Q2 2024 – Commentary

Thinking about what to write in this quarter’s investment commentary, I ponder on the state of the world, the stock market and other various asset classes. I am more concerned today about the future of those subjects than I have probably ever been. My concerns are almost too many to mention, but I have to talk about a few.

Let me start with what is going on globally with half the world’s population voting this year on new governments. Some of those elections have taken place already, with many more to come including the United States of America. It seems the citizens of these democracies are not very happy with their existing governments; for example, in Britain and France, new parties or coalitions have already been given mandates.

There was no shortage of political headlines in the United States either, including a fumble by President Biden in the presidential debate and even though Trump did not deserve to score a touchdown, he certainly won that game big time. And then, of course you have the horrific assassination attempt of former President Trump, which catapulted his popularity and certainly puts him in the driver’s seat to become the next president of the United States. If successful, he would be only the second President ever to serve non-consecutive terms. As of this writing, President Biden will no longer be considering a run for a second term, which is in itself a rare event. I would not call these normal times.

Of course, you also have two ongoing wars, which we hope will end soon and not spread to become a greater regional conflict. This adds a further layer of risk beyond the previously mentioned political uncertainty. Whether it is additional sanctions related to Russia and Ukraine or the continued attacks by Houthi rebels on commercial and military ships in the Red Sea impacting global supply chain and logistics, these conflicts can still have serious global economic ramifications.

As I move on to investing and asset classes, what we know is that interest rates will be going down. They’ve already started in Canada and this fall the talking heads have suggested that they will start going down in September in the US. Historically, there is one asset class that does very well when interest rates go down: fixed income bonds. The stock market is an asset class that does not do well historically when interest rates go down, as we’ve discussed here in the past.

The S&P 500, which represents a broad index of 500 stocks has hit a new high this year, but as we’ve written in previous quarterly commentaries the market is very thin with the so-called “Magnificent Seven” stocks being responsible for the majority of that performance. Another way of looking at the danger embedded in the current environment is that this is not a market, but a very small selection of stocks which have done exceptionally well, concealing the fact that most stocks have underperformed the index.

This very much looks like the late 90s ending with the dot-com bubble bursting. Another reason that we feel one should be very concerned about the stock market is what I called flavour of the month themes. During the dot-com bubble, it was all about the Internet and we know how that ended.

Most recently artificial intelligence, AI, has certainly taken the limelight. Nvidia, the poster child for the AI theme, now has a greater market capitalization than each of the stock markets of Britain, France and Germany. Artificial intelligence is certainly here to stay, and there will be money to be made from the sector, but sometimes these things are overdone where earnings have to catch up to valuations.

There’s an expression I grew up with where it really shouldn’t be called the stock market, but rather called a market of stocks. Right now, especially with a select handful of tech stocks, there seems to be a fear of missing out (FOMO). Let’s get in before these stocks go up even higher. Of course, in market corrections, it’s the opposite where people sell stocks, not necessarily when they’re down 10% and a little nervous, but when they’re down 20% or 30% because of fear they’re going to go down even more.

In the past, we’ve talked about gambling and sports betting and how that has morphed its way into the stock market. Young people believe they must take a lot more investment risk to catch up to their parents in terms of lifestyle and to be able to afford a home like the one they grew up in. Investors who take on excess risk to chase returns should be careful, for as the saying goes: Markets take the escalator up, but the elevator down.

Here is an interesting fact to think about – over the last 90 years the top 86 stocks in the stock market accounted for roughly 50% of the $32 trillion in wealth creation. Amazingly, the top 4% of stocks (1,000 out of the 26,000 on record over the time frame) account for all the wealth creation. Attempting to pick these few winners correctly and repeatedly is a losing proposition, so it’s no surprise that most active equity managers underperform their benchmarks. We believe it is more prudent to be the market rather than try to pick winners when it comes to developed market stocks, as nobody knows which select few may be the wealth creators 10 or 20 years from today.

It is abundantly clear that there are significant risks in global stock markets, both externally from geopolitical factors and internally from heightened valuations in a concentrated segment of the market. What we don’t know, and don’t presume to know, is what will happen in the future. Perhaps a relevant quote for these times attributed to Mark Twain is “It ain’t what you don’t know that gets you in trouble. It’s what you know for sure that just ain’t so.” Betting a significant amount on a certain market, a certain sector, or even a certain stock as many people do is bound to get investors in trouble.

The good news is that stocks aren’t the only available investment for your capital. We have written previously about how bonds present a very attractive risk/reward proposition in a falling interest rate environment. Non-Traditional investments such as mortgages and private credit provide a safe haven from public market volatility at very attractive yields. We are also seeing many more opportunistic strategies given the recent stress higher rates have brought on. These funds are able to pounce on very specific deals in real estate and other squeezed areas as they arise. Taking on significant risk to chase stock returns isn’t necessary if investors zoom out and evaluate other asset classes which large institutions have been investing in for decades.

To quote Brian Portnoy from his book, The Geometry of Wealth, “there is a distinction between being rich and being wealthy… one is the quest for more money. The other is funded contentment.” We hope this letter finds you content.

I have been read many interesting books recently, and have decided to highlight my favorites over the last few months. They tend to be books on investments, wealth, planning and living your best possible life.

Start With Why: How Great Leaders Inspire Everyone to Take Action

By Simon Sinek

The Psychology of Money: Timeless Lessons on Wealth, Greed and Happiness

By Morgan Housel

Don’t Leave a Mess!: How to Disaster-Proof Your Family Legacy By Sandy Pollack

Principles: Life and Work

By Ray Dalio

The Geometry of Wealth: How to Shape a Life of Money and Meaning

By Brian Portnoy

The Myth of the Silver Spoon: Navigating Family Wealth and Creating an Impactful Life

By Kristin Keffeler

The Mysterious Case of Rudolf Diesel: Genius, Power and Deception on the Eve of World War I

By Douglas Brunt

What This Comedian Said Will Shock You

By Bill Maher

Q2 2024 – The Markets

Q2 2024 witnessed a stark divergence in stock markets returns. The S&P 500 index was again the top performing market index among its global peers, returning 4.3% for the quarter, far eclipsing other developed markets at 1.0%. Mega-cap stocks, fueled by AI enthusiasm, drove S&P 500 gains once again. Ongoing sluggishness in the performance of Canada’s bank stocks have conspired to limit the TSX’s second quarter to a slight loss (-0.5%).

Four S&P 500 sectors made gains in Q2, while the remaining seven experienced losses. Technology’s +8.8% gain made it the top-performing sector, with Communication Services gaining +5.2% and Utilities returning +4.6%. In contrast, cyclical sectors underperformed, with Materials, Industrials, Energy, and Financials being the four biggest underperformers.

The outperformance of the S&P 500 vs. other geographies rests on a fragile foundation, as so much of its return is derived from so few stocks. The rise of a few mega-cap technology stocks has led to more and more concentration in the market. Mega-cap technology stocks continued to drive market gains, with Nvidia alone contributing 1.6% of the market’s returns for the second quarter.

For the first half of this year, the “Magnificent 7” returned a whopping 34.9% while the S&P 500 index as a whole returned 15.2%.

In contrast, the S&P Equal Weighted Index rose 5.1%, while small cap performance was disappointing as The Russell 2000 Index returned a modest 1.6%. The performance gap between the regular S&P 500 (shown in purple below), which weights stocks in accordance with their market capitalization, and the S&P 500 Equal Weighted Index (shown in orange) , where each of the constituents is given an equal 20 basis point weight, has risen to a record high.

Investors need to be cautious and not extrapolate recent stock success into perpetuity.  History has shown that stock market leadership inevitably changes over time.

S&P 500 Market Cap vs. S&P 500 Equal Weight

As in the past several years, central banks were firmly in the spotlight.

In June, the Bank of Canada and the European Central Bank began normalizing their monetary policies by reducing key interest rates by 25 basis points each. The Bank of England is expected to follow with a similar rate cut in August. By contrast, the U.S. Federal Reserve chose to maintain its current policy rates for the seventh consecutive time, highlighting a growing divergence in global monetary policies due to varying economic conditions. The Fed continues to navigate its policy stance amidst strong demand in the services sector and persistent inflationary pressures.

The bond market grappled with challenges in Q2, as rising Treasury yields dampened overall performance. Treasury yields have been volatile in the second quarter as the market navigates a complex transition from rate hikes to rate cuts. On the surface, yields ended the quarter marginally higher, but it was a bumpy ride. The 10-year Treasury yield started the quarter at 4.20%, rose to 4.70% by late April, and dropped back to 4.37% by the end of June. Despite the intra-quarter yield volatility, bonds posted relatively flat returns. Being positioned in shorter duration fixed income has been beneficial through Q2 and year to date, posting positive returns where longer term bond indexes such as the Bloomberg Global Aggregate are down -3.16% for the year.

With the yield curve still inverted (i.e., short term rates are higher than long term rates), short term bonds provide better risk-adjusted returns. The low-duration bond fund in our portfolio returned 7% over the last 12 months. With a duration of only two years, it has much less interest rate risk than the broad bond market and significantly less risk than the stock market.

In contrast to public assets, private credit and lending strategies continue to provide stable return streams at 8-12% over the last 12 months, with a faction of the risk of their public peers. Our portfolios have been holding a healthy weight in these Non-Traditional Income strategies which are expected to continue to benefit from the higher rates for some time, even as short-term rates begin to come down.

A key question now facing investors is whether the improved inflation news will continue, allowing the Fed to start cutting rates in September, as markets now expect. At the same time, can the economy continue its moderate growth pace, or will a slowdown raise the risk of recession? The bigger risk we see is that investors get too comfortable with the idea that there are no imminent threats. It means any surprise – whether on the economy, the AI theme, the Fed or geopolitics – will hit hard.

Q2 – 2024 – Charts

• Investor credit balances and margin debt overlayed with S&P 500 performance over the last 44 years. Investors have historically negative credit balances with the market at new highs.
• As markets fall, there is widespread selling of securities causing margin balances to turn positive since investors are required by their brokers to reduce their debt balances, often more than mitigating it.
• Preceding major recessions such as the Tech Bubble (2000) and the Financial Crisis (2007-2008), margin levels tend to peak with the market – making it a useful indicator to watch for future downturns.
• The indicator is back at the October 2021 low point, after which the S&P500 slipped into a bear market.

Source: Longtermtrends.net

• The Wilshire 5000 Index, which is a broad-based stock index, divided by the GDP illustrates stock valuations relative to the economy.
• This indicator of market valuation measures the market capitalization of public equities relative to Gross Domestic Product in the United States.
• When public market valuations are high relative to GDP (100%+), as they are now, that is an indication that markets may be overvalued.
• As of July 2024 the Buffet Indicator is at its highest peak of 197%.

• The S&P 500 hopes and dreams ratio measures the % of market value not explained by book value or expected earnings over the next 3 years.
• This indicator is designed to show the premium investors are paying for stocks by highlighting the value not explainable by near-term fundamental valuation.
• This metric is nearing its previous high point which occurred in 2000 during the dot-com bubble.
• Currently the S&P 500 hopes and dreams metric sits at 65%.

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