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Market Update

Market Update

Market Update July 2024

The S&P 500 Index has continued to set new record highs on the back of Mega-cap AI Growth stocks. Year to date through June 30, the S&P 500 gained 14.5%. Other areas of the overall market have not fared as well. The equal weight S&P Index is up a decent 4.96%. Whereas Small-cap stocks as measured by the Russell 2000 Index, has risen 1.02%. Small-caps continue to lag Large-cap stocks in this Bull market because of negative earnings growth. Wall Street Analyst project small-cap earnings to turn positive in the 2H.

Last quarter, semis stocks corrected from their recent highs. Some investors warn that this is a canary in the coal mine for the broader market ahead. The S&P 500 equal weight index was higher over the next year eight times with a median gain of over 15% based on Bespoke research. In the past, a correction in semis-conductor stocks leading the market has not been a problem for a Bull market.

The market is extremely concentrated, bad market breadth, which makes sense to me – buy the highest quality names in a soft-landing scenario. Money goes to where it is best treated in Mega-cap names. Those names are also defensive. Up to a certain point they deserve to trade at a premium. Historically new highs on bad breadth have tended to see the S&P 500 Index continue to rise six months out. One year later has seen stronger than normal average gains, although inconsistent according to Bespoke research. Well known market technician, Katie Stockton, says the current pullback in “breadth should eventually expand in support of cyclical bull trend in the S&P 500. It is usually healthy to see periods of breath contraction during uptrends, as it can renew demand when markets appear extended.” Market breadth is at oversold levels now. Often, there is mean reversion which bodes well for the rest of the stocks in the S&P 500 Index.

Despite a slowing US economy, Wall Street Analyst revising upward their earnings forecast. It is hard to square accelerating earnings growth with slower economic growth. The estimated earnings growth rate for the S&P 500 is 8.1% for the second quarter according to CFRA research. Industry analysts estimate the S&P 500 will report YOY earnings growth of 9.1 for the year, and next year 14.6%. Slower growth and cooling inflation would merit a rate cut which would be supportive of projected earnings acceleration. Earnings could rise if any soft patch in economic growth is brief. Stock prices lead earnings and fundamentals.

History shows that when Central Banks cuts come without a recession, the economy typically skips into a stronger expansion as restrictive monetary policy headwind ends. Moreover, in past easing cycles, earnings growth usually accelerates as economic growth strengthens. Historically, stocks have tended to appreciate before Leading Economic Indicators (LEI) improved. LEI were slightly negative in May suggesting slower growth ahead, however, the trend is a less negative reading and upward. The stock market usually has led the leading indicators according to Fidelity research.

The S&P 500 index Forward P/E of 22 is trading at its peak range based on long term average since 1950. However, earnings growth is strong and accelerating for those AI Mega-cap companies pushing up valuations. Whereas the Invesco S&P 500® Equal Weight ETF is trading at a more reasonable Forward P/E of 17.5. The Mega-cap stocks are extremely profitable businesses with sales and earnings growth that outpaces most stocks in the S&P 500 Index. They are cash flow machines with strong fundamentals that deserve a premium valuation. I do not think they are in a bubble like dot.com stocks and when compared to Growth stocks median P/E since 1990 they are not egregiously higher. Even so, this suggests that the S&P 500 Index is trading at above fair value – it is not cheap implying lower forward returns. It also implies that the S&P 500 Index has a high bar to clear to achieve its projected earnings estimates for the stock market to advance higher by year-end. The US economy must continue its expansion and more progress on reducing inflation must be made. Otherwise, the stock market may correct, and 2025 poses its own challenges in the form of Federal deficits and debt.

The US stock market is in a Bull market that could last much longer and go a lot higher. This Bull market (S&P 500 Index) gains are not even half of the average bull-market gain according to Bespoke research note. The Invesco S&P 500 Index Equal weight ETF is up 4.6% year-to-date and its annual compounded return over the last three years is a mere 4.2%. My assessment is there are more gains ahead for equity markets especially if the Fed becomes dovish. Furthermore, AI transformation is a tail wind for profit margins.

Where could the market go from here? What is normal in an election year is for volatility to pick up. Studies show that the summer months tend to be weaker periods in the stock market. It starts out strong with July being one of the best monthly returns, but August through October is prone to pullbacks of five percent or more. Historically, when the S&P 500 Index has gained more than 10% in the first six months of the year, the S&P 500 averages a 7.9% gain in the second half of the year based on CFRA research. I am fully invested in all strategies. I intend to lighten up on some equity positions in the third quarter. Then reinvest proceeds in equities sometime in September - use any volatility as a buying opportunity.
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