Market Review

Stocks

After being up 16% last quarter, the half-dozen Tech stocks that are expected to benefit from AI (Alphabet, Amazon, Apple, Meta, Microsoft and Nvidia) gave back 4% in July. These six stocks are about 27% of the S&P 500 and explain its subdued (1.2%) return in July. While the impact of AI will no doubt be profound, the volatility of these companies’ stock prices reflect the uncertainty of its future.

While the S&P 500 Index was up just 1%, the Russell 2000, a proxy index for domestic small company stocks, jumped over 10% in July, supplying some benefit of diversification. Indices reflecting non-domestic markets were little changed in July.

Expectations for the path of interest rates drive today’s stock market. Digesting the news from the Fed is a preoccupation of many investors and explains some of the volatility in stocks. Most signs are that interest rates are heading downward.

A well-diversified stock portfolio has rewarded investors recently (annual return of 13.5%). Over the past twelve months domestic large cap stocks (S&P 500) were up 22%, domestic small cap stocks (Russell 2000) were up 15%, stocks traded in internationally developed markets (EAFE) were up 10% and emerging market stocks were up 6%. A good 12-month period indeed.

Bonds

Falling yields pushed July returns up to about 1% at the short end and 2%-3% for longer maturities. Over the trailing 12-month period, bonds returned about 5%, reasonably close to longer-term expectations.  While flattening a bit, the Yield Curve remains downward sloping (longer-term yields below those at the shorter end) indicating reduced interest rates ahead. The spread between nominal and inflation-adjusted yields at five- and ten-year maturities indicate expected inflation of just above 2% – close to the Fed’s announced goals.

What we hear in the popular press notwithstanding, there is reasonably good news on the inflation front.  Over the past 12 months the CPI was up less than 3%. However, often the rate of inflation is confused with changes in price levels – a constant annual inflation rate of 3% increases price levels by 16% at the end of five years.

Interest Rates

Anticipation of interest rate changes affects both stock and bond markets. All eyes are on the Fed, expecting a reduction in the Federal Funds Rate soon, which will lead to reductions in other market- determined interest rates.

Lower interest rates reduce the cost of capital, which is positive for stocks. A lower capital cost makes more corporate investment opportunities profitable, increasing economic activity and expected earnings  (stock price is the present value of future corporate earnings discounted at the cost of capital – a lower discount rate means a higher present value).

Falling interest rates lead to falling yields and increasing bond prices and returns. Looking at individual bonds masks the effect of changing interest rates on bond values. Changing interest rates impact bonds of different maturities differently – the longer the time to maturity the greater the impact. The maturity of an individual bond shortens as it moves toward maturity. Proceeds will be reinvested at prevailing rates.

Lower interest rates are positive for stocks and bonds. However, since markets are forward looking, lower rates may already be baked into today’s prices. Surprises, including Fed behavior and future interest rate changes, affect short-term market movements. Volatility is the only sure prediction.

Recent Market Activity

The preceding discussion includes data and analysis as of the end of July – it has not been updated to include the market’s ups and downs of the first few days of August, which have been dramatic.  Explanations include the Fed voting to keep the Federal Funds Rate where it is; an uptick in unemployment; global slowdowns; the likelihood of recession; liquidity in Japanese markets; and senior traders vacationing in the Hamptons. However, these issues were well known prior to August, leaving random noise as the best explanation, confirming that markets are volatile and unpredictable