August 2024: A volatile start with a familiar finish

August 2024: The month at a glance

After a volatile sell-off in equities in the first week of August, stocks regained their footing with most broad indices posting their fourth straight positive month.

The combination of the Bank of Japan increasing interest rates more than expected on July 31st and a weaker than expected US employment report on August 2nd caused a sharp drop in equity prices to start the month. Investors unwound “yen carry trade” positions (borrowing at very low interest rates in Japan and investing the proceeds in assets with higher expected returns like the “magnificent seven” US stocks) and also dumped the economically sensitive small cap stocks that had rallied substantially in July. After the sharp but brief sell off, the rest of August saw solid economic reports and dovish Fed policy comments that buoyed investors confidence and fueled a recovery in the markets.

The July employment report showed 114,000 jobs added, well below prior months, and an unexpected increase in the unemployment rate.^[1] The softening in labor markets spooked investors, but subsequent news calmed fears of a looming recession. Consumer spending rose more than forecast, led by strong gains in auto and general merchandise sales.^[2] Initial jobless claims eased over the month.^[3] And, while all eyes were on Nvida’s earnings release at the end of the month, the full S&P 500 was having a stellar quarter, reporting 10.9% earnings growth from a year earlier, the highest growth rate since Q4 2021.^[4] 

On the inflation front, the Fed’s preferred gauge, the Personal Consumption Expenditure price index, was unchanged in July, a relief to investors after the index had increased in June.^[5] The improved inflation outlook allowed Fed Chair Powell to declare that the “time has come” for interest rate cuts, all but guaranteeing a lowering of interest rates at the Fed’s September meeting.^[6]

Stocks stabilize after a challenging start

Broad US and international equity indices posted modest gains in August. Much of the rotation that characterized July was undone during the month, with small cap stocks falling sharply to start August and not fully recovering by month’s end. Still, value stocks which also rallied in July, fared relatively better than their growth counterparts over the month. 

• S&P 500 rose 2.43% for the month and is now up 19.53% in 2024.^[7]
• The NASDAQ composite index managed just a slight gain as technology stocks came under pressure.^[8]
• Value stocks led their growth counterparts in large and small cap^[9]
• The Dow hit a record high by the end of the month.^[10]
• Small cap stocks sold off heavily at the start of the month and ended up posting negative returns for the month.^[11]
• Developed international markets slightly outpaced the S&P 500.^[12]
• Defensive industry sectors led the way in August:some text
  • Real estate and financial stocks continued their recent surge^[13]
  • 2024’s leaders, technology and communications services, lagged the broad market.^[14]

Rising expectations for a September rate cut

With Fed Chair Powell’s comments on coming shifts in policy, investors are now pricing in four one-quarter point Fed Funds rate cuts in 2024 and more in 2025.^[18] During August, the 10-year treasury yield fell 23 basis points to 3.87% to end the month.^[19] At the shorter end of the curve, the 3-month treasury bill yield fell 20 basis points to 5.21%. With rates falling over the past several months, fixed income returns have finally returned to positive territory.

• Fixed income returns were positive across all segments in August, the fourth consecutive monthly increase.^[20]‍
• Higher risk fixed income (preferreds, emerging markets and high yield) continued to lead the way^[21]‍
• Short duration fixed income posted the weakest returns for the second consecutive month.^[22]

High Equity Valuations Supported by Strong Economy

A mix of positive factors have supported a remarkable run of strong performance for US equities, especially large cap, growth and technology stocks, in the past several years. Despite the substantial increase in interest rates in 2022 and 2023 and the Fed’s “higher for longer” posture so far in 2024, economic growth in the US has remained surprisingly strong. Corporate earnings have also shown solid growth in the past several quarters with much of that growth delivered by companies in the technology and communications service sectors. More recently, stocks associated with the artificial intelligence revolution, have seen tremendous increases in their stock prices, outpacing even their exceptional earnings. As a result, the valuations of US equities in general and the stocks in these sectors and themes in particular, have risen to levels that cause fears of overvaluation.

There are many ways to view valuations, but most measures currently indicate well above average valuations for much of the US equity market. The chart below shows the Price-to-Earnings measure using the S&P 500 stock prices relative to the 10-year rolling earnings to reduce the influence of the near-term earnings cycle, the CAPE ratio.^[23] By this measure, the current valuation level is indeed high relative to history going back to 1900. The 35x level reached in August (and the 38x hit in November 2021) has only been topped in the 1999/2000 dot-com bubble. In fact, a CAPE ratio above 30 is a rare occurrence, adding only the 1929 pre-depression peak to the periods. These lofty valuation levels rightly worry investors as the chart shows steep declines in valuations following the 1929 and 2000 peaks, declines that were brought about by equity price drops rather than increases in earnings.

Still, the current period has some characteristics that are important to consider. First, like the 1999/2000 period, the high valuations are concentrated in a relatively narrow segment of the market. The “magnificent seven” and now the AI related stocks have dominated the market gains much like the dot-com companies in 1999. There are large pockets of the market whose valuations are unusually low in relative terms and so will likely perform relatively well in any correction. Small cap and value stocks are the leading candidates for such a rotation in the current environment as they were in 2000. Second, the earnings growth delivered by the current highly valued companies has been very strong and has allowed them to stay richly valued (i.e., generally above 30x) since the middle of 2017, far longer than in 1929 and 2000. In the dot-com era, most of the leading, expensive companies were reporting negative earnings.^[25] When the tide turned, many had nothing to support their operations and most companies went out of business. This is not the case now.

The two prior periods of “extreme” valuations have occurred when the economy was running at a high pace. The 1929 peak was preceded by the roaring twenties, and the 2000 peak came after the longest period of economic expansion post-World War II. They each ended with a recession. The current period has occurred during a period of mixed economic growth, but unusually accomodative monetary and fiscal policies that were put in place during the Global Financial Crisis in 2008 and furthered during the 2020 pandemic have helped avoid a recession. Whatever the long-term implications of these policies may be, they have certainly provided liquidity to keep the economy out of a recession and boost earnings that support high valuations.

While fiscal policy remains expansionary, the Fed began tightening monetary policy in 2022 in an effort to bring down high inflation. Interest rates rose substantially and quantitative easing programs started to wind down. This policy shift was widely expected to bring about a recession. So far it has not, but concern remains high that we are not out of the woods yet. Predicting recessions is not easy, but several measures have proved helpful historically.

When longer dated treasury yields are lower than shorter term treasury yields the yield curve is said to be “inverted”. Periods of inverted yield curves (i.e., negative spreads) have preceded each recession since World War II.^[26] Currently, the yield curve is inverted for 10-year minus 3 month treasury yields, but the 10-year to 2-year treasury yield spread has just returned to 0 (i.e., not inverted). There is a debate on which measure should be used, but both have shown the same predictive power historically. What we can say is that we have a mixed forecast and one that shows a less likelihood of a recession than it did in 2023 and earlier this year.

Another useful forecasting gauge is the Conference Board’s index of Leading Economic Indicators (LEI).^[29] The LEI is a composite of economic indicators that have historically provided advanced signals on the direction of the economy. When the six-month change in the LEI has fallen below -5%, it has historically been a predictor of a recession. In the current period, the signal fell below -5% in mid-2022 (with no recession) and has just returned above -5%. The measure is still in the recession “warning” state (when the six-month growth rate is below 0), but is no longer predicting an imminent recession.

Investors should rightly be wary of “this time is different” comments about the currently high US equity valuations. Still, there are some clear explanations of how valuations got this high and why they have remained at these elevated levels for longer than past episodes. Those conditions may indeed persist and allow the valuations (and the overall market) to remain high. Because equity prices tend to ultimately reconcile with company earnings, one of the supportive conditions is the very strong earnings growth from the highly valued companies. As we saw with Nvidia at the end of August, even exceptionally strong expected future earnings growth may fall short of the expectations baked into the stock price, but certainly any weakening of earnings overall for the high flyers would usher in a collapse in valuations. The major risk to continued strong earnings is a broad economic recession. On that front, it is encouraging that signs we reviewed here suggest that risk has diminished at least slightly.

^[1] https://www.bls.gov/news.release/empsit.nr0.htm

‍^[2] https://www.census.gov/retail/sales.html

‍^[3] https://www.dol.gov/newsroom/releases

‍^[4] https://www.factset.com

‍^[5] https://www.bea.gov/news/2024/personal-income-and-outlays-july-2024

‍^[6] https://www.federalreserve.gov/newsevents/speech/powell20240823a.htm

‍^[7] https://www.spglobal.com/spdji/en/index-family/equity/

‍^[8] https://www.nasdaq.com/market-activity/index/comp

‍^[9] https://www.spglobal.com/spdji/en/index-family/equity/

‍^[10] https://www.spglobal.com/spdji/en/index-family/equity/

‍^[11] https://www.spglobal.com/spdji/en/index-family/equity/

‍^[12] https://www.msci.com/end-of-day-data-search

‍^[13] https://www.spglobal.com/spdji/en/index-family/equity/

‍^[14] https://www.spglobal.com/spdji/en/index-family/equity/us-equity/sp-sectors/#indices 

‍^[15] https://www.spglobal.com/spdji/en/index-family/equity/

‍^[16] https://www.nasdaq.com/market-activity/index/comp/historical 

‍^[17] https://www.spglobal.com/spdji/en/index-family/equity/

‍^[18] https://www.cmegroup.com/markets/interest-rates/cme-fedwatch-tool.html

‍^[19] https://fred.stlouisfed.org/series/DGS10

‍^[20] https://www.spglobal.com/spdji/en/index-family/fixed-income/

‍^[21] https://www.spglobal.com/spdji/en/index-family/fixed-income/

‍^[22] https://www.spglobal.com/spdji/en/index-family/fixed-income/ 

‍^[23] https://shillerdata.com/

‍^[24] https://shillerdata.com/

‍^[25] https://www.goldmansachs.com/our-firm/history/moments/2000-dot-com-bubble

‍^[26] https://people.duke.edu/~charvey/research_term_structure.htm

‍^[27] https://fred.stlouisfed.org/series/T10Y2Y

‍^[28] https://fred.stlouisfed.org/series/T10Y3M

‍^[29] https://www.conference-board.org/topics/us-leading-indicators

‍^[30] https://www.conference-board.org/topics/us-leading-indicators

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