Economic Data: Getting Cooler

Despite the recent heat wave roiling the U.S., this month also brought data supporting the Fed’s soft landing narrative. May’s CPI was cooler than expected, with core CPI at its lowest since August 2021. Likewise, pending home sales were at their slowest pace since 2001. The May Core PCE reading of 2.6% over the past twelve months met expectations. Economists broadly expect price pressures to continue to fall in the latter half of 2024, with further consumer goods discounting in June and ongoing disinflation in services. Alas, the data was not ice cold: May nonfarm payrolls and average hourly wage data exceeded expectations, which bolsters the Fed’s case for sticking with the higher-for-longer stance.

Given the disinflation trend, cooling labor markets, and weaker economic data, markets are now pricing in a 67% chance of a September rate cut, up from 45% at the beginning of the month. The June FOMC meeting concluded with projections indicating just one rate cut this year, down from three projected in March.

Investing at the Top: Should you wait for a pullback?

One of the most common challenges for investors is timing. Behavioral finance research suggests that we often fall prey to a phenomenon known as “Anchoring”, where we consciously or unconsciously use a fixed reference point (the “anchor”) as the context for determining relative value. This can be helpful in short term decisions, such as determining which cuts of steak are on sale when shopping for a holiday barbecue. However, this bias is less helpful for long-term investing as it often leads to investors sitting on the sideline while waiting for the “right” time to commit.

Many investors look at the current price of an index, like the S&P 500, and see reports of all-time highs as a reason to wait. However, research indicates that investing at all-time highs is a reasonable strategy. Market highs tend to occur in clusters and strong performance runs are often followed by further highs.

Since the start of the year, there have been a whopping 31 new all-time highs in the S&P 500. As one will note looking at the chart below, historically 30% of the time these all-time high moments created a new “floor” (highlighted in green) which the market subsequently didn’t fall below. Indeed, research done by JP Morgan indicates that investors who bought at S&P 500 peaks since 1950 did better in the 1-, 2-, 3-, and 5-year periods that followed compared investors who bought at the average price during each of those periods.

Investors waiting for an ideal moment often miss out on the opportunity to participate in rising markets. Missing even a small number of days in any given market cycle tends to result in lower returns compared to those who remain fully invested. As we have noted previously, missing the 30 best days in the S&P 500 over the last 30 years would have resulted in less than half the return of those who were fully invested over the entire time period.

Investors with a long time horizon should heed the adage “Time in the market is more important than timing the market”.

 

Capital Markets

In June, enthusiasm for AI was evident as Nvidia surpassed Microsoft mid-month to become the world’s most valuable company. However, Nvidia’s shares subsequently dropped over 15% due to concerns about extended valuations, an overcrowded trade, and a concentrated revenue base. Meanwhile, Apple’s shares rose nearly 10% after announcing several AI integrations into its platforms, including a partnership with OpenAI to incorporate ChatGPT into Siri and other applications.

Equity returns were mixed in June. The All-Country World Index (ACWI) rose 2.3% and the S&P 500 rose 3.6%, while the EAFE and U.S. small caps fell -1.6% and -0.9%, respectively. There continues to be a wide dispersion both in valuation and performance between the large and small cap stocks. Emerging markets rebounded upward nearly 4% after falling last month on slower growth expectations in China.

Big Tech: Big Earnings

The S&P 500 constituents closed out the first quarter with strong earnings. The Q1 blended growth rate for S&P 500 companies reached 5.9%, the highest since Q1 2022 and significantly above the 3.4% analysts expected as of March 31.

Notably, when excluding the “Magnificent 7” companies, the blended earnings growth rate for the rest of the S&P 500 was -1.80%. Those 7 stocks alone swung the S&P 500 earnings by over 7%! In that context, it doesn’t seem unreasonable for the companies generating a disproportionate amount of earnings to see a disproportionate amount of affection from investors. Accordingly, in May, “Big Tech” stocks posted outsized gains relative to the rest of the market, with more than half of the S&P 500’s returns coming from NVIDIA (+27%), Apple (+13%), Microsoft (+7%) and Alphabet (+6%).

The Evolution of Trade Settlement

Effective May 28th, U.S. security trades shortened standard trade settlement to one business day (T+1) from two (T+2). For those unfamiliar with the term, the settlement period is the time between when a security is bought or sold and when the trade is considered final. During this window of time, the buyer must make the payment and the seller must deliver the securities.

The change received little attention from the media, however it has subtle but important ramifications for investors. To understand why, we need to look at a brief history of stock trading in the U.S.

 

 

The New York Stock Exchange began trading in 1817 with paper stock certificates which would require physical delivery for the next 150 years. In the early years, settlement could take up to 30 days. By 1952 train and airplane travel shortened settlement time to just two days (T+2). However, as overall volume of trading increased, settlement times became longer and a surge in trading in 1968 overwhelmed Wall Street with paperwork. Five business days settlement became the norm due to a shortage of couriers to transport bags of checks and stock certificates. This led to frequent Wednesday closures to settle trades.

With the advent of fax machines and the 1973 founding of the Depository Trust & Clearing Corporation (DTCC), electronic book entry transfer of securities allowed settlement periods to shorten. By 1993, the standard settlement time improved to three business days (T+3), a standard that remained for another 24 years until it dropped to two business days (T+2) in 2017. (Readers who noted the timeline above may be amused to note that it took 55 years of technological advances in processing trades to get back to the same two-day settlement period the U.S. had in 1952!)

Trading volumes continue to rise each year. To address this, securities exchanges have turned to machine learning. This technology analyzes data to identify patterns and allow most trades to settle through “straight-through” processing, where trades are executed, confirmed and settled without human intervention. As AI pushes the boundaries for the speed of crunching large amounts of data, we may eventually see trades settle on the same day.

What does a shorter settlement time mean for investors?

A shorter settlement period has three primary benefits:

1. Improved capital market efficiency. Shorter settlement times result in increased liquidity, as cash is freed up more quickly post-trade. This gives investors the freedom to reinvest or spend the proceeds from their investments sooner.
2. Reduced counterparty risk. Shorter settlement time reduces default risk by the other party involved in the trade, as well as the perceived risk of potential for default which can lead to actual illiquidity. A recent example of this was in 2020, where a perceived lack of liquidity in the less newsworthy investment grade bond market led to wild swings in prices. The Fed took the unusual step of announcing they were willing to buy baskets of corporate bonds and backstop municipal issuers, effectively creating an additional risk-free counterparty. Almost immediately thereafter liquidity resumed and volatility fell as investors were reassured.
3. Less time for market volatility and black swan events to affect the execution of trades. Shorter settlement times reduce the likelihood of a repeat of the “short squeeze” of January 2021 which caused a rise in meme stocks of broken companies like Gamestop. While there is no quick fix for social media hype and rampant option speculation, relieving some of the forced buying by market makers will make these types of pump-and-dump strategies less profitable than they have been in the past.

Capital Markets

Major U.S. indices closed higher in May, following a weak April. The S&P 500 and Nasdaq saw five consecutive weeks of gains before declining during the last week of the month. In May, the All-Country World Index (ACWI) rose 4.3%, the S&P 500 rose 4.8%, the EAFE rose 4.1%. and U.S. small caps rose 4.9%. Emerging market lagged, rising just 0.61% as slowing growth in China led stocks lower.

The May 1^st Fed meeting concluded with no change to the policy rate, which remains at 5.25-5.5%. Prior to the meeting, there was some concern the Fed might shift its stance after recent data suggested inflation ticked up slightly and Fed Governor Bowman indicated higher rates were a possibility.

However, Powell made a point of saying that he doesn’t believe the next policy rate move will be a hike and that he expects the Fed to gain confidence in a cut based on expectations of further disinflation and a more balanced labor market. The net result was a continuation of the Fed’s “watch and wait” posture.

How Political Leanings Skew Perception of the Economy

As we have noted in other recent Monthly Economic Updates, investors often perceive the health of the economy based on political affiliation. The onslaught of disinformation, AI-generated content, and click-bait skews people’s biases even further.

As shown in the chart below, a recent update of a survey by Pew Research Center confirms that Republicans tend to view the economy more favorably when a Republican is in the White House, and likewise for Democrats when the situation is reversed.

Although the average annual returns on the S&P 500 during the Obama administration (+16.3%) and during the Trump administration (+16.0%) were nearly indistinguishable and exceeded the average return over the past three decades, perception of leadership drove sentiment more than actual economic results or stock market performance.

 

Eagle-eyed readers will also note that perception of economic conditions often changed immediately following election day or soon after, rather than after a President’s policies actually had any influence over the economy.

Is Consumer Sentiment a reliable Predictor of Market Returns?

Famed investor John Templeton once quipped: “Bull markets are born in pessimism, grow on skepticism, mature on optimism and die on euphoria. The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell.”

As the chart below shows, over the last 60 years, the 12 months that followed a pessimistic period when consumer sentiment was low were often followed by outsized returns in the S&P 500 (+24.1% on average). By contrast, the twelve months that followed consumer sentiment peaks saw much lower returns (+3.5% on average).

 

The troughs in sentiment had only a modest correlation with periods of actual economic weakness, with only 4 of the troughs occurring during recessions. Likewise, sentiment was often quite high shortly before a recession was about to begin.

This inconsistency is yet another reminder that how one feels when watching the news is not a predictor of future returns. Regardless of how chaotic geopolitical events are here and abroad, staying invested and separating your feelings from your investment strategy is a prudent approach to building wealth.

Capital Markets

The S&P 500 closed at a new record high of 5,254 at the end of March before momentum reversed resulting in the major indices giving back some of the earlier Q1 gains. During April, the All-Country World Index (ACWI) declined -3.53%, the S&P 500 fell -4.51%, the EAFE fell -2.59%. and U.S. small caps forfeited all their 2024 gains in a -7.4% drop. Emerging market equities were the only area of strength, rising +0.48% for the month.