Welcome to the midpoint of 2024. I hope everyone had a great 4th of July holiday with family and friends.
With few exceptions, the most prominent market trends that began in 2023 have by and large continued throughout the first half of 2024.
The S&P 500 is up 15% year to date, including dividends. Along the way it has achieved 31 all-time highs during the year and is off to its 15th best first six months of any year. The index’s level of approximately 5500 has surpassed every Wall Street bank’s estimate for the year. This is on the heels of a 26% increase in 2023 and a 52% increase from its bear market low in 2022.
Despite some periodic volatility to end 2023 which carried into the early days of 2024, interest rates have barely moved after the Fed’s rate increases ended late last year. After expectations (hopes?) of several rate cuts this year were dashed by better-than-expected economic strength, interest rate markets have settled into expectations of higher rates for a little longer. That’s ok – bond and money market investors will happily collect 4% to 5% until the Fed decides what it wants to do next.
Inflation has continued its downward trend, albeit at a slower pace. In May, the Fed’s preferred inflation measure reached 2.6% and headline CPI reached 3.2%. Both metrics are inching closer to the Fed’s 2% target.
Perhaps one of the most discussed trends is the continued performance of big tech companies, often referred to as the Magnificent (or Mag for short) 7, as they have led markets higher over the last year. Comparisons to the technology boom of the late ‘90s have become commonplace and often followed by a question of if the apt comparison is 1996, when there were still years of strong returns, or 1999, just before peaking and rolling over into decline.
Whether it’s apparent or not, stock index returns over the last year, the path and level of interest rates, how we defend against inflation, and the relative performance of small groups of stocks all involve making trade-offs with our investments.
These trade-offs can be conscious or unconscious. Either way, they can have a big impact on our investment success and, often more importantly, how we feel about our investments. The latter point may seem a little less important, but the investment strategy that is going to be most successful is often the one we can stick with through good and less-than-good times in financial markets.
The classic investment trade-off is between risk and return. If we take more risk, we can expect more return. If we take less risk, we can expect a lower return. Risk in this framework typically translates to the mix of stocks and bonds in a portfolio with risk defined as volatility – more stocks equate to more volatility, or risk, and more bonds equate to less volatility.
What if we follow Charlie Munger’s recommendation and invert this concept, or look at it from a different perspective? Avoiding risk in the form of volatility by investing too little in stocks can increase the risk of not earning enough return to meet our goals over the long term, particularly when compared to inflation.
This highlights the notion that risk doesn’t go away; it just changes form. Now the trade-off becomes which kind of risk do you want to take more or less of – risk in the form of volatility or a lower return that may fall short of meeting goals?
Few times in recent memory highlight the risk trade-off more than when money market rates reached 5% last year. As I wrote more about here, 5% on cash or low-volatility assets is great – as long as it’s not used as a replacement for assets with a higher expected return. Albeit these assets come with more volatility, but this is needed as part of a long-term investment strategy that requires above inflation returns.
Cash interest rates became more attractive than they had been for over a decade during 2022. This was the same time that stocks were in a bear market and inflation was rising, which led to expectations that stocks would decline more. Despite higher interest rates, while inflation remained high but has been falling, stocks have quietly risen over 50% from their October 2022 lows.
Over-emphasizing an attractive cash interest rate to favor short-term safety over long-term returns, despite the accompanying volatility, potentially risks falling short of the accumulation needed to meet long-term goals.
Effective diversification means owning a little bit of all companies, markets and categories of stocks. The trade-off of diversification is owning less than we would prefer of the best performer and owning more than we would prefer of the laggards. In the words of Vanguard founder, John Bogle, it’s owning the haystack instead of trying to find the needle.
It seems we’ve been in a bear market for diversification the last few years. Big US-based tech stocks have continued to dominate the market. A little more broadly, US stocks in general have dominated global markets. Does this mean that diversification no longer works?
Not quite. It’s an argument in favor of diversification. It has not been uncommon for small slices of the market to dominate others over time. Emerging Markets and Natural Resources in the mid and late aughts. Technology stocks in the late ‘90s. Conglomerates, Consumer Goods, and international stocks in the ‘80s.
All these examples had amazing runs higher, leading many to wonder if they were the only things that were worthy of investment for the future. Like general bear markets, bear markets in diversification are no different – they were all caused by something different, and they all ended unexpectedly.
Has it reached new heights this time around? Perhaps. But the common threads are that every case always seems obvious with the benefit of hindsight and the next winner is never apparent until we have the benefit of hindsight. The only way to be sure you’re holding the next winner is broad diversification.
While the biggest companies get a lot of headlines and attention on their way to becoming the biggest, their track record once that title has been achieved leaves something to be desired.
There are occasional exceptions to data or results like that illustrated above. A prime example is Apple. Since it first became the largest stock in the S&P 500 it has returned a total of 1,000%. However, that is one example of dozens that have been among the ranks of top 10 stocks over time. Trees typically don’t grow to the sky and new trees grow in the forest.
The famous and successful investor Sir John Templeton said of diversification, “Diversification is a safety factor that is essential because we should be humble enough to admit we can be wrong.” Diversification also represents a trade-off of owning both what is in favor along with what is out of favor now because what is in favor now was likely out of favor not too long ago and will be out of favor again.
Whether today’s technology stocks are akin to 1996 or 1999 (see above), your well diversified portfolio holds those stocks and it’s important that we remember diversification and an appropriate risk and return balance was of utmost importance when the technology stocks of 1999 went out of favor.
A successful investment plan should not depend upon an assumption of only owning the stocks that are most in favor, as that comes with an undue risk that those stocks will fall out of favor. And they will – we just don’t know when.
Both the above trade-offs have an element of a short versus long-term trade-off in them.
Stocks can be more volatile in the short-term and present risks if the funds are needed for a short-term goal. But as the timeframe grows, their return becomes more consistent.
In a diversified portfolio of stocks, it’s easy to pick out what has performed best most recently and lose sight of all the earlier best performers that, only when linked together, form the long-term compound returns we expect from stocks. And over longer time periods we begin to see a longer track record of stocks achieving their expected returns.
Cash can feel the most secure in the short term, but in relation to stocks, it presents the greatest risk over the long-term when compared to inflation.
But holding an appropriate amount of cash (or money market funds and bonds) is critical to the success of our short-term goals given stocks’ expectations for periodic declines. We just don’t want to get too comfortable with the short-term safety of cash – even with 5% interest rates – because it comes at the expense of the long-term reward of stocks.
Investment success depends on striking the appropriate trade-offs between risk and return, concentration and diversification, and meeting short-term and long-term goals.
The best investment outcomes start with a plan for your investments that considers your goals – short and long-term – over market or economic conditions. Market and economic conditions change unexpectedly, and a well-planned investment portfolio should contain assets that can benefit throughout market cycles to keep your plans on track.