A Market Riding AI Momentum
Doug Walters
The market rally extended into the first quarter of 2024 as artificial intelligence tag-teamed with expected Fed rate cuts to keep investor sentiment elevated.
The Federal Reserve has been a driving force behind market moves for the past few years. Artificial intelligence (AI) has challenged the Fed’s hold on investor focus this quarter. The AI revolution appears to be more than just hype, promising wide-ranging potential for productivity gains across the economy. We entered the quarter wondering if we would have a hard or soft landing. We exited, wondering if the landing would take place at all.
The market has the potential to overshoot in its enthusiasm. There is certainly historical precedent for that. But this is not the Dot-Com bubble (at least not yet), where the market was putting unprofitable, unproven companies up on a pedestal. Today’s AI winners are generally highly profitable established players. The election may steal some of the attention as the year progresses, but for now, investors should not hesitate to enjoy this moment of inflection.
Dissecting Q1 2024
High rates cooled inflation, with three cuts still expected in 2024
The Federal Reserve’s fight against inflation continues to drive market sentiment. Inflation fell in the first quarter, albeit at a slower pace than it had been. The Fed’s preferred measure, PCE Core Inflation, is now below 3%.
Investors had been pricing in more rate cuts than the Fed was telegraphing, but those expectations have slipped with the slowing inflation declines. The Fed has held steady on forecasts for three 25bps cuts in 2024, with more to come in subsequent years.
Chart 1: Rates Still Expected to Be Cut This Year
Source: The US Federal Reserve, Bureau of Economic Analysis
AI optimism extended the equity rally, while two mega-caps slipped
Artificial intelligence (AI) is driving real capital investment, real profits, and real productivity gains across the economy. This stimulus has boosted equities, but a pair of mega-caps have been left behind.
The so-called Magnificent Seven have dominated market performance, as these companies have jumped seamlessly from the COVID-Induced work-from-home wave to the AI wave. Their size and performance have created unusual concentration risk within once broad-based market-cap weighted indexes like the S&P 500.
In Q1, two members of this elite group (Apple and Tesla) began to show signs of cracking, falling over 16% on average. A well-diversified portfolio that goes well beyond US large-cap exposure is as important as ever to help manage the continued mega-cap concentration risk. These are great companies, but expectations for great companies can overshoot and lead to future downside risk.
Chart 2: AI Booms as Cracks Form in the Magnificent Seven
Source: Factset
Elevated yields have lured investors out of better opportunities
The Fed has yet to cut rates, and as a result, cash yields remain unusually high. Investors can earn safe yields in excess of 5%. These tempting rates continue to draw assets away from other potential opportunities.
While money market yields are higher than they have been for years, it is important to note that they have underperformed a balanced portfolio and even gold. Investors should absolutely enjoy the higher yields they can earn today on their fixed income and set aside cash, but be careful not to be drawn out of assets with higher earning potential, like equities.
We also remind investors that yield is not the same as return. As the Fed cuts rates, yields could fall fast, particularly in short-term vehicles like money market funds. We see more opportunity in intermediate and longer-term fixed-income instruments, whose prices and value could increase more if rates fall.
Chart 3: There is a Hidden Danger in Safe Yield
Source: 60% S&P500 (VOO), 40% US Agg (AGG) rebalanced quarterly; Gold (GLDM); Schwab Treasury Obligations Money Fund -Investor Shares (SNOXX)
US Stocks Have Advanced Irrespective of the Administration
Election angst is already beginning, and we want to try to get ahead of the inevitable questions. The election outcome is unknowable (as are most future events), but investors can take comfort in past precedents.
Unsurprisingly, a look at history shows that stocks tend to go up regardless of who occupies the White House. The data in the chart below favors Democrats. But were the Great Depression, Dot-Com Bubble Burst, and Great Financial Crisis of 2008 caused by the Republicans who happened to be in power at the time? Unlikely. These economic cycles, booms, and busts are often the culmination of many years of policies combined with the natural and unavoidable market, demographic, and geopolitical flows.
Investors can take comfort in seeing how stocks rose handsomely during the Obama, Trump, and Biden administrations. Does that mean the next election cycle will produce more positive returns? No one knows. An election is a binary uncertain event. And even if we knew the winner, predicting the market reaction would be futile.
Evidence-based investors know that the future is unknowable, and the best investing action at any point in time (election or not) is one based on what we know today and not what we think will happen in the future. So we focus our efforts on where we see market opportunities currently and avoid the emotional trappings of election speculation.
Chart 4: The Economy Drives Investments Not Presidents
Source: Factset
Q1 2024 was strong across most asset classes
Equities continue to drive portfolio performance, while bond performance stalled thanks to the Fed and inflation.
US Large-Cap stocks remain atop the leaderboard once again thanks to the continued contribution of the Magnificent Seven (or at least the Fabulous Five). Foreign-Developed equities also posted strong quarterly returns as inflation fell in Europe and Japan reached a new market high for the first time since the 1980s.
Gold had a banner quarter, continuing the strength that began in the fourth quarter of last year. It has risen over 20% from its October 2023 lows and has proven once again to be a valuable diversifier.
Fixed income performance stalled as high expectations for Fed rate cuts were tempered. Investors are finally falling in line with the Fed’s “higher for longer” mantra, and bond values paid the price.
Small-Cap stocks continue to lag their larger peers despite an apparent valuation opportunity. Historically, smaller stocks have outperformed, but we prefer those with a factor overlay (Quality, Value, Momentum, Size) to help avoid the true junk in the space.
Chart 5: Asset Class Performance for Q1 2024
Source: Factset
The Q2 2024 Playbook
We enter the second quarter at an interesting inflection point. Stocks continue to rally. The Fed is poised to raise rates, yet progress on inflation has slowed, and artificial intelligence has the potential to heat things up to an uncomfortable level for Chairman Powell. The question of “Hard or soft landing?” has changed to “Do we land at all?”
If this sounds like a lot of uncertainty, it is! But the future is always uncertain, and that is okay. As evidence-based investors, we do not concern ourselves with the uncertainty about the future that is always present. Rather, we spend our time focusing on what we know today and letting that knowledge guide our long-term decision-making. Here is what we are seeing:
- AI is real. Real investment, real profits, real productivity gains. There’s a revolution in progress and equity investors are trying to properly price it in. It is quite possible investors overshoot at some point, but for now, there is no good argument for fighting the momentum. We see Momentum funds as an attractive holding in this environment.
- Concentration risk is real. The Magnificent Seven have benefited from AI enthusiasm but, in the process, have created unusual concentration risk. This quarter, Apple and Tesla fell sharply, underlining this risk. Seek diversification. Within equities, supplement your Large-Cap positions with Value, Small-Cap, International Developed, and Emerging Markets.
- Duration benefits are real. Within fixed income, as the Fed moves closer to rate cuts, the opportunity shifts from the shorter-term to the longer-term. Yields and returns in money market funds and short-term Treasuries will be quick to diminish, while longer-dated fixed income has the potential to benefit as rates fall. Yields may fall, but returns in intermediate and long-dated fixed income can rise.
In investing, preparation is worth more than prediction. Putting too much weight on prediction implies not only that the future is knowable but somehow investors’ reaction to it is as well. Reality is far different. Who would have predicted COVID, and if they did, would they have predicted strong equity performance? Probably none.
Evidence-based investors know this truth and construct portfolios based on what we know today, along with what academic research and history teach us. It is not a perfect science, but over time, it has the potential to pay off for disciplined investors.
On behalf of the team at Strategic, I thank our clients, friends, and family members for the trust they have placed in us. We appreciate everyone who has joined the Strategic community and look forward to partnering with you throughout the year.
About Strategic
Founded in 1979, Strategic is a leading investment and wealth management firm managing and advising on client assets of over $2 billion.
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