drugs from manufacturers to pharmacies, along with various related services. The stock rallied after the company settled various lawsuits related to the distribution of prescription opioids several years ago. It’s valuation, as measured by its P/E ratio, is at the highest point in many years, and we felt that McKesson’s valuation did not justify the position size it held in most portfolios.

Johnson & Johson is a pharmaceutical and medical device company, having spun out its over-the-counter consumer products division. The company has a strong new drug discovery pipeline, along with strong growth, while its price and valuation have drifted down in recent years.

In March, we trimmed Merck (MRK) and added to Pfizer (PFE). Both are large pharmaceutical companies, but we believe that Merck is trading at a premium valuation relative to Pfizer and relative to its prospects for revenues and profits, while we think Pfizer is trading at a discount. This is a reversal of the trade we made nearly two years ago, when the roles were reversed. At that time, Pfizer was riding high on the sales of its Covid vaccine and treatment, while Merck’s vaccine efforts were unprofitable.

Also in March, we added to Barrick Gold (GOLD), a Canadian gold mining company with large operations in the US, Canada and Africa. These types of mining stocks serve multiple purposes in the portfolio, both as investments for future returns and as hedges against unexpected economic turbulence. Gold often rallies in times of inflation and in times of economic distress. Barrick is one of the best managed mining companies in the industry, but the discrepancy between the value of the stock and the price of gold is among the widest we have seen in years, in our opinion.

We also selectively added Toyota Motor to accounts that didn’t have it or that had an undersized position. Toyota, of course, needs no introduction as it is the most successful auto manufacturer in the world and currently has a renewed lineup of hybrid-electric vehicles.

As always, the strategy looks for companies that are trading at a discount to their intrinsic value, but have strong prospects and are well managed. At any one time, the portfolio will invest in 30-40 companies.

Accelerating earnings and potential rate cuts make for a strong economic backdrop

Aside from the 2020 Covid bounce-back, the 2009 recovery from the financial crisis, and the 1999 technology exuberance, we have just witnessed the most impressive consecutive 5-month stock performance of the last 30 years. The 22 record closes for the S&P 500 are the most in the first quarter since 1998. The S&P 500 eclipsed an 8% first quarter return for only the 17th time since 1950. While we are unlikely to see this performance continue, since 1950, stocks have generated a 9.7% return in the subsequent 3 quarters after posting at least an 8% quarterly return[1] [2].

Clearly, the trend is our friend, until it’s not. FOMO (Fear of Missing Out) and momentum are factors pushing stocks higher. But, the current backdrop of expanding corporate earnings combined with strong odds that the Fed will cut rates eventually has provided a powerful 1-2 punch that is rarely witnessed. We feel that earnings should beat expectations in the next 1-2 quarters. However, the Fed’s ability to lower the fed funds rate will be based on upcoming inflation data. Recent inflation data has been fair at best. But, as long as investors feel that the Fed’s next move is down, this should remain a positive environment for stocks.

Aside from stickier inflation, adverse geopolitical events bear watching, including rising commodity and energy prices. Crude oil is currently pushing $90/barrel and gold is at an all-time high. Headlines will likely be more negative and critical of various political policies with this being an election year. Politicians use fear to grab headlines and drive votes. And, the media runs with negative narratives since bad news creates more clicks and draws more attention.

We would not be surprised if there were a period of consolidation, or a normal market correction prior to the election. Regardless of the election, stocks generally experience a correction most calendar years, and stocks have extended far beyond the 50 and 200-day moving averages. But, once the political uncertainty is lifted after the November 4th election, it is quite common for the market to rally. We will continue to monitor events closely and adjust asset allocations based on what the environment dictates. The path of least resistance continues to be higher for now.

Feel free to reach out with any questions regarding financial markets and the economy, or your personal financial goals. We are always here to help!

[1] Blackrock; 4/4/24; Rick Rieder Fixed Income Report
[2] Barrons; 4/1/24; Teresa Rivas and Down Jones Market Data

All indices are unmanaged and investors cannot actually invest directly into an index. Unlike investments, indices do not incur management fees, charges, or expenses. Past performance does not guarantee future results. Certain sections of this commentary contain forward-looking statements that are based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is not indicative of future results.

Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is no guarantee of future results.