by Jordan Hucht, CFP®, ChFC®, AIF®

Q2 Review: CPI, AI, and New Highs       

After stumbling out of the block in April, markets found familiar footing in May and pushed on to new highs, turning in a strong first half for stocks. The second quarter saw a return to the declining inflation, AI-inspired narrative that has mostly captivated the market since last fall.

As we head into the back half of the year, the road ahead could be bumpy as we approach the intersection of high valuations, high expectations, high intertest rates, and a highly anticipated (and likely dramatic) election cycle. Let’s examine the year’s fast start and discuss what could change the pace in the second half.

The main driver behind the stock market’s recent ascent is the widely held view that the inflation fight is nearly over and that the Fed’s actions in the fight did not push the economy into recession as many (most?) feared. At the same time, the excitement of AI has driven huge valuation increases to some of the largest public companies (Nvidia being the most obvious example), thereby skewing stock indices higher and higher with their heavy hands. To that point, the S&P 500 – which is a market-cap-weighted index and therefore heavily influenced by mega-cap tech companies – has gained more than 17% this year. On the contrary, the equal-weighted version of the S&P 500 – where each company in the index contributes equally to the overall return – is up around 5% this year. In other words, it’s been a narrow rally, and the largest companies have had the largest gains.

Looking back a bit further, the story has been pretty much the same since October of last year. We took a step back in April after a few consecutive higher-than-expected inflation reports caused a rethink of the year’s rate-cut expectations, but that was short lived. Specifically, the S&P 500 retraced 5% in the opening weeks of the second quarter, only to quickly reverse course once the economic data fell back in line with the aforementioned prevailing narrative.

From there, it’s been another leg up in the stock market, once again setting new highs. From a valuation perspective, the S&P 500 is currently priced at around 21 times expected earnings over the next 12 months. That’s meaningfully higher than intermediate- and long-term averages, but it’s also heavily skewed by large tech companies that carry justifiably higher multiples due to their projected earnings growth in the coming years. However, no matter how you spin it, the market is relatively expensive at current levels. But that doesn’t necessarily mean a correction is imminent.

Let’s look at bonds to further understand the current environment. Whereas the stock market has been almost unidirectional since last fall, the story has been more complicated in the bond market. After peaking at 5% last fall, to 10-year Treasury yield fell sharply to 3.8% by the end of 2023 on the optimistic expectation that the Fed would cut rates half a dozen times this year. As sticky inflation began to erode that hope, the yield climbed back to 4.7% by the end of April, spawning the 5% stock market pullback we discussed. Since then, yields have come back down a bit – the 10-year currently yields 4.3% – but are still meaningfully higher on the year.

Expectations for Fed rate cuts this year have gone from as many as six to as few as one or possibly even none. The magnitude and timing of expected rate cuts has been pushed out because the economy has been resilient and inflation is still above the Fed’s stated target. Notably, though, the unemployment rate is now above 4% for the first time in 3 years. On the inflation front, PCE (the Fed’s preferred inflation measure) currently stands at 2.6% vs. the Fed’s 2.0% target. The balancing act for the Fed will intensify in the coming months as it weighs cutting too soon vs. waiting too long.

From an asset allocation perspective, the inverted yield curve (where short-term rates are higher than long-term rates) has led investors to load up on short-term Treasuries and money market funds, where risk-free (or close to risk-free) returns have been in excess of 5%. That’s why more than $6 trillion is currently sitting in money market funds. But that probably won’t last forever. When Fed rate cuts come, the short end of the yield curve will fall, and investors will likely take on more duration risk to lock in longer-term yields. Additionally, with this amount of cash on the sideline, any significant, near-term pullback in the stock market could present a compelling entry point for otherwise idle cash.

Though at the moment the macro backdrop may seem favorable – resilient economy, declining inflation, strong earnings, pending rate cuts – sentiment can abruptly change, and an expensive stock market can quickly correct. And there are plenty of potential catalysts for that, from the usual suspects (economic data, earnings, etc.) to geopolitical risks to the upcoming election.

Frankly, after the gains we’ve experienced over the past 9 months, it shouldn’t be surprising at all to see some sort of price reset in the coming months. But as I’ve said before, I find neither merit nor reliability in making short-term market calls. Rather, I’m reminded of a quote I recently heard in the show The Tudors, which my wife I are currently watching:

“I don’t think anything, but I imagine everything.”

In many ways, that’s the way financial planning and investment management should be handled. Financial plans should be made with contingencies, and portfolios should be stress tested under an array of market conditions. Only then can you make confident decisions based on long-term outcomes.

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Securities and advisory services offered through Commonwealth Financial Network®, Member FINRA/SIPC, a Registered Investment Adviser.

Certain sections of this commentary contain forward-looking statements that are based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. All indices are unmanaged and are not available for direct investment by the public. Past performance is not indicative of future results.