June 2024 | Mullaney on the Markets​

A “Top Heavy” Stock Market​

By Michael Mullaney | Director of Global Markets Research

Published June 2024

Stocks rebounded in May after benign inflation reports and signs of moderation in economic activity, with the S&P 500 Index advancing by 4.96% on a total return basis. Data released during the month saw the April Core CPI reading reaching a three-year low of 3.6% on a year-over-year basis, while the Core PCE month-over-month gain of 0.2% was lower than consensus expectations. GDP growth for Q1 was finalized at 1.3% versus the preliminary estimate of 1.6% and both the Dallas and Chicago Federal Reserve purchasing managers indexes (PMIs) came in much lower than expected. Fed funds futures repriced the probability of a least one rate cut this year by the Federal Open Market Committee (FOMC) higher, from a 48% probability at the start of the month to 57% by month’s end, despite a chorus of FOMC members indicating that “higher for longer” was the most likely case for rates going forward.

Bonds responded favorably to the economic news: The Bloomberg U.S. Aggregate Bond Index gained 1.70% as interest rates fell by an average of 0.18% for U.S. Treasury bonds with maturities ranging from 2-years to 30-years in length.

Year to date, the S&P 500 Index has gained 11.31%, while the Bloomberg U.S. Aggregate Bond Index remains in the red with a loss of 1.64%.

Ten of eleven sectors post gains during the month

Ten of the eleven sectors that comprise the S&P 500 Index produced gains during May, led by Information Technology, which returned 10.08% and contributed 58% of the S&P’s overall return. Three stocks—NVIDIA, Apple, and Microsoft—generated an average return of 15.6% and contributed 88% of the tech sector gain.

Utilities had the second highest return in May at 8.97% and the second highest year-over-year earnings growth rate in Q1 of all eleven sectors (+33.4%) as electricity demand soared on AI-related projects. The International Energy Agency forecasts that by 2026 global data centers will require 1,000 terawatts of electricity, up from 460 terawatts used in 2022. Data center electricity demand in the U.S. alone is expected to increase from 2% of available supply today to 8% by 2030 according to Bank of America research.

At –0.39%, Energy was the sole sector in the loss column during the month, as the price of WTI crude oil fell from $81.93 a barrel to $76.99 and natural gas closed the month lower, finishing at $1.75 after hitting a high of $2.64 on May 23. The U.S. Energy Information Administration reported weaker fuel demand and a surprise jump in gasoline and distillate fuel stockpiles as refiners ramped up their utilization rates to the highest levels in nine months.

A dwindling number of stocks continue to drive performance

Ten sectors posted positive results on a year-to-date basis, with Communication Services in the pole position with a gain of 20.88%. Two companies, Meta Platforms and Alphabet, are responsible for 85% of the sector’s overall return.

Next up is Tech, with a YTD gain of 17.31%, as NVIDIA alone (up 129.39%) contributed nearly 74% of the overall sector return.

Real Estate remains in the cellar with a YTD drop of 4.35%, as commercial real estate losses continue to mount on loans and property valuations, which has dragged down the value of real estate investment trusts.

Risk-on dominates

“Risk on” was the prevalent trend in May, as low-quality stocks within the S&P 1500 Index (those rated “B” or lower by Standard & Poor’s) beat high-quality stocks (“B+” or higher) by 51 basis points; the highest-beta quintile of the S&P 500 beat the lowest-beta quintile by 6.89% and the Russell 2000 Index of small-cap stocks outperformed the Russell 1000 Index of large-cap stocks, 5.02% versus 4.71%.

On a YTD basis, the story is much the same: Low-quality stocks beat high-quality stocks (12.08% versus 3.57%) and high-beta securities beat low-beta securities by nearly 20%. Only small-cap stocks failed to continue the trend, with the Russell 2000 Index lagging the Russell 1000 Index, 2.28% versus 10.58%.

Mixed results for value and growth

In terms of style, large-cap value lagged large-cap growth during May, with the Russell 1000 Value Index returning 3.17% compared with the 5.99% return generated by the Russell 1000 Growth Index. Information Technology was once again the primary driver of the performance differential between the two benchmarks, with the technology sector in the growth index gaining 10.15% (and contributing 72% of the overall index return) while the technology sector in the value index returned 4.69% (and contributed just 12% of the overall return). NVIDIA, which is not included in the Russell 1000 Value Index, was alone responsible for almost 35% of the overall return of the Russell 1000 Growth Index.

Year-to-date tells a similar story with the Russell 1000 Growth Index returning 13.08% to the 7.64% return of the Russell 1000 Value Index. In a “Groundhog Day” way, technology again played a commanding role in the return differential between the two indices as “tech” in the 1000 Growth Index returned 18.02% versus the 2.66% tech return of the 1000 Value Index and accounted for 72.2% of the 1000 Growth Index return. Just two stocks, Microsoft, and NVIDIA, were alone responsible for 54.8% of the overall return of the Russell 1000 Growth Index.

In the mid-cap space, the story was different, with the Russell Mid Cap Value Index outperforming the Russell Mid Cap Growth Index by 2.52% for the month (3.59% versus 1.07%) and by 2.00% year to date (6.24% to 4.24%). Nine of the 11 value sectors outperformed their growth counterparts during the month, while 7 of 11 outperformed over the first five months of the year.

Non-U.S. stocks lag

Returns for developed-market international stocks and emerging market stocks trailed the S&P 500 in May, with the MSCI EAFE Index gaining 2.58% and the MSCI Emerging Markets Index advancing by just 0.51%, both in local currency terms. Results in U.S. dollar figures were better, with the MSCI EAFE Index gaining 4.00% and the MSCI Emerging Markets Index gaining 0.59%. Amid lower U.S. interest rates, the dollar fell by 1.46% during the month versus a currency basket comprising the euro, Swiss franc, Japanese yen, Canadian dollar, British pound, and Swedish krona, while the MSCI Emerging Markets Currency Index gained 0.51%.

The MSCI EAFE Index continues to lead the S&P 500 Index on a year-to-date basis in local currencies with a gain of 12.08%, though in U.S. dollar terms, it remains behind the S&P 500 with a return of 7.46%.

The scant return recorded in May hindered the year-to-date performance of the MSCI Emerging Markets Index, holding the gain to 6.59% in local currencies. Like the EAFE Index, the return in $USD terms was lower at 3.53%, as the dollar has appreciated against a majority of EM currencies over the course of the year.

Earnings and interest rates drive stock prices

Over time, the two primary drivers of stocks prices have been earnings and interest rates. With analysts expecting S&P 500 earnings to grow by 11.3% in 2024 and 14.2% in 2025 and revisions holding steady, the earnings backdrop for equities remains favorable over the immediate horizon, even if the growth is concentrated in the technology sector. Over the near to intermediate term, there is a low probability of earnings being hurt by a recession due to past monetary tightening actions.

The Fed and markets are data dependent

Given that the Fed has stressed that their actions (or lack thereof) are going to be data dependent, inflation and the unemployment rate are the two key economic variables worth watching. If inflation continues to moderate, then the Fed will eventually cut rates, longer-term interest rates follow suit, and stocks are fine. If inflation stays sticky at an undesirably high level, the Fed stays put (unless unemployment spikes) and the bond market needs to unwind any expected rate cut(s) imbedded in prices. In that scenario, the stock market would be vulnerable to a correction. Either way, digesting each data point implies a choppy market—and that’s before factoring in any geopolitical risk events that may crop up.

Watch market breadth

Currently we are keeping an eye on market breadth. While the S&P 500 hit its 24th record close of the year on May 21, the breadth of market movers appears to be waning, as just 61% of the stocks in the index closed above their 50-day moving average that day. Contrast that with January 8, when the S&P 500 hit its first record close of the year. Then, 91% of the stocks in the index closed above their 50-day moving average. At the end of May, only 51% were above that average. All else being equal, a broader array of stocks backing record closes is better than not.

Lastly, based on historical returns the stock market seems to be on good footing this year. Since WWII, when the S&P 500 was up through May, returns for the full year remained positive 87% of the time with an average additional gain of 9.08% from June to December.

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Michael Mullaney
Director of Global Markets Research

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