Summer Sunshine or Storms?
Fingers crossed, you had a great Independence Day (and you still have all of your fingers to cross). As we move into the middle of summer, there have been a series of major events occurring, some market related, some politically inspired, that have the investment markets feeling a bit “irritable” and perhaps have you feeling a bit uncertain. I felt that now is a great time to share some thoughts, observations, and expectations.
Historically, the summer months have been slow, quiet, and otherwise boring for capital markets. Once upon a time, most of the Wall Street banks and brokerages would slow down significantly while many of their lead decision makers would leave for vacation. Yet, as with so many other aspects of our lives this has changed dramatically as a result of our increasingly networked and connected world. This is not to say that markets are as active in the summer as they are in the rest of the year, but they are NOT nearly as quiet as they once were - a fact that cannot be ignored.
We seem to have reached a perfect “goldilocks” period in which the summer months are just active enough to foster in significant, pivotal, systemic changes but there also remains just enough belief that what was always will be. For this reason, these summer events have a disproportional impact on market conditions as those who are “on vacation” see these seismic moves after the fact then scramble to react, not being “ahead of the curve” as they may have been had it been any other time of year.
We first saw this summer phenomenon really materialize in 2015 with a massive currency event that took place in August. The Chinese government devalued their currency overnight in early August (August 11) but then more than a week later, on August 18th, the S&P 500 sold off for 6 days declining more than 11% in a week.
In June of 2022, many were of the mind the markets were “healing” after a very rough start to the year. This was also the first summer that many people finally were ready to travel again. However, as many began to step away from the office, the S&P 500 suffered a 12.5% decline over 9 days in mid-June.
Even last year, we saw the first wave of the “AI Frenzy” reach a head, resulting in a multi-month selloff from late July through October.
But it is not just market declines and selloffs that have been happening during the summer months. There have also been some rather statistically anomalous events occurring in the summer. In fact, this past Thursday (07/11/2024) presented a remarkably anomalous day for markets. However, this does not come as a surprise for us, as it confirms our assessment of market conditions and our expectation for the road ahead.
Many know just how “narrow” our markets have been over the past year and a half. I wrote about this in our last newsletter which has been subsequently published as a blog post here. I likened investing in 2023 to driving a minivan down the Autobahn while watching supercars fly past at breakneck speeds. The real nature of equity market performance in 2023 and 2024 is truly remarkable. Take for example the following which shows how many stocks in the S&P 500 are outperforming the index.
Put differently, look at how many of the S&P 500 stocks are even positive for the year. Would you have guessed this knowing the S&P 500 is up more than 15% for the year?
So what should we make of all of this?
While the media is more than happy to play into your fear centers with headlines about an inevitable, impending crash, the reality is likely to be far more positive than it may seem. While anything is possible, the current evidence strongly suggests a significant likelihood of what I am referring to as a “Breadth Rally” that will play out as follows (this is overly simplified, and I am happy to explore in more detail if you would like. Let me know):
Capital is anxious to exit these highly concentrated, extremely overvalued few stocks that are now radically overpriced and living on borrowed time. As this begins to happen, it will feel like markets are starting to crash because the headline indexes that everyone watches and views as a proxy for the “market” (S&P 500, Nasdaq 100) are cap-weighted meaning their performance is disproportionately impacted by these largest companies that will be experiencing capital-flight. The question is where this capital goes. (Hint: July 11th is your clue)
In our opinion, rather than flee to assets and asset classes that had previously been seen as “safe” or “risk-off” (bonds, T-bills, etc.), we believe it will be repositioned in the vast array of stocks that are significantly undervalued. This includes small cap companies (with the exception of regional banks, at first), value companies (consumer durables, staples, utilities, etc), and International companies.
This will lead to a breadth rally that will in many ways go undetected as the headline indices will appear to be falling, triggering a sentiment collapse. This may, in turn, prove to be disinflationary, thereby allowing the Federal Reserve some leeway to slowly begin cutting rates. These rate cuts will then further bolster the small cap companies as their future success depends on their having access to easy (cheap) capital, a.k.a. lower interest rates.
It will be at this point that capital will then begin to get nervous of equity (stocks). Historically, on first rate cuts, markets rally but that rally should be sold as inevitably, the rate cuts correlate with market and economic turmoil. Also, rate cuts will lead to the bond market to look far more appealing, so capital will begin to chase this. It is at this point we believe the real risk will begin to surface in the markets.
We have no interest in trying to predict what the future will hold. Instead, our analysis suggests this to be the most likely scenario based on current conditions. This does not mean it will happen. We will be monitoring and remain more than willing to change our minds if evidence necessitates. In the meantime, we hope you are having a great summer.
Respectfully,
Casey V. Fulp, CFP®️