How is it already July? Some posit that time seems to accelerate because each successive year represents a smaller fraction of our lifetime. In briefer contexts, the perception of time seems to depend on where you sit. For example, during the recent deciding Game 7 of the National Hockey League’s Stanley Cup Finals, the Florida Panthers led the Edmonton Oilers 2-1 early in the final 20-minute period. The announcer insightfully observed that Edmonton players and coaches likely saw the clock flying by (their time running out), while to the Florida side it seemed to crawl. (Florida outlasted the clock, hanging on to win 2-1 and taking its first-ever championship.)
Another Banner Quarter for Stocks
Time moves briskly for investors when stock indexes are surging upward as they have in 2024, and while the pace of the rise moderated in the second quarter, equity markets still did well. The leading global benchmark added about 3%, taking its year-to-date gain to nearly 12%. Meanwhile, the S&P 500 US large cap index did better still as the usual tech giants fueled a 4.3% second quarter rise, bringing the year-to-date return to a heady 15.3%. Since the 2022 financial markets debacle, the S&P 500 is up a remarkable 45.6%
Bond returns remained lackluster in the second quarter, as interest income mostly offset modest bond price declines. But stellar stock market returns were enough for balanced portfolios to deliver solid returns in the second quarter and for 2024 year-to-date.
Both stocks and bonds may benefit from newfound, if cautious, optimism that the economy will achieve a soft landing, bringing inflation back toward central bank targets without a near-term recession. For a more detailed discussion on the economy and financial markets, be sure to see our accompanying quarterly Economic and Market Review.
Curbing Our Enthusiasm
To put recent equity market returns in perspective, US stocks have compounded at an average rate of about 10% per year over the past century, so we’ve seen about four years’ worth of normal returns in just the past 18 months. As usual, we have no crystal ball—returns over the next 3, 6, or 12 months could fall anywhere on the map. But common sense tells us that in an economy growing at its long-term trend rate of about 2% per year (net of inflation), recent equity market returns are not sustainable.
Further tempering our view is that by historical measures, stocks are expensive. What do we mean by “expensive?” We maintain an internal measure that compares how much investors are paying for a dollar of corporate earnings (from stocks) to what they must pay for a dollar of bond interest. As compensation for accepting the much greater volatility of stock markets, we would expect a dollar to buy more earnings than interest. When the spread is narrow, the expected reward for owning stocks is less, and in that situation, we might say stocks are expensive.
By our measure, the S&P 500 is, by a small amount, at its most expensive since at least 1941. Sadly, knowing when stocks are expensive has not been a reliable guide for market timing (and nor has anything else). Stock markets can remain expensive for a long time and continue climbing throughout. And there’s never any guarantee that historical relationships will be the norm in the future. Nonetheless, we believe the risk-reward tradeoff for stocks is less attractive than usual. Accordingly, in the second quarter we modestly trimmed our equity allocations in balanced portfolios. Should the situation persist, we are likely to continue to trim.
We note that valuation is only one of many factors we consider in determining target asset allocations. Even with our recent reduction in equity allocation, we remain slightly above a neutral target stock allocation. And, of course, regular portfolio rebalancing helps ensure that buoyant stock markets don’t leave risk exposures at undesirably high levels.
The Big Get Bigger
The ten largest US stocks now account for 37% of the S&P 500’s total value, their highest level since the 1960s. Just three stocks—Microsoft, Nvidia, and Apple—make up 21% of the index value. As investors, should we be concerned about the rising concentration? The answer is a definite maybe.
Those who worry about growing concentration cite similar periods in market history that ended badly. Some recall the so-called “Nifty 50” from the late 1960s. Xerox , GE, IBM, and Coca-Cola headlined the list of companies to buy and hold forever. The problem with this almost religious devotion to any set of stocks is that investors begin to ignore price. Almost any stock price can be justified—for a time. Eventually, usually after a negative turn in investor sentiment, people begin to scrutinize how much they are paying for an uncertain stream of future earnings. Before long, this buy-and-hold-no-matter-what wisdom is widely (and smugly) regarded as just another chapter in the long history of foolish speculative manias. Such was the fate of the Nifty 50.
Arguing the other side are those who say that this time is different. Today’s market leaders are viewed as quasi-monopolies that have already won a winner-take-all game. The omnipresence of Microsoft software, Apple iPhones, and Nvidia chips (reportedly an 80+% share of the AI chip market) makes this a compelling argument.
Absent the crystal ball, it’s impossible to know which side will prevail. Fortunately, you don’t need to pick sides. Diversification through index funds assures exposure to the market’s leaders. Index funds are often called “passive” because they simply replicate the weightings of a selected benchmark index such as the S&P 500. In fact, indexes (and the funds that follow them) are quite dynamic. Their company weightings change minute to minute based on the relative performance of the component stocks. Additionally, stocks are regularly added to (and removed from) the index based on such factors as a company’s growth (or shrinkage) and company mergers.
Most importantly, the stocks that perform the best make up a growing share of the index over time. If today’s big keep getting bigger, their weight in the index fund will continue to grow. And just as important, when today’s leaders are ultimately supplanted by companies we’ve not yet heard of, the index fund will own those, too.
[1] “Nifty” now seems like such a quaint word.
[2] The younger generations might be shocked to know that baby boomers viewed the first photocopiers with the same kind of wonder now reserved for virtual reality and artificial intelligence.
[3] In case you missed it, our recent webinar on AI touches on the potential rewards and risks of owning Nvidia. You can watch a replay here.
For a fuller discussion, be sure to see our Q2 Economic & Market Review.