The election of Donald Trump has had a significant and immediate impact politically, both at home and abroad. There has been a reshuffling of the power structure in Washington, with Elon Musk’s stature most notably elevated. International relationships are simultaneously strengthening and fraying, and legal battle lines are being drawn domestically. However, the economic and investment impact has been more muted since November. We could highlight a few market moves that have been driven by changing political expectations, but, in general, the market has continued with the same trajectory it had going into the Presidential election. We do not want to downplay the volatility inherent in Trump’s far-reaching, and sometimes contradictory, economic agenda. But it is also important to emphasize how challenging it is for any administration to wrestle with something as large as the U.S. economy. The levers that steer this giant ship are hard to identify, to say nothing of pulling them in a well-orchestrated fashion to speed things up or slow things down. This is why markets are often so desensitized to changing political winds – the momentum of an economy so often overrides all else. And it may be more significant than any additional commentary to note that the incoming administration is inheriting a relatively healthy economy with moderating inflation.

We give credit here to the Federal Reserve for balancing the historically competing demands of curbing inflation and maintaining economic growth. Normally, the austerity required to accomplish the first goal torpedoes the second, but this time around Jerome Powell seems to have walked a careful line somewhere in between these competing endpoints. Inflation could be lower and growth could be higher, but the “Goldilocks Economy” has proven more than adequate for investors, and it continues to push the stock market gradually higher. The incoming administration has inherited these benign conditions. We are skeptical that this administration, or any other, could do much to radically redirect the economy higher, but one aspect of the economy that is still lagging is the construction market, both residential and commercial. If that could recover this year it would help the economy and some cyclical corners of the stock market that have been left out of this technology-driven rally. The construction market is obviously economically important, and it is also an interesting illustration of some of the new variables for investors.

Within his big political tent, there are many allies of Donald Trump who would push wholeheartedly for increased construction, as just one facet of a larger plan to increase economic growth. The difficulty for investors now is determining which voices to listen to within this tent. In our view, the pro-growth advocates are implicitly at odds with Trump’s campaign trail promises of mass deportations and across-the-board tariffs. The likely impact of those two policies would be increased material and labor costs for any construction project, obviously making the larger goal of more construction quite a bit more challenging. An inflationary shadow, implicit within this protectionist agenda, hangs over many other industries in a similar way. Given the equanimity of markets so far, it seems the prevailing approach is to
view some of Trump’s economic talking points as merely tools. This framing refashions much of the President’s economic agenda as a stand-in for conventional diplomacy, where the threat of action is more important than its implementation. If this is indeed the narrative that the market is adopting, it is one we can buy into for the moment. Much of Trump’s first term played out along these lines, and it is an interpretation that allows one to remain in the markets and not spin their wheels too much contemplating the mercurial elements of the President’s agenda.

However, the drumbeat of tariffs is constant now, and has been a theme ever since Trump started campaigning nearly a decade ago. The Executive Office can singlehandedly change the direction of the domestic economy, permissible under the auspices of national security, with the imposition of widespread tariffs. This would change economic decision making across the board, and we will go on record arguing it would cause damage to the economy and stock market. Despite that, this administration remains enamored with the idea and that cloud hangs over a stock market that is near an all-time high.

Current Strategy

There is an obvious tension between these two narratives. An optimistic view focuses heavily on the relative strength of the U.S. economy today, while assuming much of the agenda that could derail it is never put into effect. A pessimistic view pairs a stock market that has already made significant progress over the last two years with new storm clouds to contemplate on the horizon. Our goal now is to balance both views going forward. After several strong years of returns in the stock market, we think investors will have to take bigger risks in order to achieve potentially diminished returns. That is not a great setup and our overall allocation reflects that, with cash in reserve for better opportunities. However, it is also important to view potential new investments through a clear lens, one that is not politically cloudy. We found many great new investments on behalf of clients during Trump’s first term, all of which required situational optimism. We’re confident we can do so again.

There have been some moves in the stock market, with obvious political motivations, that are worth mentioning. As noted above, we are not interested in jumping on the carousel of politically-motivated investment thinking, but it is illuminating to simply outline some of what has transpired since November. The incoming administration is seen as favorable to cryptocurrencies, while advocating for less financial regulation, and Bitcoin and banks staged a rally in the first days after Trump got elected. Conversely, there is understandable hand-wringing among investors over the possible Congressional confirmation of Robert F. Kennedy Jr. and what that would mean for healthcare companies. Any changes to healthcare policy coming from this new administration are still vague, but this new brand of Republicanism carries a tonal shift that is more skeptical of, and possibly more antagonistic toward, the healthcare industry.

Perhaps the most significant market development with political origins since Trump’s election has occurred in the U.S. bond market. The same equanimity present in stocks is not shared by bonds, and it is fair to say that holders of longer-dated Government debt are anxious. It is far too early to try and detail Trump’s full economic ambitions and means of accomplishing them, but a rough sketch involves some mixture of tariffs and increased economic growth. Both would likely be inflationary and involve higher deficits for the foreseeable future. (We are skeptical that a Department of Government Efficiency will find meaningful spending cuts that are politically viable). More inflation and larger structural deficits would be unwelcome by bond investors, and in the months since the election, longer-dated bonds have turned lower. This pushed yields higher. If they continue to climb higher from here, that alone could be enough to sap the economy and markets. Mortgage rates are climbing back up past 7% and bond yields may be starting to put pressure on stock valuations, which are always jockeying in competition for investor dollars.

With the election fast approaching, the tension in the United States is palpable.  Markets are reflecting some of this apprehension as deposits to money market funds have risen substantially, gold and Bitcoin are hitting new highs, and a measure of impending volatility (the VIX Index, also known as the “fear index”) is increasing.  Everyone is waiting for an election that appears razor tight, and may not be resolved on election night, or for months afterward if certain scenarios unfold.  We are making no prediction about this election, as we have no clue as to what voters may decide on the Presidential race, the key Senate battles, or numerous, hotly contested races for the U.S. House.  But we will outline the electoral strategies of the major parties and likely investor reaction to possible outcomes.   

The two major parties are largely focused on turning out their own base voters, while furiously picking at the weak seams in the opposition’s coalition.  The Democratic Party has tried to expand its coalition by welcoming disaffected Republicans, exemplified by Liz Cheney and many former staff members of the Trump administration.  How many suburban women, and men, who may have recently voted Republican will follow their lead is anyone’s guess. The Democrats feel that stressing the rule of law and respect for democracy will win over some of these voters as it did with Liz Cheney.  And they believe that others may be attracted to the Party’s strong stance on women’s rights and protecting the rights of marginalized, minority groups.  It doesn’t hurt that most of these persuadable Republicans and Independents are doing well financially in a period of high home values, record stock prices, and high interest rates on bonds and money market funds.

The Republican Party senses that there are quite a few vulnerabilities to exploit in the Democratic coalition.  Republicans have been hammering on the inflation rate of 2021-2023 in an attempt to peel off some lower income voters, including younger men of color who come from traditionally Democratic families.  This demographic is less likely to own a home or stocks and bonds, so the buoyant state of asset prices holds no interest for them, maybe just resentment.  They may have jobs where wage increases have not kept up with the rising costs of food, cars, and rent.  The Democrats have done a poor job of explaining that inflation comes with a lag effect measured in years.  The seeds of inflation were planted in 2020 when governments throughout the world rapidly poured funds into their economies to fight the War on Covid.  While the financial markets have been celebrating the successful inflation-fighting efforts of the Biden Administration and the Federal Reserve, consumers harbor anger over the price rise that occurred on Biden’s watch.  A populace that doesn’t understand economic lag effects will often assign blame or give credit to the wrong party.  In addition to inflation, twelve months of conflict in the Middle East has created fissures in the Democratic Party.  Looking to exploit these divisions, Donald Trump recently appeared on stage with the Arab-American mayor of Dearborn, Michigan, once a Democratic stronghold.

Individual investors have electoral preferences and their emotions are running high, but markets in the aggregate are cold and calculating when measuring political impact.  Markets have done well for the past two years of the Biden-Harris term.  Business leaders and shareholders of businesses prefer to operate under a system of laws and policies that are fairly predictable.  Kamala Harris has been part of an administration that telegraphed its moves and did nothing to alarm or confuse the business community.  There is every reason to believe that the markets would be content with a Harris victory and a continuation of known, favorable policies.  The re-election of Donald Trump could be another matter, as his tariff proposals have no recent precedent.  At a recent rally he said that all income taxes could be abolished and replaced by trillions of dollars in annual tariff revenue paid to the U.S. by other countries.  It sounds good on the stump, may even pick up a few votes, but there is a reason why this hasn’t been the funding policy of the United States since the 19th century.

The markets did not react negatively when Trump was President, and they are not reacting negatively to the possibility of a second Trump term, mostly because investors ignore much of what he says and proposes.  The big, beautiful health care plan that he was dreaming up to replace the Affordable Care Act (Obamacare) never made it out of his mind, and he doesn’t talk about it anymore.  The idea that Mexico would pay for a wall never happened, and Trump doesn’t pitch that anymore either.  He did push some tariffs through in his term, but even those were watered down.  The Trump tariffs specifically exempted most products that Americans care about, such as cell phones.  It would seem that Trump always accedes to power, whether it be powerful companies such as Apple, or leaders such as Putin.  If that holds true then he becomes predictable, and the markets like predictable.  But if reports that he was blocked by his staff or the military on hundreds of occasions are correct, then who knows what he might try to do unchecked by a more pliant staff, particularly given his advancing years.  That prospect, in time, could put some fear into the markets should he be re-elected. 

Current Strategy

The stock market continued to push higher in the third quarter, helped by the first interest rate cut at the Federal Reserve and encouraging economic data.  A year ago, there was considerable debate over whether the economy would suffer a soft landing or an all-out recession.  But employment remains healthy, consumer spending has held up, and inflation is subsiding.  The stock market reflects this positive news flow, and encouragingly, the breadth of the market rally has increased in the last quarter.  When we wrote our update in the summer, the market was thinly supported by a few giant tech stocks, while most stock prices languished.  Since then stocks across a variety of industries have picked up ground.  It has become a little easier for all investors, not just tech investors, to make money in this market. 

Many of the investments we hold have performed well during this expanding rally, and we took some profits during the quarter.  Opportunities for buying still exist, and we have bought into some new investments for many clients.  But our enthusiasm for new purchases is balanced by  the knowledge that little is given away cheaply in highly optimistic markets.  Put another way, investors should be careful with stocks that look like “deals” as markets set all-time highs.  The overall position we maintain continues to be cautiously balanced across bonds, stocks and cash for most clients.

The bond market rallied in the wake of the interest rate cut from the Federal Reserve in September.  Bonds of all maturity lengths rose, but in the weeks since the bond market has exhibited notable caution, even concern.  Some of this stems from language out of the Federal Reserve indicating that they are going to move slowly, meaning that the bond market may have gotten a little ahead of itself.  But also, there are significant ramifications for long bond investors around the upcoming election.  Neither candidate presents themselves as a deficit hawk, but independent analyses estimate far more debt being added by Trump’s proposed policies.  Longer-dated Treasury bonds, the investment perhaps most sensitive to the U.S. structural deficits and growing debt burden, have weakened as Trump’s election chances have improved.  We will consider shorter-term treasuries at attractive yields, but will avoid longer-dated treasuries until the election has concluded. 

When investors comment on how a market performed over a given time period, whether a day or a year, they generally are referencing the performance of a basket of stocks, like the Dow Jones Industrial Average or the Standard & Poor’s 500 Index.  These particular indices are useful both because of their longevity and also because they are thought to accurately reflect the broader stock market, which in turn is thought by many to be a good reflection of economic forecasts.  But there are times when the movement of an index can be a bit misleading or send a confusing signal.  Stock price movements are not always a proper reflection of economic forecasts, especially over shorter periods of time.  And an index, depending on how it is composed, does not reflect the average price movement of most stocks within it.  The first half of 2024 has been a period where one index in particular has not, in our view, mirrored changing economic expectations, and certainly has not been a measure of the average stock within the broader market or even the index itself.

The S&P 500 Index climbed over 15% in the first half of this year.  This is a historically strong return, and, without further investigation, one might conclude that the stock market generally was very strong and perhaps that the economic outlook was improving.  Yet the first half of the year has been marked by moderating expectations for economic growth, a weakening housing market, and slowly rising unemployment.  Many companies that sell directly to the consumer talk of financial stresses emerging, especially among lower-income customers.  It is generally a challenging environment for many companies and share prices reflect this.  The average stock in the S&P 500 is up 4.7% in the first half of the year, the venerable Dow Jones Industrial Average is up 4.8%, and the Russell 2000 Index, a measure of 2000 smaller- and medium-sized companies in the stock market, is up only 1.7%.  These are all a far cry from the 15% return on the S&P 500 Index.  To understand how these figures could be so far apart, and why the most cited measure of stock market performance, the S&P 500, could be so far above most companies, it is critical to note that the Index weights performance based on the size of the company.  The performance of larger companies has more impact on the Index than the performance of its smaller members.  And thus far in 2024, this discrepancy between large and small has been stunning.

At the end of the 2nd quarter, there were six companies in the U.S. stock market that were valued at over a trillion dollars: Microsoft, Apple, Nvidia, Alphabet (Google’s parent company), Amazon, and Meta (Facebook’s parent company).  All are technology companies, and together they make up nearly a third of the entire market when measured by size.  Their performance in the first half of the year contributed 10% to the overall return of the market, which quickly explains how the S&P 500 climbed 15% when the average stock rose less than 5%.  Nvidia alone accounted for much of that strength, as it single-handedly pulled the entire S&P 500 Index higher by 5%.  It is unusual for the largest companies to so dramatically outpace their smaller peers.  There has not been this concentration of market strength amongst the largest few companies since 2000 in the dot-com bubble.  From that point forward, all of those shares (companies like Cisco, Nokia, Worldcom and Lucent), stalled under the weight of enormous expectations or disappeared entirely.  From 2000 onwards, the average stock in the S&P 500 outperformed the Index over the next fifteen years, while the largest companies acted as a drag on market performance.

Cisco is a particularly interesting case study.  In 2000, Cisco’s prescient and animated CEO, John Chambers, described the landscape as follows: “business and government leaders are beginning to dramatically transform their traditional business models into Internet Economy business models.  These new Internet-based models reduce costs, generate revenue in new ways, empower employees and citizens, and provide the agility needed for the Internet Economy’s rapid pace.”  Cisco stood at the center of this transformation with its networking equipment and briefly became the largest company in the world.  Twenty-five years later, and the company is still the largest networking company in the world, but its shares have never regained the highs they set when Chambers made these comments.  An investor buying into the enthusiasm in the Spring of 2000 would still be sitting with a loss today.

Nvidia feels similar in many ways.  It is a semiconductor company run by a brilliant and ambitious CEO, Jensen Huang, who just recently made this comment to investors: “The next industrial revolution has begun – companies and countries are partnering with NVIDIA to shift the trillion-dollar traditional data centers to accelerated computing and build a new type of data center – AI factories – to produce a new commodity: artificial intelligence.”  Nvidia has already had massive success selling its semiconductors to AI customers, and it may go on to have continued business success, just like Cisco did.  But this moment may also represent the high water mark for its shares, just as 2000 was for Cisco.  And it is important for investors to be mindful that, at the moment, the S&P 500 Index is much more a story of Nvidia and its largest tech peers than the other 494 companies that make up the entire Index.

Current Strategy

It is a difficult time to keep pace with the S&P 500 Index.  To match its composition, an investor would have to have roughly half their money in technology companies, with most of that in companies that are connected to Artificial Intelligence (AI).  That is a rather extreme concentration in one theme, but that is the structure of the Index at this point.  The valuations in this AI theme are quite high, driven by lofty expectations for future growth; and because they dominate the Index, this has driven the valuation of the entire Index to a high level.  However, the exceptionally strong performance of a few stocks leaves many other stocks out of favor, so some opportunities exist, and are emerging, for an investor looking for decent values.  

Consumer spending is slowing, especially when looking at larger, more discretionary purchases.  This has resulted in large declines in the shares of many consumer-oriented companies.  But spending is cyclical, and soft spots, like we are in now, often create a good entry point for investors hoping for good long-term returns.  In the last quarter, we added to our exposure to consumer stocks, and we will look for more opportunities in the months to come.  Also, the rush into AI stocks has been so extreme that it has pulled money away from technology companies that are not deemed to be part of the AI theme.  Investor money is leaving these software and hardware companies, resulting in better valuations.  The potential exists for a fracturing of tech into AI “winners” and “losers” large enough to create opportunities to buy shares in high-quality technology companies, whose only shortcoming is that they do not resemble Nvidia or OpenAI (a leading developer of AI technology).  In 2000 there were good opportunities in a high market.  They were not plentiful and required careful stock picking, and investors still had to be very careful to not become over-exposed to a market that was generally unattractive.  We hope to employ that same judiciousness in this market, as the ideas above illustrate possibilities that may exist for an investor looking beyond the handful of AI stocks that are driving this market.

Slowing economic conditions have been matched with slowing levels of inflation.  It appears the Federal Reserve has finally neared its goal of tempering inflation towards an acceptable level.  Slowing consumer spending and an uptick in unemployment are some of the painful remedies often required to cure an economy of high inflation.  What remains to be seen is if this time the job can be done while still avoiding a recession.  With lower inflation, the bond market has finally gotten the signal it was looking for, and most bonds have started to rise in value, with yields dropping slightly.  We entered the quarter with what we believe to be a generally full bond portfolio for most clients, and there was little fixed income investment activity as a result.

When economic conditions are deemed to be benign or favorable, investors will often get aggressive, placing very high values on future profits that may or may not materialize.  Declining inflation and hopes for interest rate cuts buoyed stocks in the final two months of 2023, and that enthusiasm carried through the first quarter of 2024.  After two years of sharp declines and subsequent rallies, the S&P 500 Index finally broke above its previous high watermark set in 2021.  But now the entire rationale for the first quarter rally has been thrown into question as hotter inflation has reemerged and interest rates have risen accordingly.  Just a few months ago most investors anticipated seven interest rate cuts in 2024 – the current expectation is for one or none.

The Federal Reserve has been hoping for that perfect mix of economic forces that tempers inflation to the two percent level, without pushing the economy into a recession.  At the moment, they are still falling short of that first goal, as inflation has been holding steady above three percent and is more recently pushing back towards four percent.  The job market is tight, boosting wages.  While this is a good thing for most people, it complicates Fed policy by raising inflation.  Exacerbating the challenge is a fundamental shortage of housing, which has kept prices elevated in many locations, despite higher mortgage rates.  Housing costs are the single biggest input to the inflation indices, as housing is the biggest expense for most people.  There is no sign that prices will moderate any time soon.  With wages and housing prices working against the aims of the Federal Reserve, the central bank has altered its language in recent months and indicated that it will move more slowly than expected in lowering interest rates.  

The level of interest rates has a big impact on the valuation of both stock and bond prices.  Warren Buffett is quoted as saying “interest rates are to stock prices as gravity is to matter”.  In other words, higher interest rates should exert a downward pull on stock prices. But that didn’t happen in the first quarter of 2024.  Rates rose from a low point at year-end without denting the stock market rally.  Investors shrugged off the interest rate rise and continued to believe that the Fed was still on the cusp of a rate-cutting campaign.  Those hopes were finally dashed in April as more hot inflation data was released.  Stocks began to fall, retreating some five percent.  Gravity seemed to be taking hold.  

Stocks, bonds and cash are always priced in competition with each other.  Lower yields on cash and bonds encourages investors to put money into stocks, while higher yields on cash and bonds makes them more appealing to investors, creating an alternative to stocks.  That is a simplistic, but generally accurate, outline of the forces that push trillions of dollars across these competing asset classes.  The average dividend yield on stocks fell to a paltry 1.4% in the first quarter, as higher stock prices translated into lower dividend yields.  Meanwhile, the yield on short-term Treasury bonds, considered the safest of investments, remained above 5%.  That is a tough mathematical comparison for stocks, so it is not surprising that stock prices have retreated in recent weeks. 

Current Strategy

The stock market rallied hard in the first quarter of 2024, spurred on by expectations of a big shift in Fed policy.  Investors assumed that rate cuts would start in March and then occur regularly throughout 2024.  But so far there have been no interest rate cuts.  It appears that just the mention of possible interest rate cuts was enough to stoke a rally in stocks and bonds,  creating a wealth effect as investors looked at higher account balances.  This in turn led to more consumer spending, preventing inflation from falling to the Fed’s two percent target.  The Fed has tied its own hands as it can’t lower rates in the face of renewed inflation.  The shift in Fed policy was simply an illusion.  It remains to be seen how a market rally based on an illusion unfolds during the remainder of 2024. 

We did not find our preferred set-ups for stock purchases in the first quarter of the year.  We did take some profits in the rally, in most cases trimming back on some large gainers as opposed to an outright sale of the whole position.  And we continued to hold substantial portions of accounts in short- to intermediate-term bonds and money market funds.   With bonds and cash yielding in the 4.5% to 5.25% area, depending on the maturity length of the paper, we felt that waiting for better stock buying opportunities made sense.

Bond yields are rising again on longer-dated maturities, making bonds an increasingly attractive alternative to cash.  At some point interest rates will most likely fall, but maybe not in 2024 as previously expected.  A recession or geopolitical events that hurt economic activity could trigger a rush to bonds.  The exact catalyst for a drop in interest rates is hard to predict and could catch most investors by surprise.  It is wise, in our opinion, to be in position with some intermediate-term bonds before such an event occurs.  The opportunity to build a reliable, base return of about 4.5% to 5.25% per year for several years or more is currently available, but that may not always be the case.

The final two months of the year saw a significant rally in both stocks and bonds. A market that
had been extremely thin, resting on the strength of only a handful of companies, broadened to
include a majority of stocks, which was a welcome development for many investors. And after
languishing all year, bonds began to recover. Prior to this rally, 2023 was proving to be another
frustrating year for most investors, save for those whose portfolios leaned on a small basket of
technology stocks. But after the late rally, which included a much wider array of industries and
asset classes, most investors could view 2023 as a successful year.

What investors found so encouraging was both an improvement in the economic data and an
improving narrative around that data. Investors are constantly shaping narratives to fit new
data as it emerges, and often the narratives turn far more quickly than the underlying data.
Stock and bond investors have now settled into a rosy view of a “Goldilocks Economy,” in which
growth that is neither too hot nor too cold avoids the twin risks of inflation and recession. For
the moment, the temperature is just right: employment and consumer spending have improved
slightly, while inflation continues to moderate and the Federal Reserve has begun to talk in clear
terms about interest rate reductions. Looking back, it was this turn in narrative from the Federal
Reserve, in November and December, that allowed investors to develop more positive narratives
of their own. The odds that the central bank can reign in inflation without provoking a recession
are increasing, a scenario that seemed unlikely a year (or even a few months) ago.

There are some dangers to a market rally built on this foundation. Most notably, inflation is still
well above the Federal Reserve’s stated goal of 2%, and the most recent reading of core inflation,
stripping out food and gas prices, was actually a touch above expectations. If the Federal Reserve
has to keep rates at the current level beyond this spring, that would be an unwelcome surprise.
A recession seems like less of a concern at the moment, but investors will want to see a good
economy reflected back in corporate earnings. Many companies were impacted negatively last
year as price and wage increases took a toll on profit margins. Profitability should improve this
year, but so far many executives have been cautious when providing their outlooks for 2024.
One reason for this is that for many large U.S. companies, China has become a very important
market. Demand there is weak and it is hard to forecast an improvement, which cuts against an
improving view of the domestic economy.

Yet these dangers pale in comparison to the fears that gripped the market early last year and
again in the fall: that the economy would topple into a stagflationary mix of recession and
stubbornly high prices. Such a mix is historically toxic for stocks and bonds. Fortunately, we
believe it can be discounted with improving data. The temperature may not be perfect going
forward – and it is quite easy to point to a rally that has gotten slightly ahead of itself – but the
danger of getting badly burned in the near term seems diminished.

Current Strategy

If the temperature stays just right for investors in 2024, it should call for a broadening of the
current rally. It is important to note that the Russell 2000 Index, a basket of smaller companies,
is still 20% below its all-time highs. So, even as the largest tech giants soar to new heights,
a large swath of stocks are still technically in a bear market. This mix of smaller companies
typically carries more cyclicality and volatility, but an improving economic outlook and benign
inflation would be just the mix required to push shares higher. While we find much of the
technology sector to be overheated on premature enthusiasm for AI, we believe this does leave
other parts of the market reasonably priced.

There is an aspect to this market that calls back to the tech bubble of 2000. We have made
this comparison sporadically in recent years, but increasingly there feels like a single path to
investment success. The enthusiasm for tech stocks appears to be sucking oxygen out of the
room for other corners of the market. There is only so much money to allocate to stocks, and
on many days of late, the success of technology stocks is matched by declines in other sectors.
If the economic outlook is improving generally, it would point to success for a diverse mix of
companies and industries. While the rally did start to broaden a bit at the end of the year, a
benign environment should provide ample room for this broadening to continue, with so many
stocks still struggling for any investor attention in the shadows of the tech giants.

The bond market rallied significantly as the Federal Reserve changed its language in November.
Prices climbed, sending yields lower on longer-dated bonds. Yields on much shorter-dated
bonds will fall as well, but only when the central bank lowers rates. The timing of this is up for
some debate at the moment, both amongst investors and amongst the twelve Federal Reserve
members who set policy. But the bank is likely to begin cutting rates sometime in the spring or
summer, based on the consensus view and commentary of its voting members. While short-term
rates will fall, we question whether long-term rates will continue to decline as well. At a certain
point, a good economic outlook should support higher long-term rates. In robust economic
times there is a demand for money, and all borrowers, including the U.S. Government, have to
compete for lenders. This has meant historically that 10-year Treasury bonds often command
yields of 4-5% or higher. A return to normal, both in regards to inflation and economic growth,
would signal that the bond rally has left longer yields in about the right place. If this is true, even
as short-term yields decline for fixed income investors, they will hopefully have the opportunity
to build out a longer-dated bond portfolio at yields that are in line with historical levels.
Critically, we do not anticipate a return to the era of super-low yields for fixed income investors
if the good economic outlook holds in 2024.

There has been growing adoption of new weight-loss drugs throughout this year, driving enthusiasm for the two manufacturers of these drugs, Eli Lilly and Novo Nordisk. After a year of strong gains, these two companies are now the first- and third-largest healthcare companies in the world as measured by market capitalization. Novo Nordisk’s success is so significant that it has single-handedly raised the economic outlook for the entire country of Denmark, which is where Novo is based.

The success of the weight loss drugs has set in motion a counter-trend for many other medical companies. On July 20th of this year, a seemingly innocuous comment from Intuitive Surgical, the leading manufacturer of robotic surgical equipment, triggered a widespread move in dozens of leading medical companies when the company announced it had seen a slight softening in demand for bariatric surgeries. The language was measured, but the stock market was swift in its reaction. Shares of Intuitive Surgical, and many medical equipment peers, began to fall in July.

Investors have now started to map out a new megatrend within the economy and stock market. Their assumption is that the world is going to be reshaped by widespread adoption of weight-loss drugs. Eli Lilly and Novo Nordisk have continued to gain momentum since the summer, while the list of medical companies losing value has grown longer and longer. Shares of medical companies treating sleep apnea, diabetes, heart disease, and kidney failure have all plummeted, some by as much as 50% in just a few months. Makers of knee and hip replacements have lost a quarter of their value, as investors contemplate a population putting less wear and tear on their joints. The entire medical equipment sector within the S&P 500 has declined by roughly 30% since the end of July. More recently, makers of packaged foods and restaurants have joined the decline. Shake Shack, Pepsi, Utz Brands, and Kellogg are just a small sampling of food companies that have lost nearly a quarter of their value or more in recent months. Food packaging companies are declining, as are companies that sell equipment to restaurants.

Much like the enthusiasm around artificial intelligence (AI) that we wrote about in the summer, the excitement over weight-loss drugs has a legitimate foundation. The clinical effects of these drugs are significant. A follow-up trial by Novo has shown that Wegovy, its leading weight loss drug, can reduce heart attacks and strokes in certain populations. Widespread adoption certainly has the potential to alter medical care and, to a smaller degree, food consumption. But as with AI, the impact within the stock market seems overly swift and exaggerated. Is society on the brink of seismic change that will alter everything? Or is there a reason why investors might be too willing to buy into that narrative and overextend themselves?

In our view, the macroeconomic backdrop matters tremendously in helping explain the emergence of two market megatrends in the same year. At the moment, the average stock is beset by two problems. First, interest rates continue to climb, which then pressures valuations for most companies. With investors able to get 5% in a money market fund or Treasury Bonds, many stocks simply have to get cheaper to remain mathematically compelling. And second, the economic outlook is atypically cloudy, with conflicting signs of strength and weakness throughout many pockets of the economy. The average stock in the market is on pace for another negative year at the moment, given the interest rate headwind and economic uncertainty.

Faced with these inferior returns, it’s understandable that investors would latch onto any narrative that seems simple and compelling. Whether that narrative concerns AI or weight-loss drugs, at a minimum an investor can say confidently that these trends will have some impact in the future. Of course, “impactful” is not the same thing as “transformative,” but in an environment where it has become quite hard to build confidence around most investment themes, it is not surprising to see investors potentially overplaying their hands when it comes to these two trends.

Current Strategy

The third quarter was challenging for stocks. The enthusiasm for AI stocks began to fade; most medical stocks were weak; and consumer staples companies fell sharply. The slide in most stocks has continued into October, as rising interest rates have exerted more pressure on stock valuations. Economic data continues to offer a mixed view on the economy, with the labor market remaining healthy even as consumer spending is under some pressure from rising interest rates. To illustrate the conundrum presented in the data, it seems most people are still able to find a good job, but more of their salary may be going towards 8% mortgages, higher rents or burdensome auto loans.

The set-up for many stocks and industries has not felt very compelling through the summer and early fall. For most clients, we were selling stocks in equal measure with any new buys. That is beginning to change, as the stock market churns lower and approaches a modest correction. More companies are showing the economic impact of higher rates, and earnings are starting to suffer, with share prices following them lower. In our view, the table is being set for a more prolonged, durable and widespread recovery in stocks in the future. For many clients, we have a lot of cash on hand, setting us up to begin stepping back into the stock market. But as always, we will invest in stocks judiciously, especially recognizing the current value of cash that yields above 5%.

The bond market may be nearer an inflection point. The shorter-term end of the bond market has not moved materially now for several months. There are growing expectations that the Federal Reserve is near the end of its rate hiking cycle, and the primary question now is how long they may keep rates at current levels. Inflation is declining, although the Federal Reserve would like to see it decline more significantly. The long-term end of the yield curve (typically bonds that mature in 10-30 years) is struggling, and yields are rising. Investors can now get reasonably good rates of interest for the next decade. Committing money for that long can be scary, and cash, at the moment, is just as rewarding. But it is not likely that cash yields will stay this high forever, and fixed income investors must plot years into the future. With some bonds maturing very soon, we are looking to extend the maturity of the fixed income portfolio for clients to ensure that we can earn a good rate of interest for years to come.