Quarterly Letter to Clients
6/30/2024
Written by: Thomas Flaig, CFA
While the market averages are up for the year, activity has primarily been driven by a relatively narrow group of high-momentum stocks within the technology sector. There is currently a great deal of excitement over new developments in artificial intelligence, and many investors are quickly embracing it. The AI craze has driven the S&P 500 and Nasdaq indexes to new all-time highs. Unfortunately, many other industry sectors and individual stocks have been left in the dust so far this year. The great divide is clearly evident in the performance differential between the large capitalization S&P 500 index and the Russell 2000 small-cap. index. The Russell index is essentially flat year to date, while the S&P 500 index is up 14%. It is also noteworthy that nearly half of the S&P’s performance has come from only a half dozen names, including the star performer within the AI sector- Nvidia. An equal-weighted index of the same 500 S&P names is only up 5% year to date.
The evolution of artificial intelligence is still in its infancy, yet many companies across a broad spectrum of industries are hoping to eventually utilize it to improve their business operations. AI enables computers to analyze vast quantities of data at a lightning-fast pace. It operates in real-time and constantly adapts to new data inputs and utilizes software to execute tasks resembling human capabilities. The goal of AI is to recognize patterns and then make increasingly more accurate predictions or decisions. On its own or in combination with other technologies (e.g. sensors, geolocation devices, robotics), AI can perform tasks that might otherwise require human intervention. Digital assistants, GPS guidance and autonomous vehicles are just a few examples of where AI can be utilized. While it remains to be seen which sectors of the economy will benefit the most from advances in AI, there is currently somewhat of an arms race going on to acquire the technology (both specialized semiconductors and software) that will be necessary to implement these functions.
The U.S. economy has remained resilient through the first six months of the year. GDP advanced by 1.4% in the first quarter and is expected to increase by at least 2% in the second quarter. Employment trends have been steady and real household income levels are positive on a year-over-year basis. Consumer spending, however, has begun to show signs of slowing over the past couple of months. While inflation continues to moderate (the consumer price index was up 3.3% last month), it is still higher than the Federal Reserve’s target level of 2%. One of the stickiest components within the inflation figures is housing. Housing costs continue to increase as available inventory levels remain near historic lows. Homeowners who locked in 3% mortgage rates several years ago just aren’t interested in selling their existing home and moving somewhere else if it means having to take on a new mortgage loan, which carries an interest rate now approaching 7%. A relatively tight labor market is also making it difficult for homebuilders to find an adequate supply of construction workers.
Corporate profits increased by 7% from a year ago in the first quarter. The third quarter of 2023 seemed to have marked the bottom in terms of negative earnings comparisons. It is likely that we will see continued gains in earnings over the balance of this year as companies lap easier comparisons from a year ago. Valuation levels for the market are still somewhat elevated by historic standards. However, if earnings continue to expand there may be justification for current price levels. From a technical analysis perspective, it would be encouraging to see greater market breadth, with an expansion of the number of stocks and industry sectors that are participating in the current bull market rally. Market breadth has historically been an important characteristic of enduring bull markets. Lower interest rates could potentially provide the catalyst needed to generate greater enthusiasm for a broader spectrum of stock participation. Hopefully, inflation continues to recede and the Fed begins cutting its benchmark interest rate target soon.
