Hello, everyone, and welcome to the August edition of Market Compass. We are more than halfway through the year. And the one word that seems to capture the economic and market activity is resilience. Despite strong headwinds of high borrowing costs, still elevated inflation, and geopolitical uncertainty, the US economy has fared much better than expected. The same goes for corporate profits and equity markets, which we're not going to complain about.
Even though major indices have been more volatile recently, large cap stocks are up more than 20% from last year's lows and are not far from their all-time highs. So what justifies the move higher in stocks? We think the improvement in inflation, a strong labor market, and expectations for an end to the Federal Reserve's rate hiking cycle have moved us away from any worst case scenarios. But hefty gains taken together with flat earnings growth for the S&P 500 this year mean that valuations have increased, and investors need to be more selective going forward.
Historically, August and September have been less favorable for stocks, with volatility tending to pick up. However, this shouldn't be a reason to stop working towards your long-term goals. With that in mind, here are three opportunities we see in today's markets based on the macroeconomic conditions we expect for the rest of the year. The first, diversify into lagging segments of the equity market that carry lower valuations.
Until recently, market leadership has been very narrow, with just a handful of mega-cap technology stocks accounting for the majority of this year's gains. Beyond the largest seven S&P 500 companies by market cap, gains have been more modest not only within the S&P 500 itself, but across other indices and asset classes. These include value-style investments, small caps, and international equities, which trade at a larger than average discount.
From a sector perspective, so far this year, only 3 of the 11 sectors have been able to outperform the S&P 500 index, while some defensive sectors have posted losses year to date. We think participation could broaden, and therefore recommend investors rebalance as appropriate. The second opportunity we see is the dollar cost average to take advantage of the potential for higher volatility. We think the path has widened for the economy to avoid a recession, but some downside risks to growth remain.
Historically, a strong first half of the year has been associated with further gains for the remainder of the year, but with deeper pullbacks. To avoid trying to time the market and also take advantage of the potential for volatility, we recommend investors dollar cost average by investing systematically at regular intervals. Dollar cost averaging can spread out your purchases and help you buy more shares when prices pull back.
The third opportunity is to complement, in our view, CDs and other cash-like investments with longer term bonds. Yields are historically attractive across the curve, providing great opportunities for investors to generate income in certificates of deposit, as well as longer term bonds. We think this is a good time for investors to complement their CDs and short-term bonds with longer duration bonds that have higher interest rate sensitivity.
These bonds offer the opportunity to lock in historically high yields for a longer period. They also may appreciate if yields start to move lower as economic growth softens and the Fed starts cutting rates possibly in 2024.
To highlight this exact point, let's look at some historical data going back to 1980. Over the past seven rate hiking cycles, 10-year yields have declined by 1% on average six months after the Fed's last rate hike. This highlights that the end of tightening can be a positive catalyst for government bonds, which experienced a historic decline last year.
To sum up, we think that the evolution of growth and inflation provides a solid foundation for stocks to remain in a sustainable uptrend, but with higher volatility in the months ahead. Yet, market gains over the past several months should not be a reason to stay on the sidelines as we still see opportunities in parts of the equity market, including the defensive sectors. And within fixed income, we see an opportunity to position for potentially lower yields next year. With that, thank you for joining us. We hope to see you again next month.
15 сен 2024
