Todd Burchett and Sentinel Trust’s Investment team review the markets in the third quarter of 2024.
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Executive Summary
- The third quarter of 2024 had a little something for everyone. The quarter was rife with uncertainty and both encouraging and concerning records. Nearly all asset classes delivered strong results.
- In our view, Q3 was a classic example of how difficult it is to predict sentiment, geopolitical events and market outcomes. We continue to believe that a fully invested, well-diversified portfolio is the best defense against an ever-uncertain world.
The Economy
For doomsdayers, Q3 was rife with foreboding omens. Earth yet again recorded its hottest days ever measured by humans. The wars in Ukraine and the Middle East heated up and drew in additional participants. In the US, Donald Trump survived two assassination attempts. President Biden dropped out of the election he appeared to be losing. The contentious election now appears to be a coin toss. Both parties are more inclined to think the other is out to destroy America than at any other time.
On the US consumer front, pessimism and dark clouds loomed along with some cognitive dissonance. Although US consumers still benefit from near-record strong balance sheets, US consumer confidence ticked down recently to sub-pandemic level lows. Consumers in fact report to feeling about as bad about their prospects in five years as they did during the depths of the Great Financial Crisis (GFC). The share of Americans worried about losing their job touched a 10-year high, despite a near record low level of actual layoffs and solid real wage growth. There are certainly issues with surveys. Participation rates hover at all-time lows. One must ask who has the time to take these and are they being honest. Confidence levels also have become highly correlated with political affiliation and election probabilities.
Still, signs of consumer stress appear in the hard data. The percentage of overdue credit card balances reached ten-year highs. This is at a time when credit card interest rates are also near record highs of 20+%. Subprime auto delinquencies are above GFC-level highs and prime auto delinquencies are quickly approaching those levels. Upside down car loans, where borrowers owe more than their cars are worth, touched a new record in Q3.
In Q3, the three-month moving average of the unemployment rate jumped 0.5% triggering the Sahm rule. Economist Claudia Sahm noted in 2019 that every such past increase has coincided with a recession and thus calls for fiscal stimulus. The rule was created in 2019, is based on just ten recession observations and has forecasted just one recession ex-post in 2020. Sahm herself noted that the recent rise in the unemployment rate may be more driven by immigration than layoffs. Also, while the labor market appeared to be cooling for most of 2024, the September jobs report was strong with the unemployment rate falling to 4.1% and thus back below Sahm’s trigger point.
Outside of the Sahm rule, various other recession indicators are flashing red. The difference between 10-Year and 2-Year Treasury yields recently moved from a negative level or inversion to a positive spread.
A recession has followed this move every time over the past 40 years. As noted above, consumers are also feeling more pessimistic about their future prospects. Similar declines in this reading have also been associated with every recession in the US over the past 40 years. Finally, the Conference Board’s Leading Economic Index or LEI remains in negative territory. All prior negative readings over the past forty years have also been associated with recessions. Despite these signals, economists’ probabilities of an oncoming recession fell from 75% to 25% over the past year.
Bonds
Concerns around a recession and particularly a slowing labor market did lead the Federal Reserve to cut short-term interest rates for the first time since the pandemic by 0.5% in September. There is an old saying that the Fed reacts, and the market overreacts. This appeared to be the case in Q3. The Barclays Aggregate, a broad index of taxable bonds, jumped over 5% for its second-best quarterly return since the GFC. 10 and 30-Year Treasury bonds now yield just 4.1% and 4.4% respectively, which does not seem like adequate compensation against 3+% core inflation. Neither political party has expressed an interest in fiscal austerity despite deficit to GDP levels at near record levels outside of wars and recessions. In the next recession, we may very well see yields rising and bonds falling like we did in 2022. We expect to use the recent government bond rally to take a few chips off the table.
Outside of taxable government backed bonds, all other bond categories also delivered strong returns. High grade and high yield municipals gained 3% while high yield corporates jumped 5%. We are sticking with a neutral stance on municipals as we believe their finances broadly are in much better shape than Uncle Sam’s. There is also a good chance tax rates, especially for higher income earners, will move higher following the sunsetting of the 2017 Tax Cuts and Jobs Act. We are, however, a bit more cautious on high yield corporates. Chapter 11 bankruptcy filings stand at mid-GFC levels while the added yield for owning riskier corporate debt stands near all-time lows. We are also quite skeptical on private credit as we’ve seen an acceleration in both defaults and in-kind payments. Overall, across the bond spectrum, we prefer shorter maturities, higher quality and greater liquidity.
Stocks
Turning to US equities, the quarter again had a bit of something for everyone. The broad US market gained 6%. Pessimists note that the market has become more concentrated than ever with 36% of the S&P 500 concentrated in just 10 stocks. Such high concentration levels have been associated with major bubbles in the past in the late 1920s and 1990s. Bears also note that perhaps these generals have left the battlefield with the AI heavy technology sector gaining just under 1% in Q3 in choppy trading. Contrarians note that despite the dour consumer sentiment highlighted above, US equity investors are quite ebullient with sentiment toward stocks near all-time highs.
Another old saying goes that the stock market is the only market where people buy more when prices rise. The S&P 500 cyclically adjusted price-to-earnings ratio indeed stands near record highs that were only previously reached again in the late 1920s and 1990s bubbles. The earnings yield on the S&P 500 relative to 10-Year bond yields stands at a near 20-year low. Despite these relatively rich valuations, a record high 30% of the American population has a stock market portfolio worth more than $500k. The
American household allocation to stocks also set a record in Q3 of over 40%. Although J.P. Morgan estimates that somehow most retail traders have lost money in the market this year, speculation via zero-day option trading and after-hours trading hit record highs. Berkshire Hathaway’s Warren Buffett is heeding his own advice of selling when others are greedy. Berkshire raised its cash holdings to a record $277 billion while significantly reducing share buybacks, another cautionary signal for investors.
Despite some solid evidence for caution, there are also encouraging signs. CEOs appear confident, earnings continue to be relatively strong, and share buybacks broadly are near all-time highs. While the generals may have left the battlefield, the rally became broader and more inclusive in Q3. Mid and small-cap stocks in fact led the market higher gaining 7% and 10% respectively. Mid and small-cap shares not only trade at much more reasonable valuations, but they also have less AI enthusiasm baked into forward earnings growth projections. Small caps had their largest 5-day positive divergence versus large caps in over 40 years and small-cap funds saw their second largest weekly inflow ever. While we are sticking close to our US equity targets and generally believe in owning the broad market-cap weighted index, we are tilting slightly toward mid and small caps where possible. The current situation is somewhat reminiscent of the tech bubble where small and mid-cap stocks lagged in the late 1990s euphoria but outpaced large caps significantly once the bubble popped.
Turning to international markets, Q3 was yet again a classic example of geopolitical events and news flow diverging substantially from returns. Japan experienced its worst single day stock market loss since 1987. The volatility index or fear gauge jumped from the low teens to over 50% with Japan experiencing its highest volatility since the GFC. Japan’s Nikkei fell 25% just after touching an all-time high on July 11th. Elections in Mexico, India and Venezuela were all seen as bad outcomes for their markets. China’s population growth turned negative, and the country stopped reporting on net trading flows after earlier hiding its youth unemployment rate. More Chinese citizens now blame their poverty on unequal opportunities and an unfair economic system than ever before.
Despite this negative news flow, international equity markets gained 8% outpacing their US peers. Long beleaguered Chinese stocks jumped over 20% in very short order following stimulus announcements. Market movements that often take years to develop have happened over a few days and hours. While we generally remain tilted more to the US given its long-term competitive advantages, we continue to keep our international exposure near targets and see international stocks as another important diversifier in an uncertain world.
Alternatives
Finishing with alternative assets, Q3 was yet again filled with surprises and contradictions. For example, listed real estate stocks jumped 16% despite commercial mortgage delinquencies and foreclosures approaching early GFC levels. The sector was fueled by the Fed’s rate cuts and falling interest rates. The real estate market overall seems enthused that some 80% of global central banks are expected to be in easing mode as we close 2024. The only issue here is that past instances of such coordinated central bank easing were associated with major crises like the tech bubble, the GFC and the pandemic. Gold gained nearly 13% in Q3 with central banks themselves driving demand. Despite the wars in Ukraine and the Middle East and declining inventories in the US, energy related commodities and stocks were one of the few money-losing areas in Q3. Go figure.
In private markets, despite the strong overall stock market, the IPO market remained extremely weak. Private equity general partners are setting records in fact by calling vastly more capital than they are distributing. Start-up firms are shutting down at record rates. So far, 2021 and 2022 are looking like tough vintage years for limited partner investors. Fewer funds are coming back to raise capital in this market despite all the innovation and AI enthusiasm. As always, we think it is vital to maintain vintage year diversification by digging holes and planting seeds across time in private markets. We are seeing tremendous deal flow and more opportunities to make fee-free co-investments with trusted partners.
While we have been investigating AI and data centers, we are particularly interested in opportunities around both power generation and defense spending. While we are heading toward a contentious election, both parties agree that America needs to spend more in both areas and to do so efficiently.
Conclusion
In conclusion, the third quarter was filled with uncertainty, volatility and contradictions. If an investor knew all the geopolitical events that occurred in Q3, it is doubtful they could have predicted the strong returns delivered by nearly every asset class. We think this drives home the point that investors should always take the daily news flow with a grain of salt. Headlines are written to sell ads. As always, it is vital to have well defined strategic targets, a diverse portfolio and a long-term perspective.
This material is published solely for the interests of clients and friends of Sentinel Trust Company, L.B.A. and is for discussion purposes only. The opinions expressed are those of Sentinel Trust Company management and are current as of the date appearing on this material and subject to change, without notice. Any opinions or solutions described may not be suitable for investments nor applicable to all scenarios. The information does not constitute legal or tax advice and should not be substituted for a formal opinion. Individuals are encouraged to consult with their professional advisors.
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