Global economic activity remained robust in the first quarter. Among other factors, this helped to drive impressive performance for stocks which gained 10% in the quarter, marking the S&P 500’s best first quarter since 2019.
The Federal Reserve began hinting at interest rate cuts to come as soon as June, despite signs of inflation re-accelerating.
Bonds, as measured by the Barclays U.S. Aggregate, declined slightly in the quarter as inflation held firm and interest rates ticked higher.
Economic and Market Overview
Economic activity experienced further resiliency in the first quarter with above-trend job and income growth, increased consumer and business spending, and rebounding investor sentiment. Policymakers have shown their unyielding support of economic growth whether it be the Federal Government’s massive peacetime 6% fiscal deficit relative to GDP or the Federal Reserve further signaling rate cuts despite inflation showing meaningful signs of re-acceleration.
While we have been far more constructive on the U.S. economy over the past twelve months than the recession-concerned consensus called for, we are mindful that consensus has now picked up on the view that the economy is still growing. In the investing world, aligning investment strategy with market consensus is often a vulnerable approach. The largest risks that the U.S. economy is currently facing are primarily concentrated to exogenous shocks and a potential Federal Reserve monetary policy error, which is most notably the risk of the Fed letting inflation re-accelerate and a repeat of the stop and go monetary policy of the 1970’s.
Stocks climbed higher to start the year, resuming their ascent that was kicked off by Federal Reserve Chairman, Jerome Powell’s, November 2nd press conference where he abruptly changed his 2024 expectations for interest rates. As measured by CNN’s Fear & Greed Index, market sentiment remains firmly greedy. The most greedy activity is typically seen during times of market euphoria. Among many other causes, periods of market euphoria can be exemplified by large waves of initial public offerings, “meme stock” booms, and robust offering volumes of leveraged investment products (ETPs). A great example of a leveraged ETP was launched in the first quarter and provides investors with 2x leveraged exposure to stock of Nvidia. As if un-leveraged stock exposure isn’t enough, there are now even products with 5x leveraged exposure to the popular “Magnificent 7”[1] stocks! Buyer beware…
“For whatever reasons, markets now exhibit far more casino-like behavior than they did when I was young. The casino now resides in many homes and daily tempts the occupants.” – Warren Buffet, February 2024
While last year’s stock performance was driven by a very narrow segment of the stock market, we are now seeing signs of performance broadening out which is being driven by the more favorable U.S. economic backdrop disproportionately benefiting smaller and undervalued sectors that were previously neglected by most market participants. The broadening of the market is occurring while a growing list of richly valued mega-cap stocks are starting to show signs of weakness. As shown below, the divergence between mega-sized “market cap weighted” sectors and reasonably sized “equal weighted” sectors is beginning to narrow.
Market weighted sector returns are most heavily influenced by the sector’s largest companies, whereas equal weighted sector performance applies an equal weighting to all its companies regardless of company size. The high-flying Nvidia stock, valued at over $2 trillion, is a good example to demonstrate this. Nvidia’s stock performance makes up nearly 5% of the market weighted S&P 500 index performance today, yet only 0.2% of the equal weight index performance.
Generally, we believe that the median sized (equal weighted) companies have more favorable investment prospects in today’s economy than average sized (market weighted) companies in their respective sectors. Furthermore, many investors hold overweight allocations to market weighted indices today, and significantly underweight allocations to equal weight indices and the median sized companies in them.
Fixed income returns were mixed throughout the first quarter with short-term U.S. Treasury Bills outperforming longer-term Treasuries, as the value of long-term bonds is more sensitive to increasing interest rates. In the corporate bond arena, riskier high yield bonds outperformed investment grade amid better-than-expected economic data causing credit spreads to narrow. Intermediate term bonds, including Treasuries, corporates, and municipal bonds, fell as interest rates trended higher over the quarter amid signs of inflation acceleration re-emerging.
When it comes to fixed income performance, it is important to note a major distinction between individual bond issues and bond funds. Investing in individual issues can help protect investors from bond price volatility driven by swings in interest rates. If interest rates rise while holding an individual bond, that bond might lose value “on paper” in the short-term, yet it will still mature at par value so long as the issuer does not go bankrupt or call the bond early. On the flipside, bond funds can potentially expose investors to loss of value. Bond fund managers generally seek to maintain a certain weighted average duration of their underlying bond portfolio. This means that a manager may choose, or need, to sell certain bonds over time and replace them with new bonds with durations that meet the fund’s strategy mandate. Should this type of selling and reinvesting activity occur as rates are rising, the bond manager may be selling the old lower-yielding bonds at a value below par value, locking in a loss for investors.
However, this isn’t to say that bond funds don’t have any of their own advantages or merits, like diversification for example. At RISE, we invest in both individual bond issues and bond funds as circumstances vary. However, we favor individual bond issues in many cases, and especially in rising rate environments.
In today’s market with higher interest rates at the shorter end of the yield curve than at the longer end (i.e. an inverted yield curve), our preference in fixed income tends to be for shorter-term maturities which demonstrate less price volatility than longer term maturities. However, this comes with reinvestment risk as the short-term bonds pay off; with the risk being that short-term yields fall in the future and pose less-attractive reinvestment opportunities upon the original bond maturing. To mitigate this reinvestment risk for clients that rely on bonds for predictable income, we build “bond ladders”. Rather than going all-in on short-term bonds with maturities of one to two years, a bond ladder portfolio involves a more strategic approach of incorporating individual bond issues with varying terms and maturity dates, providing a more predictable stream of income despite interest rate volatility that may occur.
Magnificent 7 Competition
The stellar performance of the Magnificent 7 stocks over the past decade, among other factors, has made these stocks very popular picks for investors. The success of these companies and their stock performance has been so enduring largely due to their oligopolistic profit margins stemming from major competitive advantages and frankly, lack of real competition. The central bank’s money printing, near-zero borrowing rates, and a global pandemic in 2020 only further benefited the Magnificent 7. Yet, we believe the level of success that these companies have achieved over the years is now at serious risk of disruption from the entrance of competitive challengers.
While there are several potential competitors to the Magnificent 7, a key emerging threat resides in the emergence of China as a major industrial and innovation powerhouse. Many view China through a 2000’s lens where they just entered the World Trade Organization and exported cheap, lower quality goods to foster lower global inflation at the expense of America’s working class. However, China has quietly been becoming a formidable competitor to American corporations. China’s population now churns out more science graduates each year than there are existing science majors in the United States. Fifty percent of all the engineers in the world are Chinese, and that percentage is gaining market share.
Chinese companies are already competing against several of the Magnificent 7. For example, China’s technology darling, Huawei, makes a smart phone Mate60 that is gaining significant Chinese market share relative to Apple’s iPhone. We believe that as Huawei builds out adequate capacity, it poses a severe threat to Apple’s dominance outside of China where the incremental buyer of Apple iPhones and products reside.
China poses significant competition against other Magnificent 7 companies too. While currently evident in electric vehicles (BYD Auto Co. vs. Tesla) and the social media industries (Tik Tok vs. Meta), we believe the other four Magnificent 7 companies (Nvidia, Amazon, Alphabet & Microsoft) could all be poised to face serious competition in the years ahead as China continues to build capacity and becomes a more advanced economy. While we could certainly be proved wrong, we find it improbable that the Magnificent 7 companies could maintain 40% profit margins as legitimate challengers inevitably enter the competitive landscape and would be satisfied with a profit margin in the single digits.
Most importantly, our view is that most investors remain overweight these Magnificent 7 stocks whether it be through the individual stocks, passively managed market cap weighted ETFs, or target-date mutual funds. At RISE, we construct your investment portfolios with a broader diversification strategy. This approach has proven conviction of serving as a superior way to preserve and grow wealth by providing clients with exposure to more regions (as prudent), sectors, and industries that reduces overall portfolio risk.
Strategic Positioning of Core Portfolios
We made no major adjustments to your investment portfolio over the first quarter and your portfolio remains invested in-line with your core strategy designed to help you achieve your long-term investment goals and objectives.
Employing diversification across all major industry sectors and company sizes, we maintain a healthy blend of exposure to companies poised for outsized future growth as well as those that possess undervalued stock prices relative to the future growth they’re poised to achieve.
Average Sector Weightings - All RISE Client Portfolios
Our lives are measured in decades, and the actions that all of us take today can stick with us for years or generations to come. In this sense, we resist the urge to act majorly on bold and speculative calls or forecasts, which is one of the surest disciplines we utilize to help our clients achieve their financial objectives and what matters most, the long-term outcome.
We are privileged to serve as your financial fiduciary. Please do not hesitate to reach out if you have any questions or if you’d like to discuss this update.
Footnotes and Disclosures
Microsoft, Apple, Amazon, Nvidia, Meta, Alphabet & Tesla
*RISE Investment Management, LLC (aka "RISE Investments") is a state Registered Investment Adviser. Registration as an investment advisor does not constitute an endorsement by the Commission and does not imply a certain level of skill or training. Advisory services are only offered to clients or prospective clients where RISE Investments and its representatives are properly licensed or exempt from licensure. This publication is solely for informational purposes and past performance is not indicative of future results. Any historical returns, expected returns, or projections are provided for informational purposes only. No advice may be rendered by RISE Investments unless a client service agreement is in place.