Positioned for Market Upside, but with a Measure of Prudence

Matt Freund, CFA, Michael Kassab, CFA

Summary Points:

• The US economy has proven remarkably resilient over recent quarters, but signs of economic weakness are increasing.
• During the second quarter, equity market performance has been driven more by momentum and less by fundamentals and valuations.
• Given a less certain economic outlook, narrow market leadership, and geopolitical and election uncertainties, our team has maintained an emphasis on high-quality companies.

Despite persistent forecasts of an economic slowdown and numerous indicators signaling weakness—notably, the Leading Economic Indicators’ consistent decline since December 2021—the economy demonstrates unexpected vigor.

We believe the economic resilience of these past several quarters can be attributed, in part, to the lingering effects of Covid-related stimulus measures and robust fiscal spending, which effectively counterbalanced the impact of elevated short-term interest rates. At the same time, a growing wealth effect and rising incomes have mitigated the adverse impacts of persistently high inflation and sustained consumer spending. However, there are recent signs of emerging weakness, particularly among lower-income consumers.

Equity Market Dynamics: The AI Revolution

Recognizing AI’s significant opportunities, investors have directed their attention—and capital—toward potential “AI winners.” This focus has led to a historic concentration of market value in a handful of stocks. Currently, the four largest companies in the S&P 500 account for nearly 25% of the index, a level of concentration not witnessed since 1964.

Technology-related sectors have emerged as clear frontrunners, consistently outperforming benchmark returns. However, it’s crucial to note that the average growth stock’s performance has been more subdued than many investors realize. For example, the capitalization-weighted S&P 500 Technology sector delivered an impressive 34% return in the first half of the year, but the same group of companies yielded a more modest 12.6% return when weighted equally.

Market Trends and Factor Performance

This market dynamic has fostered intriguing trends. Momentum—the tendency for rising stocks to continue their upward trajectory—has emerged as the dominant factor influencing performance. Conversely, fundamentals and valuations, which typically drive outperformance over extended periods, have exerted minimal influence on stock performance.

As a result, valuations have surpassed historical averages. However, with earnings growth projected to accelerate in the latter half of the year (current expectations place S&P 500 earnings for 2024 at approximately $245 per share, representing an 11% increase from 2023) we do not anticipate that these elevated valuations will negatively impact returns.

Looking Ahead: Challenges and Opportunities

There are indications that many of the tailwinds propelling the economy are beginning to dissipate. Financial conditions show signs of softening, and stress signals are emerging among the most vulnerable consumer segments. Additionally, the upcoming US election and many geopolitical risks pose significant challenges for investors.

In this complex environment, we are focusing on risk management and identifying high-quality companies capable of generating substantial cash flow and earnings growth while maintaining robust and flexible financial positions. Although we expect technology to remain at the forefront of investment opportunities, the proliferation of AI benefits across various sectors should broaden the landscape for potential investments.

As AI’s transformative impact permeates the broader economy, we anticipate a corresponding expansion of investment prospects beyond the technology sector, potentially leading to a more diverse and balanced market environment.