Mid-Year Commentary: A Buying Opportunity Awaits the Disciplined Investor

By: W. Kirk Taylor, CFP®

In our 2024 Fearless Forecast, published on February 1st, we said the following: Our outlook for 2024 is bullish for both stocks and bonds. While we expect more modest equity returns in 2024 compared to last year, we see the S&P 500 rising 8%-12% this year, as falling inflation, modest economic growth, above-average profit growth, lower interest rates, and the now famous “Powell Pivot” breathe life into the prospects of a soft-landing.

In this Mid-Year Commentary, we lay the foundation for the continuation of our optimistic outlook, as we shed light on recent volatility, put concerns about the slowing economy into perspective, and share our outlook on the Fed and interest rates.

Better Than Expected

Through June 30th, the stock market exceeded our return forecast for the entire year! Indeed, the S&P 500 has outperformed all but the most bullish of Wall St. forecasts this year, which begs the question “What now?”. In short, we see more gains for investors in the second half of the year.

However, we also suspect that the July/August correction for the S&P 500 may set the stage for up to a 20% (peak-to-trough) correction ahead of the November election. In fact, as of August 5th, the S&P 500 has corrected 10% in the past 16 trading days, and the NASDAQ 100 has corrected 16% correction in the past 19 trading days for the NASDAQ 100. I think we’ve found ourselves officially in correction territory, but not a bear market.

What’s Behind the Recent Sell-Off?

The recent sell-off is driven by both technical and fundamental factors. From a technical perspective, August and September are historically the worst two months of the year, and October is known for significant declines and crashes, such as Black Monday in 1987.

Since 1980, the S&P 500 has experienced a 10% correction, on average 1.2 times a year. Corrections are part and parcel of multi-year bull markets, and we’ve had ten 10% corrections since 2020, not including the most recent correction. Nonetheless, from the COVID-19 low in March 2020, the S&P has risen 150%. Each of those corrections proved to be an excellent buying opportunity for patient, long-term investors.

Moreover, since 1950, when the S&P 500 is up more than 10% in the first half of the year, the S&P 500 has gained another 9.8% on average. There have been 23 instances of this scenario since 1950. In 19 of those 23 instances, the market rallied in the second half of the year. That’s a success rate of 83%. The four instances where the market did not experience second-half gains were 1975, 1983, 1986, and 1987, which essentially occurred during the Volcker era, when the Fed was excessively tight with monetary policy to stamp out runaway inflation (1). Historical probabilities still favor a strong second half of the year, in our view.

Canary in the Coal Mine

Consequently, there are signs of spending exhaustion among US consumers, as high energy, food prices, and healthcare costs weigh on consumers. One dollar simply doesn’t go as far as it did pre-Covid, and its toll is evident on consumers now that the Covid-induced government stimulus has been largely spent by consumers.

Various data points including the Leading Economic Indicators Index, Consumer Confidence, and Consumer Spending are flashing warning signs that tend to precede or coincide with a recession. Moreover, the yield curve has been inverted (a condition where short-term rates are higher than long-term rates) for longer than any other period on record (2). Many see the inverted yield curve as a “canary in the coal mine” as it’s rare for a recession to occur without experiencing an inverted yield curve.

Softness in these indicators may well continue in the third quarter, with the Presidential Election squarely on the minds of consumers and businesses, so they bear watching. However, in our estimation, we see two rate cuts coming this year, and another two rate cuts (or more) coming in the first half of next year.

Why? This view is largely due to the spread between the Federal Funds rate (currently 5.25%) and inflation at 2.5% – 3.0%, depending on one’s preferred measure of inflation. We expect that today’s tight monetary conditions will be eased, and with it, discretionary cash flow for US households should rise meaningfully. New homeowners stuck in a 30-year fixed mortgage at 7% or 8% will benefit greatly. We see a mortgage refi-boom coming, which will be good for consumers and the economy, so we’re inclined to give consumers and the economy the benefit of the doubt over the coming months.

Diversification Woes

The table below shows returns (through June 30th) for the major US and non-US equity markets and Barclay’s Aggregate Bond Index. As shown, large-cap stocks carried the day in the first half of the year, while mid and small-cap companies lagged notably. As was the case for small and mid-cap equities, as fixed income returns were not additive to diversified portfolios, registering a 0.20% loss.

The S&P 500 gained 3.9% in the second quarter and 14.5% in the first half of the year. That’s a great start to the year and history suggests that strong first-half returns beget additional second-half returns. Repeating the dominating theme of 2023, returns for the S&P 500 were again largely driven by gains in the Magnificent 7, notably NVIDIA, which rose 149% in the first half of the year. The Magnificent 7 stocks accounted for 61% of the first-half gains in the S&P 500 and they now represent 34% of the S&P 500, up from 21% in 2023 (3). A basket of equally weighted S&P 500 stocks gained a meager 4.7%.

Broadly diversified investors who have not meaningfully overweight large-cap stocks during the current bull market continue to experience subpar returns compared to the S&P 500. The same has been true for investors with oversized allocations to non-US markets, both developed and emerging markets; areas that we have long viewed as inferior investment opportunities.

Small Caps Set to Shine

As previously noted, broadly diversified investors who rightfully have had exposure to small and mid-cap stocks have been left behind over the last few years. We think that’s about to change. Why? Simply put, small companies have lagged because their balance sheets and income statements have more levered interest rates than large companies that can borrow lavishly when interest rates are at multi-decade lows. For small companies, borrowing at mid-to-high single-digit interest rates versus today’s mid-double-digit interest rates is the difference between making money and losing money.

When the Fed recently indicated their commitment to lower the Federal Funds rate before inflation hit their 2% target, investors quickly reduced their exposure to large-cap companies, especially AI leaders such as NVIDIA, rotating into small-cap stocks writ large (4). The move was broad and significant as small-cap stocks soared roughly 12% while the S&P 500 slipped 5% in the same period.

The Russell 2000 currently trades at a median P/E of 11 versus 20 for the S&P 500, and forward-looking earnings for small-cap stocks are expected to grow 8% faster than the S&P 500 next year. Over a recent 11-day stretch, (before the early August sell-off) small-cap stocks rose 1% on 10 of the 11 days. Such an occurrence has happened only nine times since 1979, and in every case, small caps stocks were higher over the following 1,3, 6, 9, and 12-month periods. The average twelve-month gain during those nine rallies was an astounding 40% (5).

While this is not the first time that small-cap stocks have surged on the heels of expected rate cuts, the broad nature of the recent advance likely implies even bigger gains await investors with exposure to small-cap stocks. For investors who find themselves overweight in large-cap stocks and underweight in small-cap stocks, we believe it’s finally time to harvest large-cap gains and reinvest them into undervalued small-cap stocks.

The Presidential Election

Earlier this year, we stated “The 2024 Election will provide plenty of theater for investors and every opportunity to fear the worst if your party and/or candidate loses, regardless of your political affiliation. The outcome will not likely alter the fundamental course of the economy or the stock market in 2024 and maybe not in 2025. The simple truth is that the President is one person, and that person is subject to Congressional and Judicial checks and balances, against the backdrop of a $26 trillion US economy.

Sadly, the political landscape in our country is so divisive at present, that Americans will continue to be (for better or worse) subjected to Congressional gridlock. This “balance of power” means the status quo will remain in place until it doesn’t. As we alluded to at the start of Fearless Forecast, investors should not let a political headache turn into a portfolio heartbreak.”

We repeat the prior commentary verbatim, as it strikes us as being just as true today as it was then. To say that the political landscape has recently provided investors with “plenty of theater” is a mild understatement. If only we knew that the events of the past few weeks would unfold as they have!

Gridlock is Good!

Nonetheless, we continue to believe that the path forward for the economy will be impacted more by monetary policy, than by fiscal policy over the near-term, especially given the inability of either party to raise or lower taxes, and/or to increase government spending due to “gridlock”.

In the epic 1987 movie Wall Street, Gordon Gecko, played by Michael Douglas, famously said “Greed, for lack of a better word, is good”. For our money, Gridlock, for the lack of a better word, is good. It’s a tough pill to swallow when the political winds blow in the other direction, yet the silver lining is that neither party, at present, can pass policy that is wholeheartedly ruinous fiscal policy to the detriment of the economy. But that can change!

Please Join Us!

With that said, we invite our friends, family, prospective clients, and clients to join us on October 1st at 6pm at Westwood Country Club in Vienna for refreshments and hors d’oeuvres, as we pontificate about the 2024 presidential and congressional election results and examine how the balance of power in both the House and Senate may shape legislative agendas.

We will assess the potential economic implications across key sectors like healthcare, technology, and energy, as well as the broader market outlook. We’ll discuss how a Democratic or Republican majority might influence fiscal policy, regulatory approaches, and investment climates. This presentation will provide insights into market reactions and consider historical trends and investor sentiment, to help investors navigate the evolving political landscape and to anticipate potential opportunities and challenges.

To RSVP, please email Isabelle Crouzet at isabelle@kirkcapitaladvisors.com or call her at 703.755.5120. We encourage you to invite friends, family, or work colleagues to participate in the discussion!

As always, do not hesitate to reach out to me directly or to your advisor with questions.

Respectfully yours,

KirkW. Kirk Taylor, CFP® –
Founder & Chief Investment Officer

Commentary Disclosure

This commentary is a publication of Kirk Capital Advisors, LLC. The information contained herein does not constitute investment advice or a recommendation for you to purchase or sell any specific security. This information is intended to be educational in nature, and not as a recommendation or endorsement of any strategy, approach, product, concept, or asset class. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment or strategy will be suitable or profitable for your investment portfolio. All investment strategies have the potential for profit or loss. All expressions of opinion reflect the judgment of the authors as of the date of publication and are subject to change without notice to the reader and should not be regarded as a complete analysis of the subjects discussed. You are solely responsible for reviewing the content and for any actions you take or choose not to take based on your review of such content. A professional advisor should be consulted before any investment decisions are made.

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