Executive Summary
- The Federal Reserve commenced its long-awaited rate cutting cycle
- U.S. equities surged to new highs, fueled by sector rotation & broad participation
- The 10s, 2s UST spread went positive following a record 26 months of inversion
- Double-digit S&P 500 corporate earnings in 2024 are forecasted to improve in 2025
- Crude oil testing multi-year lows, despite elevated tensions in the Middle East
“Overall, the economy is in solid shape. We intend to use our tools to keep it there.” – Chair Jerome Powell at the National Association for Business Economics, 9/30/24
The S&P 500 has been in a scorching uptrend since rebounding from the lows of the Fed induced “bear market” in Q4 2022. Since then, the U.S. flagship equity benchmark has finished higher in seven of eight quarters, including four consecutive in the green. Over the prior four quarters, it has a total return of 36.3%, which in the last 20 years has only happened when the stock market was rebounding off the 2020 covid lows and 2009 GFC lows. Through the end of Q3, the S&P 500 has a total return of 22.1% for its best YTD gain through three quarters since 1997.
The ongoing bull market flies in the face of one of the steepest rate hiking cycles in modern times, and accordingly, there have been many cynics along the way doubting the health and sustainability of the trend. Admittedly, there have been periods of time characterized by narrow leadership where the majority of stocks underperformed their cap-weighted benchmarks; however, they were eventually ben followed by a healthy rotation into previously underperforming sectors and industries. Importantly, S&P 500 corporate earnings growth rebounded sharply in 2024 and is expected to do so again in 2025.
That healthy sector rotation was evident here in Q3 as the major equity benchmarks were led by the S&P 500 Equal Weight Index (+9.6%), followed by the small cap Russell 2000 (+9.3%), the blue-chip Dow Jones Industrials (+8.7%), and the Russell Microcap (+6.9%) indices.
Both small- and large-cap Value, as well as small-cap Growth, meaningfully outperformed large-cap Growth.
Ten of 11 large cap sectors finished higher in Q3, led by Utilities, (+19.4%), REITs (+17.2%), Industrials (11.6%), Financials (+10.7%) and Materials (+9.7%). Energy (-23%) was the only sector in the red, but stands with a respectable 8.4% total return YTD.
In similar fashion, 10 of 11 small-cap sectors finished higher, including seven with double-digit returns. REITs (+17.6%), Communications (15.9%), Financials (+15.8%), and Utilities (+14.1%) were the top performers while Energy (-8.1%) was again the only sector in the red.
In September, the Federal Reserve cut the overnight FFR by 50 bps while communicating the future path remains data dependent meeting to meeting. The quarterly Summary of Economic Projections (SEP) released at September’s FOMC showed a median forecast for another 50bps in 2024 and 100bps in 2025. The marketplace is more “dovish,” pricing another 75bps in 2024 and 125 bps in 2025.
Chair Powell noted the Fed’s confidence that inflation is headed back towards its target allows it to focus on the slowing labor market by moving off its restrictive rate policy, evidenced by a record 26-month inversion in the 10s,2s UST spread. The market’s anticipation of the rate cut led to a sharp steepening of this spread in mid-July before normalizing into positive territory in early September.
The 2022-2023 rate hike cycle disproportionately hurt smaller companies that tend to have more floating rate debt which pressures margins. The dovish pricing of rates in Q3 is one of the primary drivers of the sector rotation from large-cap growth into small caps, value and cyclicals — reminiscent of Q4 2023. In particular, the rate-sensitive regional and community banks have trended sharply higher in correlation with the markets anticipating increased rate cuts. In July, amidst a backdrop of slowing growth and softening employment data leading to a sharp decline in rates, the small-cap Russell 2000 Financials Index had its best monthly performance (+16.6%) since inception in 1996.
While lower rates have been a tailwind for stocks, corporate earnings have arguably been the principal driver. S&P 500 companies saw 11.3% YoY earnings growth in Q2 with 80% beating estimates versus a five-year average of 77%. Q3 earnings growth is expected to slow to 4.3%. According to FactSet, S&P 500 earnings are forecasted to grow 11.3% in CY 2024 and 14.4% in CY 2025.
Last week, China announced a broad range of stimulus measures resulting in dramatic moves higher in the stock market. China’s Shanghai Shenzen CSI 300 Index rallied 25% over the ensuing five sessions, which, from a market perspective, may signal and an end to its near four-year bear market.
Despite elevated Middle East tensions, WTI crude is testing multiyear support in the $65 – $69 range. From a technical perspective, crude is increasingly at risk of breaking support, which could unleash increased downside momentum. While lower crude prices can often reflect a sharp economic slowdown, this cycle’s catalyst could be supply driven. Lower energy prices would provide an additional tailwind for global growth.
While some sectors of the U.S. equity markets may appear stretched, others are on the cusp or in the early stages of breaking out from large ranges, which may suggest the early stages of new uptrends.
The broad-based S&P 500 Equal Weight Index is in the early stages of breaking out above its prior cycle highs from January 2022.
The S&P 500 Materials Index is just starting its breakout from a 3+ year range.
The Dow Jones Transportation Index appears to be on the cusp of breaking out from a more than three year trading range.
Given the strong run over the first three quarters of 2024, any near-term corrective price action would not be too surprising and arguably somewhat healthy for the intermediate to longer term time frames. Elevated risks markets will have to contend with include heightened geopolitical tensions in the Middle East, political uncertainty ahead of the upcoming presidential election, a richly valued S&P 500, which is trading at ~21.5x forward 12M earnings, and most recently dockworkers striking at every major port on the U.S. East and Gulf coasts for the first time in over 50 years.
Over the intermediate to longer term, cheap energy, China stimulus, global central banks easing, corporate earnings growth and a Federal Reserve aiming to use its tools to keep the economy in “solid shape” should bode well for markets.
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