Q3 2024 “Student of the Markets”

1. The Rally Continues

Despite a mid-summer swoon, global stocks broadly have delivered strong returns thus far in 2024.

2. The market’s summer selloff was totally normal.

The S&P 500 sold off more than 8% in July into August prior to rebounding. This year’s decline was hardly unusual. Since the start of 1980, the S&P 500 has declined by 14% on average during a calendar year. Despite these selloffs, the S&P 500 has delivered positive full-year performance in 33 of the last 44 years.

3. Market selloffs are a normal feature of stock market investing.

Since the start of 1926, the S&P 500 has experienced a selloff of at least 5% during the year 94% of the time. A 10% or greater selloff has happened in nearly two-thirds of the years. And a 20% or worse decline has occurred in roughly a quarter of the last 97 calendar years.

4. 2024 has looked a lot like 2023

Beneath the surface, global stock performance in 2024 thematically has been very similar to 2023 with U.S. stocks outperforming non-US stocks, U.S. value outperforming growth and U.S. large caps outperforming small caps.

5. The “Magnificent 7” has continued to be the driving force behind S&P 500 performance in 2024.

Apple, Amazon, Alphabet, Meta, Microsoft, Nvidia and Tesla—the “Magnificent 7”—have been the predominant drivers of market performance over the last three years. These seven stocks contributed 63% of the positive performance in 2023. They also contributed 56% of the negative performance for the index in 2022. Thus far in 2024, they’ve collectively contributed 45% of the index’s positive performance for the year.

6. However, Q3 bucked the trend of the previous one and a half years in terms of Magnificent 7 outperformanceThe S&P 500 sold off more than 8% in July into August prior to rebounding. This year’s decline was hardly unusual. Since the start of 1980, the S&P 500 has declined by 14% on average during a calendar year. Despite these selloffs, the S&P 500 has delivered positive full-year performance in 33 of the last 44 years.

7. The U.S. stock market remains historically concentrated among the largest companies.

   The the current scale of market dominance among the market’s largest companies is greater than in other narrative-led periods with the top five and 10 companies in the S&P 500 now comprising 26% and 35% of the index, respectively.

   

8. The largest companies in the S&P 500 Index trade at expensive valuations relative to the rest of the market.The 10 largest stocks in the S&P 500 currently trade at a significant valuation premium relative to the rest of the market. It’s worth noting that the largest stocks haven’t always carried higher valuations than the rest of the market.
9. Today’s big tech companies are highly cash generative.Research from Goldman Sachs reveals that today’s dominant companies are highly profitable and fortified by strong balance sheets. In terms of fundamental strength, today’s leaders are much more profitable and have stronger balance sheets than those that dominated the market during the tech bubble.
   
   

10. The valuations of today’s dominant companies are also considerably more attractive than during the tech bubble.

    Goldman Sachs further shows that the dominant companies today are not nearly as expensive as those during height of the tech bubble.

    
    

11. History suggests investors should be wary of assuming today’s market leaders will remain so in the years aheadInvestors should nevertheless be cautious about chasing the strong recent performance of today’s largest stocks. The largest companies in the market have historically tended to underperform the rest of the market despite delivering solid absolute performance according to data from Goldman Sachs.
    
12. Non-U.S. stocks are cheap vs. U.S. stocks on relative basis.Foreign stocks currently trade at a price-to-earnings ratio of 14.1x which is in line with their median valuation over since the end of 2000 and a nearly 40% discount to the 22.6x P/E ratio for U.S. stocks. Foreign stocks have become progressively cheaper relative to U.S. stocks since 2008/2009 when they traded at a premium to U.S. stocks. If the valuation gap starts to close between the two markets, foreign stocks stand to deliver relative outperformance vs. their U.S. peers.
    
13. U.S. value stocks are cheap vs. U.S. growth stocks on relative basis.Since the end of 1997, U.S. large- and mid-cap value stocks have on average traded at a 28% discount to their growth counterparts. Today, they trade at a 41% discount.
    
14. Where the value investing strategy still works.Value investment strategies have suffered from a poor stretch of performance in the U.S. over the last 15 years. Data from Dartmouth professor Kenneth French’s data library, published in the Financial Times shows that value stocks in the U.S. have noticeably lagged the broader market over the last 15 years.However, the story looks strikingly different beyond U.S. borders.Value internationally suffered a similar swoon as in the U.S. through the depths of Covid. However, since March 2020, its performance in non-U.S. developed markets has been remarkably strong. Value’s outperformance internationally since March 2020 has been so good that as of earlier this year, the value factor was showing outperformance over the trailing three-, five-, 10- and 15-year periods.Value’s outperformance in non-U.S. markets calls into question the idea that something is fundamentally broken the value investment strategy. As the author of the FT piece notes “If something structural has shifted in the market to make value not work, why has that only affected the U.S.? If quantitative investing is too simplistic and just buying the cheapest stocks is a dumb strategy, why have the idiots who practice this approach outperformed in Europe and Japan?”

     

    

15. The stock market has delivered periods of both strong and weak performance following the Fed’s first rate cut of a new easing cycle.The wide variation in stock market performance following the Fed’s rate cut suggests the Fed’s recent actions are not a reliable signal to be used for market timing purposes.
16. The stock market has generally gone up under Republican and Democratic presidents alike.The U.S. stock market has delivered double-digit annualized gains during seven of the last eight presidential terms. The data strongly suggest that Presidential elections are not nearly as important to financial markets as intuition might suggest or that the media or the candidates play them up to be.The reason for this is likely quite simple: markets just generally go up. As this is for the simple reason that the profit motive doesn’t go into hibernation when a new President takes office, and businesses have a remarkable way of profitably delivering goods and services to paying customers no matter who occupies the Oval Office.

17. Stock market sector performance appears unrelated to party affiliation.

    Once again, contrary to conventional wisdom the historical track record demonstrates that sector performance has been unrelated to party affiliation.

    Consider for example that fact that the best and worst performance sectors during the Obama and Trump administrations were nearly identical—the Technology and Consumer Discretionary were the top performers and Energy was the worst performer—despite the two administrations sharing very little in common in terms of their policy preferences. Further, it’s interesting to note that Energy was the worst performing sector during Trump’s time in office and thus far has been the laggard during the Biden administration—again despite the two having very different energy policies.

1. Bonds have delivered generally solid performance thus far in 2024 due in large part to higher starting yields to begin the year

A wide variety of bond strategies outperformed cash (government money markets) through the first nine months of the year.

2. Money markets and short duration bond strategies have materially outperformed the broader bond market over the last four years.

Ultra-short-term and short-term bonds have delivered positive total returns since the broad investment-grade taxable bond universe peaked and began its historic drawdown in July 2020.

3. The relationship between longer-term bond yields and Fed rate cuts is not as straightforward as is commonly assumed.The yield on the 10-year Treasury note, a benchmark for mortgage rates and a variety of other borrowing costs across the economy, historically has not directly followed the path of the Federal Funds Rate.
4. 10-Year Treasury notes have delivered solid positive performance following the Fed’s first rate cut of a new easing cycle.

Despite the uneven relationship between the Fed’s rate policy and the 10-year U.S. Treasury yield, 10-year Treasuries have historically delivered solid positive performance following the Fed’s first rate cut.

1. Direct lending (private credit) continued to deliver strong performance through the second quarter.

The Cliffwater Direct Lending Index (CDLI) an asset-weighted index of approximately 16,200 directly originated middle market loan holdings totally $358 billion as of June 30, 2024, continued to deliver strong and consistent performance thought the end of the second quarter (the latest date for which data was available) driven primarily by high interest income offset by modest, albeit below historical average, credit losses.

2. Direct lending yields remain attractive relative to traded public credit assets such as high yield bonds and leveraged loans.

As of June 30, 2024, current yields (coupon interest divided by current price; a more conservative calculation of yield than yield to maturity) on direct lending were 11.65% which represented a noticeable premium to the yields available on traded public high yield bonds (6.75%) and leveraged loans (8.79%).

3. Direct loans continue to demonstrate fundamental resiliency as indicated by still below-average levels of non-accruals.

One indicator of future realized credit losses for direct loans is the percentage of loans on non-accrual status—loans that are no longer current in paying interest income and would be considered in default. The chart below presents the percentage of outstanding loan amounts both as a percentage of cost value (CV) and fair value (FV). As a percentage of cost value, the 1.60% June 30, 2024, non-accrual rate was up slightly over the previous quarter but remained well below its 2.17% average over the last 17 years.

4. Direct lending payment-in-kind (PIK) income has been on the rise and is something to watch as it may be indicative of potential future market stress.

Interest income from a loan portfolio is mostly comprised of quarterly cash payments. However, in some situations, interest is paid in additional non-cash principal, referred to as payment-in-kind or PIK income. Generally, PIK is less desirable than cash interest income and high proportions of PIK can show deterioration in loan quality and signs of market stress, rising during periods of economic strain and falling periods of economic growth. During the second quarter, PIK jumped to 8.4% of current income, up from approximately 7% over the last several quarters.

5. Commercial real estate prices continue to modestly rebound.

Through September, a commonly cited benchmark for commercial real estate prices, the Green Street Commercial Property Price Index, has reported either flat or positive month-over-month changes in real estate values every month this year. The all-property index has increased by 3% this year.

1. Job growth continues to power on.

September was the 45^th consecutive month of jobs growth in the US. Thus far in 2024, the economy has added approximately 200k jobs per month

2. Pretty much everyone who wants a job has a job.

The employment-to-population ratio for people aged 25-54 is a good indicator of the overall health of the labor market since it’s focused on people who are unlikely to be in college or to take early retirement. As of September, this measure was at 80.9%, which is higher than both before the pandemic and the average since the start of 1980, and is within one percentage point of the all-time high of 81.9% in 2000.

3. The unemployment rate remains near generationally low levels.

The widely cited headline unemployment rate, which isn’t as reliable of a statistic as the employment-to-population ratio (since it depends on who says they are currently actively looking for a job), while up modestly over the last year or so, remains near generationally low levels and well below the average levels over the last 50-plus years.

4. Job losses remain at low levels.

Initial claims for unemployment (a good proxy for job losses/layoffs) continue to run at levels broadly similar to those of 2023 as well as in 2018-2019. In other words, despite a slight uptick in the unemployment rate, we’ve not seen a material rise in job losses which is what we’d expect if labor markets were materially deteriorating.

5. Wages continue to grow at a healthy pace in excess of inflation.

The still robust and healthy labor markets have continued to power wages higher. Through the first nine months of the year, workers’ wages have consistently grown by 4-5% on a year-over-year basis. Inflation’s cooling to 2-3% has resulted in wage growth consistently outpacing inflation. American workers have now experienced real wage growth for 16 consecutive months dating back to May 2023. This is a welcome relief after more than two years where wages failed to keep pace with inflation from April 2021 through April 2023.

6. Real (i.e., net of inflation), personal income has nearly caught up to its pre-pandemic trend.

After lagging its pre-pandemic trend for a few years coming out of the pandemic, real personal income excluding government transfer payments has now nearly caught back up to trend. Inclusive of government transfer payments, real personal income is modestly ahead of trend.

7. Total economic output (GDP) continues to grow at a healthy clip.

GDP growth for the second quarter (latest data available) came in at 3.0%.

8. Household balance sheets appear to be in pretty good shape.

As a result of the ongoing equity bull market combined with rising housing prices, household balance sheets appear to be in better shape than prior to the pandemic. Liabilities as a percentage of disposable income is roughly unchanged from the end of 2019 at approximately 100%. However, since then, the asset side of household balance sheets has surged to more than 8.6x disposable personal income. Household net worth now sits at 7.6x disposable personal income, more 25% higher than prior to the pandemic.

9. Every income group is significantly less levered relative to recent history.
   One knock against the aggregate statistics presented above is just that—the figures represent the aggregate. However, even when breaking down households by income, we see that every income grouping is significantly less levered today than in the recent past with liabilities as a percentage of assets well below historical levels.
10. Some signs of building consumer stress continue to bear monitoring.

Despite continued job and wage growth, the cumulative effect of higher prices and higher interests continues to put pressure on household budgets. According to an August report from the Federal Reserve Bank of New York, a rising share of credit card and auto loan debt turned delinquent over the last year.

Important Disclosures

Kathmere Capital Management (Kathmere) is an investment adviser registered under the Investment Advisers Act of 1940. Registration as an investment adviser does not imply any level of skill or training. The firm only transacts business in states where it is properly registered or is excluded from registration requirements. Content in this presentation should not be regarded as a complete analysis of the subjects discussed. All expressions of opinion reflect the judgment of the author on the date of publication and are subject to change. Information presented does not involve the rendering of personalized investment and should not be viewed as an offer to buy or sell any securities discussed. Tax information provided is general in nature and should not be construed as legal or tax advice. Always consult an attorney or tax professional regarding your specific legal or tax situation. Tax and ERISA rules are subject to change at any time. All investment strategies have the potential for profit or loss. Different types of investments involve higher and lower levels of risk. There is no guarantee that a specific investment or strategy will be suitable or profitable for an investor’s portfolio. Historical performance returns for investment indexes and/or categories, usually do not deduct transaction and/or custodial charges or an advisory fee, which would decrease historical performance results. There are no guarantees that a portfolio will match or outperform a specific benchmark. Market performance results and index returns do not represent the performance of Kathmere or any of its advisory clients.

The information presented in the material is general in nature and is not designed to address your investment objectives, financial situation or particular needs. Prior to making any investment decision, you should assess, or seek advice from a professional regarding whether any particular transaction is relevant or appropriate to your individual circumstances. Although taken from reliable sources, Kathmere cannot guarantee the accuracy of the information received from third parties. The opinions expressed herein are those of Kathmere and may not actually come to pass. This information is current as of the date of this material and is subject to change at any time, based on market and other conditions. Index performance used throughout is intended to illustrate historical market trends and performance. Indexes are managed and do not incur investment management fees. An investor is unable to invest in an index. Past performance is no guarantee of future results. The mention of specific securities and sectors illustrates the application of our investment approach only and is not to be considered a recommendation by Kathmere Capital Management. The specific securities identified and described above do not represent all of the securities purchased and sold for the portfolio, and it should not be assumed that investment in these types of securities were or will be profitable. There is no assurance that securities discussed in this article have been purchased or remain in the portfolio or that securities sold have not been repurchased.  It should not be assumed that any change in investments, discussed in this article have been applied to your account.  Please contact your investment adviser to discuss your account in detail.

The information herein was obtained from various sources. Kathmere does not guarantee the accuracy or completeness of information provided by third parties. The information in this report is given as of the date indicated and believed to be reliable. Kathmere assumes no obligation to update this information, or to advise on further developments relating to it. All investment strategies have the potential for profit or loss. Different types of investments involve higher and lower levels of risk. There is no guarantee that a specific investment or strategy will be suitable or profitable for an investor’s portfolio. Historical performance returns for investment indexes and/or categories, usually do not deduct transaction and/or custodial charges or an advisory fee, which would decrease historical performance results. There are no guarantees that a portfolio will match or outperform a specific benchmark. Index returns do not represent the performance of Kathmere Capital Management or any of its advisory clients. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. Economic forecasts set forth may not develop as predicted and there can be no guarantee that strategies promoted will be successful. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not ensure against market risk. Asset allocation and diversification do not assure or guarantee better performance and cannot eliminate the risk of investment losses. Tactical allocation may involve more frequent buying and selling of assets and will tend to generate higher transaction cost. Investors should consider the tax consequences of moving positions more frequently.

Stock Investment Risk

Stock investing involves risk including loss of principal. Investing in stock includes numerous specific risks including: the fluctuation of dividend, loss of principal and potential illiquidity of the investment in a falling market. Investing in foreign and emerging markets securities involves special additional risks. These risks include, but are not limited to, currency risk, geopolitical risk, and risk associated with varying accounting standards. Investing in emerging markets may accentuate these risks. Currency risk is a form of risk that arises from the change in price of one currency against another. Whenever investors or companies have assets or business operations across national borders, they face currency risk if their positions are not hedged.

Bond Investment Risk

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond and bond mutual fund values and yields will decline as interest rates rise and bonds are subject to availability and change in price. Government bonds and Treasury bills are guaranteed by the U.S. government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value. However, the value of fund shares is not guaranteed and will fluctuate. High-yield/junk bonds are not investment-grade securities, involve substantial risks, and generally should be part of the diversified portfolio of sophisticated investors. Municipal bonds are subject to availability, price, and to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rate rise. Interest income may be subject to the alternative minimum tax. Federally tax-free but other state and local taxes may apply. Investing in foreign and emerging markets debt securities involves special additional risks. These risks include, but are not limited to, currency risk, geopolitical and regulatory risk, and risk associated with varying settlement standards.

Alternative Investments Risk

Alternative strategies may not be suitable for all investors and should be considered as an investment for the risk capital portion of the investor’s portfolio. The strategies employed in the management of alternative investments may accelerate the velocity of potential losses. Investing in real estate/REITs involves special risks such as potential illiquidity and may not be suitable for all investors. There is no assurance that the investment objectives of this program will be attained. Commodity-linked investments may be more volatile and less liquid than the underlying instruments or measures, and their value may be affected by the performance of the overall commodities baskets as well as weather, geopolitical events, and regulatory developments. The fast price swings of commodities may result in significant volatility in an investor’s holdings. There is a risk of substantial loss associated with trading commodities, futures, options, derivatives and other financial instruments. Before trading, investors should carefully consider their financial position and risk tolerance to determine if the proposed trading style is appropriate. Investors should realize that when trading futures, commodities, options, derivatives and other financial instruments one could lose the full balance of their account. It is also possible to lose more than the initial deposit when trading derivatives or using leverage. All funds committed to such a trading strategy should be purely risk capital.