Stocks Commentary
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Stocks: A Logical Spot To Take A Breather

March 2024

U.S. large-cap stocks (S&P 500) continued to melt-up in February and turned out a 5.3% total return during the month, as earnings season provided an upside catalyst with mega-cap technology stocks tied to the artificial intelligence (AI) theme leading the way. Encouragingly, market leadership broadened out during February and at month-end over two-thirds of the stocks in the S&P 500 were trading above both their respective 50 and 200-day moving averages. This data point makes it tough to argue that the market is on shaky footing due to a narrow leadership profile. However, while improved market breadth and price momentum make it tough to find much fault with the current market backdrop, March would still be a logical spot in the calendar for stocks to take a breather and digest sizable recent gains.

After a 21%-plus gain for the S&P 500 since the end of October, market participants focused on preserving gains could be eager to hit the sell button and take profits amid the first signs the market is losing momentum. Momentum can be a powerful driver of stock returns but is also a double-edged sword as it often feeds on itself – both to the upside and downside. Thus, any selloff in stocks when price momentum falters could be quicker and potentially larger than anticipated. From a seasonal perspective, March has historically been a ‘middle of the pack’ month for the S&P 500, generating an average return of 0.5% dating back to 1928, and the index has typically fallen short of its average monthly return in presidential election years such as this. The historically weak seasonal backdrop along with few identifiable catalysts for near-term upside leading up to quarterly reporting season in mid-April leaves stocks susceptible to losing momentum during this stretch in the calendar and are reasons for only guarded optimism.

Pundits calling for a ‘market top’ grew louder during February as stock prices moved higher, but investors focusing on price momentum able to tune out the noise have been richly rewarded for staying the course up to this point. Calling market tops or bottoms is a challenging endeavor, but that hasn’t stopped many from attempting to do so in recent months. However, we, nor most other allocators, have a required edge when it comes to identifying market inflection points, thus, we prefer a more measured approach to asset allocation that includes rebalancing portfolios as exposures exceed pre-determined tolerance bands. A systematic approach can help investors avoid having to call a market top and make emotional decisions to sell winning stocks/positions when momentum fades and the prevailing market narrative shifts. Historically, a strong S&P 500 return in the January/February time frame has, on average, led to a nearly double-digit return over the balance of a given calendar year. With history on the side of the bulls, an orderly 3-5% pullback in the index would likely act as a healthy reset and leave us incrementally more constructive on the outlook for stocks over the balance of 2024.

Diversification Harder To Achieve Via Large Caps, A Potential Tailwind For SMid: The current level of concentration in the S&P 500 has been an oft-cited concern as prognosticators have pointed toward narrow market breadth and the rise of the ‘Magnificent 7’ as a sign the rally is on shakier ground. However, historically, it has not been unusual for sectors and/or industries tied to a theme, in this case AI, to garner capital inflows as investors crowd into a smaller number of expected beneficiaries. While the top-10 holdings in the S&P 500 accounted for approximately 31% of the index at the end of February, Germany, Canada, and the United Kingdom each carry higher allocations to their respective heavyweights, while Japan’s Nikkei 225 is only modestly more diversified with a 27% weighting to its top-ten constituents. With the S&P 500 and other indices abroad increasingly more concentrated, investors seeking greater diversification could increasingly look to small- and mid-cap (SMid) stocks to alleviate concentration concerns. Notably, the S&P Mid-Cap 400 index has just 8% tied to its top-10 holdings, while the S&P Small-Cap 600 has 6%, highlighting minimal single-stock risk.

As February rolled along, smaller capitalization stocks exhibited positive price momentum with some of the lower quality, unprofitable pockets outperforming, a sign of improved investor risk appetite. This is a notable shift in sentiment for a pocket of the market that has lagged the S&P 500 by 20% since the end of 2022. Small and mid-cap (SMid) stocks rallied in February as Treasury yields encountered resistance and trended lower, and if recent inflation prints moderate after a noisy seasonal period, Treasury yields could continue to fall and rate cuts will likely be priced back in, a potentially powerful tailwind for the asset class. Should the S&P 500 pull back or move sideways over the near-term, SMid wouldn’t be immune, but the underlying sector performance across SMid appears less frothy. This cohort hasn’t benefited from the AI frenzy to the same degree as large caps, instead experiencing positive momentum in cyclical areas like industrials and discretionary stocks, that diversification benefit bodes well for small and mid-cap stocks on a relative basis.

2024 Setting Up To Be A Country Selection Story Abroad: Japan has remained a standout performer abroad, the Nikkei 225 rising just shy of 10% on a total return basis year-to-date through February. The Nikkei’s year-to-date rally is in addition to a 21.8% total return in 2023, and in February the index reached a new all-time high, its first since 1989. Outside of Japan, France, Germany, and Italy have performed well on a relative basis year-to-date, while Australia, Spain, and the U.K. have floundered. Encouragingly, the year-to-date rally in the Nikkei has occurred amid signs that Japan’s economic growth is slowing and that inflationary pressures remain stubbornly elevated. In response, the Bank of Japan (BoJ) is expected to pivot in the coming months and potentially scrap its long-held yield curve control policy. The Nikkei 225 making a new all-time high is far from bearish, but with uncertainty surrounding the BoJ’s upcoming shift, volatility in the Japanese yen and Japanese stocks over the next few months is likely, with an equity pullback potentially in the cards should the yen strengthen. As is the case with the S&P 500, the Nikkei has rallied far and fast, and investors should be on guard for the index to lose momentum and perhaps take a breather over the next month or so before resuming its uptrend.

Emerging markets have kicked off ‘24 in lackluster fashion as China’s ongoing issues have remained a concern for investors evaluating the space. Sentiment remains negative and positioning is light when it comes to Chinese stocks. At some point, this dynamic could present a contrarian buying opportunity, but near-term catalysts for an improved outlook on China’s economy and stock market remain difficult to identify and, as a result, we see better opportunities in emerging markets outside of China. In that vein, India and Taiwan, which together account for over 34% of the EM index, have been strong performers year-to-date, and while Brazil and Mexico, two countries that performed well in ’23, have lagged, we remain constructive on both as inflationary pressures subside and central banks cut rates/ease monetary policy. Given our cautious outlook on China and the belief that some of the countries that carry smaller weights within the MSCI EM index offer better investment opportunities at present, active managers running portfolios that look different than the MSCI EM index could be set up to perform well over the balance of this year and beyond.

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