When investors comment on how a market performed over a given time period, whether a day or a year, they generally are referencing the performance of a basket of stocks, like the Dow Jones Industrial Average or the Standard & Poor’s 500 Index. These particular indices are useful both because of their longevity and also because they are thought to accurately reflect the broader stock market, which in turn is thought by many to be a good reflection of economic forecasts. But there are times when the movement of an index can be a bit misleading or send a confusing signal. Stock price movements are not always a proper reflection of economic forecasts, especially over shorter periods of time. And an index, depending on how it is composed, does not reflect the average price movement of most stocks within it. The first half of 2024 has been a period where one index in particular has not, in our view, mirrored changing economic expectations, and certainly has not been a measure of the average stock within the broader market or even the index itself.
The S&P 500 Index climbed over 15% in the first half of this year. This is a historically strong return, and, without further investigation, one might conclude that the stock market generally was very strong and perhaps that the economic outlook was improving. Yet the first half of the year has been marked by moderating expectations for economic growth, a weakening housing market, and slowly rising unemployment. Many companies that sell directly to the consumer talk of financial stresses emerging, especially among lower-income customers. It is generally a challenging environment for many companies and share prices reflect this. The average stock in the S&P 500 is up 4.7% in the first half of the year, the venerable Dow Jones Industrial Average is up 4.8%, and the Russell 2000 Index, a measure of 2000 smaller- and medium-sized companies in the stock market, is up only 1.7%. These are all a far cry from the 15% return on the S&P 500 Index. To understand how these figures could be so far apart, and why the most cited measure of stock market performance, the S&P 500, could be so far above most companies, it is critical to note that the Index weights performance based on the size of the company. The performance of larger companies has more impact on the Index than the performance of its smaller members. And thus far in 2024, this discrepancy between large and small has been stunning.
At the end of the 2nd quarter, there were six companies in the U.S. stock market that were valued at over a trillion dollars: Microsoft, Apple, Nvidia, Alphabet (Google’s parent company), Amazon, and Meta (Facebook’s parent company). All are technology companies, and together they make up nearly a third of the entire market when measured by size. Their performance in the first half of the year contributed 10% to the overall return of the market, which quickly explains how the S&P 500 climbed 15% when the average stock rose less than 5%. Nvidia alone accounted for much of that strength, as it single-handedly pulled the entire S&P 500 Index higher by 5%. It is unusual for the largest companies to so dramatically outpace their smaller peers. There has not been this concentration of market strength amongst the largest few companies since 2000 in the dot-com bubble. From that point forward, all of those shares (companies like Cisco, Nokia, Worldcom and Lucent), stalled under the weight of enormous expectations or disappeared entirely. From 2000 onwards, the average stock in the S&P 500 outperformed the Index over the next fifteen years, while the largest companies acted as a drag on market performance.
Cisco is a particularly interesting case study. In 2000, Cisco’s prescient and animated CEO, John Chambers, described the landscape as follows: “business and government leaders are beginning to dramatically transform their traditional business models into Internet Economy business models. These new Internet-based models reduce costs, generate revenue in new ways, empower employees and citizens, and provide the agility needed for the Internet Economy’s rapid pace.” Cisco stood at the center of this transformation with its networking equipment and briefly became the largest company in the world. Twenty-five years later, and the company is still the largest networking company in the world, but its shares have never regained the highs they set when Chambers made these comments. An investor buying into the enthusiasm in the Spring of 2000 would still be sitting with a loss today.
Nvidia feels similar in many ways. It is a semiconductor company run by a brilliant and ambitious CEO, Jensen Huang, who just recently made this comment to investors: “The next industrial revolution has begun – companies and countries are partnering with NVIDIA to shift the trillion-dollar traditional data centers to accelerated computing and build a new type of data center – AI factories – to produce a new commodity: artificial intelligence.” Nvidia has already had massive success selling its semiconductors to AI customers, and it may go on to have continued business success, just like Cisco did. But this moment may also represent the high water mark for its shares, just as 2000 was for Cisco. And it is important for investors to be mindful that, at the moment, the S&P 500 Index is much more a story of Nvidia and its largest tech peers than the other 494 companies that make up the entire Index.
Current Strategy
It is a difficult time to keep pace with the S&P 500 Index. To match its composition, an investor would have to have roughly half their money in technology companies, with most of that in companies that are connected to Artificial Intelligence (AI). That is a rather extreme concentration in one theme, but that is the structure of the Index at this point. The valuations in this AI theme are quite high, driven by lofty expectations for future growth; and because they dominate the Index, this has driven the valuation of the entire Index to a high level. However, the exceptionally strong performance of a few stocks leaves many other stocks out of favor, so some opportunities exist, and are emerging, for an investor looking for decent values.
Consumer spending is slowing, especially when looking at larger, more discretionary purchases. This has resulted in large declines in the shares of many consumer-oriented companies. But spending is cyclical, and soft spots, like we are in now, often create a good entry point for investors hoping for good long-term returns. In the last quarter, we added to our exposure to consumer stocks, and we will look for more opportunities in the months to come. Also, the rush into AI stocks has been so extreme that it has pulled money away from technology companies that are not deemed to be part of the AI theme. Investor money is leaving these software and hardware companies, resulting in better valuations. The potential exists for a fracturing of tech into AI “winners” and “losers” large enough to create opportunities to buy shares in high-quality technology companies, whose only shortcoming is that they do not resemble Nvidia or OpenAI (a leading developer of AI technology). In 2000 there were good opportunities in a high market. They were not plentiful and required careful stock picking, and investors still had to be very careful to not become over-exposed to a market that was generally unattractive. We hope to employ that same judiciousness in this market, as the ideas above illustrate possibilities that may exist for an investor looking beyond the handful of AI stocks that are driving this market.
Slowing economic conditions have been matched with slowing levels of inflation. It appears the Federal Reserve has finally neared its goal of tempering inflation towards an acceptable level. Slowing consumer spending and an uptick in unemployment are some of the painful remedies often required to cure an economy of high inflation. What remains to be seen is if this time the job can be done while still avoiding a recession. With lower inflation, the bond market has finally gotten the signal it was looking for, and most bonds have started to rise in value, with yields dropping slightly. We entered the quarter with what we believe to be a generally full bond portfolio for most clients, and there was little fixed income investment activity as a result.
