Your Money, Your Update

A Quarterly Review of Investment Trends and Strategy From Our Investment Committee

Quarter 3, 2024

Join Bob Brown, CFP® and John Burke, two of Stone House’s Managing Partners, as they discuss major market happenings heading into the fourth quarter of 2024, including unemployment, Federal Reserve rate cut, stocks & bonds, and the upcoming election. Yes, they get into all of it! They also offer perspective on international markets and the global stock market.  

*Filmed on September 27, 2024

Q3 Update

As we close out the third quarter of 2024, we would like to provide an update on the current investment landscape and share key themes and ideas that may impact your portfolios in the coming months. For the first time in about fourteen months, the Federal Reserve changed their target interest rate, cutting it by 0.5%. The last change was July 2023 when they raised it by 0.25%; it was the first cut since March 2020 during the COVID monetary response. The Fed is likely to cut rates several times in the upcoming year to get their short-term rate closer to what is called the “neutral” rate where they’re not intending to slow nor boost economic output.

Of course, we have an upcoming election cycle which is front of mind for many investors with concerns about stock volatility as we near election day. Despite these concerns of an election and a slowing economy, all major stock indices were positive for the quarter. Small companies, as represented by the Russell 2000 index, advanced about 9%. US bonds, as represented by the US Aggregate Bond Index – also gained about 5% for the quarter which was the strongest return for bonds in several years.

Unemployment

As we examine why the Federal Reserve began its rate cutting cycle, let’s look at unemployment over a prolonged period in the United States. The Fed follows what’s called a dual mandate – to maintain maximum employment and keep prices stable. The Fed does this by controlling the money supply and interest rates while targeting inflation at 2%. Inflation has been running about 2.5-3% by most measures over the past month; so, while not yet at goal, it’s been steadily declining. At the same time, we’ve seen a rise in unemployment, signaling a weakening economy.

We can see from Exhibit 1 that unemployment has risen to about 4.2%. This move triggered the so-called Sahm Rule, created by economist, Claudia Sahm. This states that when we see the most recent three-month moving average of unemployment rise by more than 0.5% from a three-month moving average during any of the preceding twelve months, we should see the start of a recession. Every rule seems meant to be broken: Sahm herself appeared on CNBC on September 13th to discuss how she believes we don’t have an imminent recession. She sees the backdrop of this instance is different than in previous years. Looking at Exhibit 2, we see that companies through their commentary on earnings calls, have been reporting more ease in filling open positions. One of the major reasons the Fed raised interest rates was to get “slack in the labor market.” It would appear their objective has been achieved and Jerome Powell, Fed chair, in his most recent press conference, said the risks are now balanced between the labor market and inflation. This triggered their change in stance and resulted in a 0.5% September decrease. The expectation is this will continue until we reach the “neutral” rate.

Federal Reserve Rate Cut

With interest rate cuts happening, it’s interesting to look at history to see how asset classes have performed after rate cuts have begun. Fed rate cuts are expected to lower borrowing costs, which could stimulate economic growth and in turn support equity markets.

Stocks & Bonds

From a historical perspective, US bonds have performed well looking one year in the future after the first Fed rate cut, regardless of recession or growth. But stock performance comes down to what economic activity will be over the next twelve months. If we don’t have a recession, stock performance historically has been above average.

Long-term stock performance depends on valuation (how expensive relative to earnings vs. history are those stocks) and what is happening with earnings growth. We discussed last quarter that the valuation of US large capitalization stocks today is about 21-22 times their twelve-month earnings. Historically, when stocks are around that valuation, subsequent five-year forward returns are below average. We pointed out that valuations of small and international stocks are currently far lower than US large companies.

Global Stock Market

This chart gives a range of historical valuations and what we see is that inside the US, we’re well above average, but most global stocks outside of the US are at or below valuation history. This is helpful for us as we plan portfolio design; we need to have areas of the market which are seen as “value” stocks and not just momentum– oriented.

One of the many reasons the United States has been ahead of the rest of the world is the stimulus in the economy post– COVID as well as the capitalist bedrock of our companies. The US is still seen by most as the best place to do business globally.

Image source: https://dailyshotbrief.com/the-daily-shot-brief-august-30th-2024/

As shown in this chart, we’ve seen nice growth in corporate profits adjusted for inventory valuation and capital consumption, in contrast to economies like China which have struggled recently. Their economic output has been subpar and company performance has suffered. In the US, our corporate profits are at all-time highs; profit growth has been directly correlated with stock price changes over longer periods of time.

Upcoming Election

Lastly, we have an election coming in early November. Historically, election years can bring increased market volatility as investors react to potential policy changes. Over extended periods of time, there is little evidence of better market performance whether one party or the other holds the Presidency. So, while there can be short term volatility, we don’t believe trying to predict market returns vs. who becomes President is a winning strategy. That said, the parts of the market we’d own will vary depending on who’s at the helm. As we review data in an election year, we’re off to a strong start on the S&P500; the third strongest start of an election year through August.

Since 1928 there have been nine other instances of January to August returns of over 9.5% and all saw September to December returns with additional gains. Normally concern going into an event like the election leads to those concerns being released after the event, followed by higher stock prices. Of course, data like this is not conclusive but indicates there are strong reasons to look beyond the election at long– term returns.

Stone House Recap

In terms of our portfolio changes and positioning, we reduced stock concentration in our Diversidex® Portfolio in September. For example, our moderate risk portfolio on Diversidex® contains about 61% stock and 39% bond while that option with our Flex platform is running about 65% stock and 35% bond. We did slightly increase our international holdings and moved some assets from a growth tilt to a more value style.

We did “flex out” to a money market for about ten days in early August around the large drop in the Japanese stock market. This event held the potential for greater longer-term volatility but was resolved quickly, and we re-entered the market and have remained in stocks for the duration of the quarter.

Within our Essential portfolio, we now hold about 25% small and medium-sized stocks as well as about 35% in international markets. This contrasts to Diversidex® at about 15% small/medium and around 25% outside of the USA.

If you have any questions or would like to talk further, please contact your advisor.