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Climbing the Wall of Worry  

We may not be in the “pessimism” phase, but the daily headlines are pretty far from the “euphoria” phase. The mood around the July-September period was a continuation of a market that’s been questioned but has performed well. A few headlines that at times triggered investor uncertainty in Q3:

  • Slowing economy 
  • Middle East war 
  • Contentious election 

Despite the issues, financial assets shrugged off concerns, and the S&P 500 moved to record highs. From our perspective, we remain confident that holding a diversified collection of growing and/or income-producing assets is the right path to the investment side of a financial plan. We’re constantly assessing the market context but rely on evidence-based strategies to position portfolios based on the long-term potential for risk and reward.

Broadened Participation 

Unlike recent quarters when the majority of stocks were left in the dust by well-covered mega-cap tech stocks, Q3 saw money flow into other styles and sectors. If you look at the table showing returns for the quarter below, you’ll see that “Large Growth” was a significant laggard:

On a sector basis, technology underperformed.  Strength in Utilities and Consumer Staples and Real Estate was partly a function of the unfolding rate cycle but also a response to being ignored during the prior tech-dominant period.

Looking deeper, you can make the case that the previous chase into “Mag 7” tech names (Apple, Microsoft, Nvidia, Amazon, Alphabet, Meta, and Tesla) was, in fact, justified by their improving business fundamentals. And you can make the case now that the dominance going forward may not be as clear.

If we throw in lower valuations for the non-Mag 7, the Q3 rotation makes absolute sense. While those large companies benefitted disproportionately by issuing cheap long-term debt after COVID and then generating vast piles of (higher-earning) cash, smaller companies who weren’t all able to do the same may now be in a position to get help from the Fed’s rate-cutting actions.

Large Companies 

vs. Small Companies 

Q3 Actions 

At the beginning of the quarter, we made a swap in our small-cap value exposure. To reinforce the earlier point regarding mega-cap tech dominance, small-cap stocks have been out of favor relative to large caps. We believe that proper diversification means that a couple of positions in the portfolio will cause short-term heartburn at any given time.

This is a feature, not a bug. If all asset classes or managers work well at the same time, this opens us up to the risk that they all disappoint at the same time. As it stands, we think the small-cap value is the best diversifier you can have in domestic stocks relative to large-cap benchmarks.

We replaced one small-cap value manager with another – out of State Street (SLYV) and into Avantis (AVUV). While we still think the State Street fund is solid, we believe the Avantis fund can provide similar exposure but with better returns, as they have demonstrated since the fund launched in 2019. The exposure to this group is modest, but we believe improved this risk/reward balance of the portfolios as a whole.

Risks and Outlook 

With businesses generally in good shape, there are three areas on our minds as we close the year and look to 2025:

  • Employment 
  • Election and Beyond 
  • Global Conflicts

For perspective on each, a few graphics:

Jobs 

The pace of hiring has faded from the extreme tightness of 2021-22…

… but jobs are being added monthly, and it’s still a historically healthy job market.

Election 

While there have certainly been sector rotations after presidential elections, the general trend has been that the health of the U.S. economy does not lie with one person or one party. Performance has been similar regardless of who’s calling the shots.

We’ll be monitoring events and considering the implications, but at this point, we are not expecting radical portfolio changes based on election results.

Conflict 

Quantifying this one is hard, but we can all feel it. And we know the direct economic impact:

  • Russia/Ukraine war (food inflation and government spending)
  • China/Taiwan invasion (loss of semiconductor access)
  • Israel and its neighbors (higher energy prices)

The harder part to assess is the impact on actual people, physically and psychologically. None of these issues are good and have an impact well beyond the economic side. We consider all of these when assessing portfolio risk. Still, conflict has been the default backdrop throughout most of history, and it’s always been a major brick in the wall of worry mentioned in the opening. Over time, taking risks has been the only way to maintain and grow purchasing power:

Less of a “worry” and more of a market fascination, the Federal Open Market Committee (FOMC) started a rate-cutting cycle in September. For at least the next few quarters, the history of rate cuts with stocks near highs should provide comfort for those in the skepticism phase.

Conclusion 

We’re confident in the positioning of both our growth and defensive sleeves and the balance between the two. We’ll continue to monitor the environment and loop you in on any changes to our thinking. As always, we appreciate your trust and welcome your feedback.

 

 

 

 

 

 

 

*The views expressed are those of the author as of the date noted, are subject to change based on market and other various conditions. Material discussed is meant to provide general information and it is not to be construed as specific investment, tax or legal advice. Keep in mind that current and historical facts may not be indicative of future results.