View from the Observation Deck

As represented in the chart above, a seismic shift in the performance of small cap stocks relative to their large cap counterparts appears to be underway. In light of this, we set out to review several of the factors we think set the stage for this environment. Our data set covers just nine business days commencing with the final day of Federal Reserve (“Fed”) chairman Jerome Powell’s most recent testimony to the Financial Services Committee on 7/10/24. For reference, the chart above includes the price-only returns of the largest 100 stocks in the S&P 500 Index (the S&P 100 Index), the S&P 500 Index, and the S&P Small Cap 600 Index normalized to a factor of 100.

• On 7/8/24, prior to Powell’s address, the federal funds rate futures market indicated there was a 72.0% chance that the Fed would cut its policy rate at its September meeting. That expectation surged following his remarks, rising to 98.0% on 7/23/24.
  
  
• Historically, the Fed’s policy rate has nearly matched the rate of inflation.
  • Over the 30-year period ended 6/30/24, the federal funds target rate (upper bound) averaged 2.57% on a monthly basis. Inflation, as measured by the 12-month change in the consumer price index (CPI) averaged 2.5% over the same time frame.
  • Comparatively, the federal funds target rate (upper bound) stood at 5.50% at the end of June, well above June’s CPI reading of 3.0%.
    
    
• Valuations for small cap stocks appear to be more attractive than their large cap counterparts. In fact, the price to earnings (P/E) ratio of the S&P Small Cap 600 Index currently sits at 16.29 compared to its 10-year average of 24.75 (as of 7/24). For comparison, the P/E ratios of the S&P 100 and S&P 500 Indices stood at 25.57 and 23.90, above their 10-year monthly averages of 20.83 and 21.13 as of the same date. Notably, year-over-year earnings for the S&P Small Cap 600 Index are estimated to decline by 5.48% in 2024 before becoming increasingly favorable the following year. In 2025, earnings are estimated to increase by 19.46% for the S&P Small Cap 600 Index, compared to 13.69% and 13.66%, respectively, for the S&P 100 and S&P 500 Indices.
  
  
• For reference, the price only returns for the indices in today’s chart were as follows (7/10/24 – 7/23/24): S&P 100 Index (-2.51%), S&P 500 Index (-1.39%), S&P Small Cap 600 Index (+8.92%).

Takeaway: Perhaps unsurprisingly, smaller companies are often more dependent on outside capital than their larger counterparts, who generally operate in a state of going concern. Given that equity valuations can vary based on the cost of raising capital (internally or externally), an easing in monetary policy would likely have an outsized impact on small cap valuations relative to other market capitalizations. Will the Fed cut rates in September? We don’t know, but the market appears increasingly certain of that outcome. Another noteworthy point is that the spread between the federal funds target rate (upper bound) and the CPI remains well-above historical norms. We expect small cap valuations could benefit from a narrowing of that spread, over time. In addition, small cap stocks remain a relative value compared to their peers. The trailing 12-month P/E ratio for the S&P 100 and S&P 500 Indices stood at 25.57 and 23.90, respectively, as of 7/24/24, above their 10-year monthly averages of 20.83 and 21.13. The S&P Small Cap 600 Index had a P/E of 16.29 as of the same date, well below its 10-year average of 24.75.

This chart is for illustrative purposes only and not indicative of any actual investment. The illustration excludes the effects of taxes and brokerage commissions and other expenses incurred when investing. Investors cannot invest directly in an index. The S&P 100 Index is a capitalization-weighted index based on 100 highly-capitalized stocks selected from the S&P 500 Index. The S&P 500 Index is an unmanaged index of 500 companies used to measure large-cap U.S. stock market performance. The S&P SmallCap 600 Index is an unmanaged index of 600 companies used to measure small-cap U.S. stock market performance.

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View from the Observation Deck

Today's blog post is for those investors who want to drill down below the sector level to see what is performing well in the stock market. The S&P 500 Index was comprised of 11 sectors and 126 subsectors on 7/19/24, according to S&P Dow Jones Indices. The 15 top-performing subsectors in the chart posted total returns ranging from 68.40% (Semiconductors) to 20.60% (Tobacco). Click here to view our last post on the top performing subsectors.

• As indicated in the chart above, the Financials sector had the most subsectors (4) represented in the top 15 performers on a year-to-date basis. Information Technology had three subsectors represented in the top 15 over the same time frame.
  
  
• With respect to the 11 major sectors that comprise the S&P 500 Index, Information Technology posted the highest total return for the period captured in the chart, increasing by 27.02%. The second and third-best performers were Communication Services and Financials, with total returns of 23.47% and 14.84%, respectively. The S&P 500 Index posted a total return of 16.30% over the period.
  
  
• As of 7/19/24, the most heavily weighted sector in the S&P 500 Index was Information Technology at 31.86%, according to S&P Dow Jones Indices. For comparison, the Communication Services and Financials sectors had weightings of 9.02% and 12.82%, respectively.
  
  
• Using 2024 consensus earnings estimates, the Information Technology and Energy sectors had the highest and lowest price-to-earnings (P/E) ratios at 36.68 and 12.74, respectively, as of 7/22/24 (excluding Real Estate). For comparison, the S&P 500 Index had a P/E ratio of 24.23 as of the same date.

Takeaway: The Information Technology, Communication Services, and Financial sectors accounted for 52.42%, 15.08%, and 9.20%, respectively, of the total return of the S&P 500 Index YTD through 6/28/24, according to data from S&P Dow Jones Indices. With a total return of 27.02%, technology stocks are the top-performer in the S&P 500 Index YTD through 7/19/24, followed closely by communication services companies (23.47%). Notably, four of the 15 subsectors in today’s chart come from the S&P 500 Financials sector, which happens to be the third-best performer YTD with a total return of 14.84%. For those investors who may have an interest, there are a growing number of packaged products, such as exchange-traded funds, that feature S&P 500 Index subsectors.

This chart is for illustrative purposes only and not indicative of any actual investment. The illustration excludes the effects of taxes and brokerage commissions and other expenses incurred when investing. Investors cannot invest directly in an index. The S&P 500 Index is an unmanaged index of 500 companies used to measure large-cap U.S. stock market performance, while the S&P sector and subsector indices are capitalization-weighted and comprised of S&P 500 constituents representing a specific sector or industry.

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View from the Observation Deck
 
We update this post on small-capitalization (cap) stocks every now and then so that investors can see which of the two styles (growth or value) are delivering the better results. Click Here to view our last post on this topic.

• The S&P SmallCap 600 Pure Growth Index (Pure Growth Index) outperformed the S&P SmallCap 600 Pure Value Index (Pure Value Index) in four of the six time frames covered by today’s chart.
• In our previous post this week, we talked about how sector allocation may have contributed to the performance delta between large cap growth and value stocks (Click here for that post). That does not seem to be the case here.
• As of 6/28/24, the largest sector in the Pure Growth Index was Consumer Discretionary at 20.0%. The largest sector in the Pure Value Index was Financials at 20.7% as of the same date.
• The top performing sectors in the S&P SmallCap 600 Index on a trailing 12-month basis and their total return were as follows: Financials (38.95%), Industrials (32.17%), and Energy (23.74%). 

The total returns in today’s chart, thru 7/16/24, were as follows (Pure Growth vs. Pure Value):

• 15-year average annualized (12.33% vs. 11.25%)
• 10-year average annualized (8.18% vs. 7.11%)
• 5-year average annualized (8.13% vs. 13.48%)
• 3-year average annualized (1.52% vs. 8.79%)
• 1-year (22.82% vs. 15.52%)
• YTD (14.28% vs. 1.82%)

Takeaway: As today’s chart illustrates, the Pure Growth Index has enjoyed substantially higher total returns than the Pure Value Index over the trailing 12-month and YTD time frames (thru 7/16/24). Conversely, the Pure Value Index had the better showing over the 3-year and 5-year time periods. The last time we posted about this topic, we presented the idea that sector allocation may have been the differentiator between these two benchmarks. From our perspective, that estimation may no longer hold. What then, could be driving the recent outperformance in small cap pure growth relative to pure value companies? Current Price to Earnings (P/E) multiples may provide insight. At 14.32, the current (as of 7/17/24) P/E ratio for the Pure Growth Index stood well below its 10-year annual average of 22.86. By comparison, the current P/E for the Pure Value Index stood at 17.34 on 7/17/24, also well below its 10-year annual average of 24.86. From our perspective, growth or value, small cap valuations look increasingly attractive in the current environment.

This chart is for illustrative purposes only and not indicative of any actual investment. The illustration excludes the effects of taxes and brokerage commissions or other expenses incurred when investing. Investors cannot invest directly in an index. The S&P SmallCap 600 Index is an unmanaged index of 600 companies used to measure small-cap U.S. stock market performance. The S&P SmallCap 600 Pure Growth Index is a style-concentrated index designed to track the performance of stocks that exhibit the strongest growth characteristics based on three factors: sales growth, the ratio of earnings-change to price, and momentum. It includes only those components of the parent index that exhibit strong growth characteristics, and weights them by growth score. Constituents are drawn from the S&P SmallCap 600 Index. The S&P SmallCap 600 Pure Value Index is a style-concentrated index designed to track the performance of stocks that exhibit the strongest value characteristics based on three factors: the ratios of book value, earnings, and sales to price. It includes only those components of the parent index that exhibit strong value characteristics, and weights them by value score. The respective S&P SmallCap 600 Sector Indices are capitalization-weighted and comprised of S&P SmallCap 600 constituents representing a specific sector.  

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View from the Observation Deck

We update this post every few months so that investors can see which of the two styles (growth or value) are delivering the better results. Click here to see our last post on this topic.

• We have often noted that value stocks tend to outperform growth stocks when the yield on the benchmark U.S. 10-year Treasury note (T-note) rises and underperform them when the yield on the 10-year T-note falls. The yield on the 10-year T-note rose by 282 basis points (bps) over the 3-year period ended 7/12/24. For comparison, the yield on the 10-year T-note declined by 154 bps over the 25-year period ended the same date.
• The most recent increase in the federal funds target rate occurred on 7/26/23. Since then, the consensus has been that the Federal Reserve (“Fed”) would cut the federal funds target rate multiple times in 2024; a scenario that has yet to occur. Perhaps unsurprisingly, the S&P 500 Pure Growth Index (Pure Growth Index) outperformed the S&P 500 Pure Value Index (Pure Value Index) by a significant margin since these rate cut forecasts gained prominence.
• The total returns in today’s chart are as follows (Pure Growth vs. Pure Value): 

          25-year avg. annual (8.42% vs 8.33%) 
          15-year avg. annual (15.67% vs. 14.81%)
          10-year avg. annual (10.51% vs. 7.37%)
          5-year avg. annual (10.48% vs. 8.13%)
          3-year avg. annual (1.75% vs. 6.43%)
          1-year (25.39% vs. 10.28%)
          YTD (19.14% vs. 5.78%)

• On 6/28/24, Information Technology stocks accounted for 41.3% of the weight of the Pure Growth Index, according to S&P Dow Jones Indices. At 30.9%, Financials made up the largest weighting in the Pure Value Index as of the same date.
• With a YTD total return of 33.89% (thru 7/12/24), Information Technology was the top performer of the 11 major sectors in the S&P 500 Index. By comparison, Financials posted a YTD total return of 13.49%.
• The top three performing S&P 500 Index sectors and their YTD total returns (through 7/12/24) are as follows: Information Technology (33.89%); Communication Services (27.13%); and Utilities (14.38%). As of 6/28/24 those three sectors comprised a combined 49.8% and 10.7% of the total weighting of the Pure Growth and Pure Value Indices, respectively.

Takeaway: The Pure Growth Index outperformed the Pure Value Index in six of the seven time periods presented in today’s chart. While this blog post does not account for changes to index constituents over time, it is notable that Pure Growth’s most recent outperformance appears to be driven largely by sector allocation. The three top performing S&P 500 sectors YTD account for 49.8% of the weight of the Pure Growth Index but just 10.7% of the weight of the Pure Value Index. That said, current multiples may signal opportunity ahead for value-oriented investors. The Pure Value Index had a Price to Earnings (P/E) ratio of 10.48 on 7/15/24, well-below its 20-year average of 18.41. By comparison, the Pure Growth Index had a P/E ratio of 26.38 at market close on the same date, above its 20-year average of 22.31. Are multiple rate cuts already priced in the Pure Growth Index, or is there more room to run? Stay tuned!

This chart is for illustrative purposes only and not indicative of any actual investment. The illustration excludes the effects of taxes and brokerage commissions or other expenses incurred when investing. Investors cannot invest directly in an index. The S&P 500 Index is an unmanaged index of 500 companies used to measure large-cap U.S. stock market performance. The S&P 500 Pure Growth Index is a style-concentrated index designed to track the performance of stocks that exhibit the strongest growth characteristics based on three factors: sales growth, the ratio of earnings-change to price, and momentum. It includes only those components of the parent index that exhibit strong growth characteristics, and weights them by growth score. Constituents are drawn from the S&P 500 Index. The S&P 500 Pure Value Index is a style-concentrated index designed to track the performance of stocks that exhibit the strongest value characteristics based on three factors: the ratios of book value, earnings, and sales to price. It includes only those components of the parent index that exhibit strong value characteristics, and weights them by value score. 

This chart is for illustrative purposes only and not indicative of any actual investment. The illustration excludes the effects of taxes and brokerage commissions and other expenses incurred when investing. Investors cannot invest directly in an index. The S&P 500 Index is a capitalization-weighted index comprised of 500 companies used to measure large-cap U.S. stock market performance, while the 11 major S&P 500 Sector Indices are capitalization-weighted and comprised of S&P 500 constituents representing a specific sector. 

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View from the Observation Deck

Companies often return capital to their shareholders through dividend distributions. The practice is so common that as of 7/3/24, 403 of the 503 constituents in the S&P 500 Index (“the Index”) distributed a cash dividend to their equity owners. In addition to acting as a conduit for the return of capital, dividend distributions account for a significant portion of the Index’s total return. According to data from Bloomberg, dividends contributed to over 37% of the total return of the Index over the 96-year period between December 30, 1927, and December 29, 2023.

• Dividend payments from S&P500 Index constituents totaled $70.91 per share (record high) in 2023, up from $67.57 (previous record high) in 2022. 
  •    As of 7/11/24, dividend payments are estimated to total $76.09 and $80.88 per share in 2024 and 2025, up from $74.54 and $79.66 per share in 2024 and 2025, respectively, on 1/31/24.
• Of the 11 major sectors that comprise the Index, eight of them had yields above the 1.34% generated by the Index over the period captured in the table. Financials, Information Technology, and Health Care contributed the most to the Index's dividend payout at 15.76%, 15.08% and 14.27%, respectively. 
• The payout ratio for the S&P 500 Index stood at 36.09% on 7/10/24. A dividend payout ratio between 30% and 60% is typically a good sign that a dividend distribution is sustainable, according to Nasdaq.
• Many investors view changes in dividend distributions as an indication of strength and or weakness in the underlying company. For that reason, companies will often avoid decreasing or suspending their dividend payout. There were a total of nine dividend cuts and zero suspensions year-to-date through 7/3/24. For comparison, 15 dividends were cut and four were suspended from 12/30/22 to 7/31/23.

Takeaway: Dividend distributions continue to be one of the most efficient methods by which companies can return capital to their shareholders. As such, investors often view consistent dividend payments and dividend increases as indications of strength. In the 96-year period between December 30, 1927, and December 29, 2023, more than 37% of the total return of the Index came from dividends. Remarkably, dividend growth estimates for the Index have increased since the start of the year. The Index’s 2024 dividend payments were forecast to total a record $76.09 per share on 7/11/24, up from $74.54 per share on 1/31/24. Furthermore, dividend sustainability appears to have improved since 2023. Just nine dividends were cut and zero have been suspended this year (through 7/3), down from 15 cuts and four suspensions through July 2023.

This chart is for illustrative purposes only and not indicative of any actual investment. The illustration excludes the effects of taxes and brokerage commissions and other expenses incurred when investing. Investors cannot invest directly in an index. The S&P 500 Index is a capitalization-weighted index comprised of 500 companies used to measure large-cap U.S. stock market performance, while the 11 major S&P 500 Sector Indices are capitalization-weighted and comprised of S&P 500 constituents representing a specific sector. 

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View from the Observation Deck

A myriad of factors, including strong earnings growth, developments in Artificial Intelligence (AI), and expectations regarding the direction of U.S monetary policy, sent the S&P 500 Index (“Index”) surging by 17.57% on a total return basis year-to-date (YTD) through 7/5/24. Ten of the eleven sectors that comprise the Index are positive over the same period. The Index closed at a record 5,567.19 on 7/5/24, notching its 34th record high of the calendar year so far. This begs the question: where do each of the eleven sectors stand with regard to their respective all-time highs? 

As revealed by the chart above, nine of the 11 sectors that comprise the Index were within ten percentage points of their all-time highs as of 7/5/24. Six of those nine sectors (Energy, Financials, Health Care, Industrials, Information Technology, and Materials) set new all-time highs in 2024.

• Excluding the Information Technology sector, which set its all-time high on the day we pulled this dataset, the Consumer Staples sector was closest to its all-time high (-1.62%), which was set on 4/20/22. At -25.97%, Real Estate was furthest from its all-time high which was set on 12/31/21. Communication Services and Financials, the second-and-third best performing sectors in the Index YTD, stood -5.00% and -2.02%, respectively, below their all-time highs.
  
  
• As of 7/5/24, 298 stocks in the S&P 500 Index (currently 503) had positive returns on a price-only basis in 2024, down from a total of 332 when we last posted on this topic on 3/21/24, according to data from Bloomberg. For comparison, 329 stocks had positive price returns in 2023, up from 146 in 2022.
  
  
• A Bloomberg survey of 20 equity strategists found that their average year-end price target for the S&P 500 Index was 5,312 as of 6/18/24, up from 4,962 as of 3/19/24. The highest current estimate was 6,000, while the lowest was 4,200.

Takeaway: The S&P 500 Index has risen to a new all-time high on 34 separate occasions so far this year (thru 7/5/24). In total, six of the 11 sectors that comprise the Index set record highs in 2024. In our view, persistent earnings and revenue growth combined with rapid implementation of new technologies (AI) catapulted equity valuations to new heights. Strategists are scrambling to update their targets. In a recent survey, 20 equity strategists forecast an average year-end price target of 5,312 for the S&P 500 Index (up from 4,962 in March 2024). That said, the Index closed at 5,567.19 on 7/5/24, 4.58% higher than these recent estimates. We’ll leave it to the pundits to debate the day-to-day direction of equity markets. From our perspective, investors with a long-term view should take comfort in the fact that given enough time, equity markets have never failed to produce new highs.

This chart is for illustrative purposes only and not indicative of any actual investment. There can be no assurance that any of the projections cited will occur. The illustration excludes the effects of taxes and brokerage commissions and other expenses incurred when investing. Investors cannot invest directly in an index. The S&P 500 Index is an unmanaged index of 500 stocks used to measure large-cap U.S. stock market performance, while the 11 major S&P 500 Sector Indices are capitalization-weighted and comprised of S&P 500 constituents representing a specific sector.   

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View from the Observation Deck
 
One of the most common questions we field on an ongoing basis is the following: What are your favorite sectors? Today’s blog post is one that we update on a quarterly basis to lend context to our responses. Sometimes the answer is more evident than at other times, and sometimes it only makes sense via hindsight. While the above chart does not contain yearly data, only two sectors in the S&P 500 Index have been the top-performer in back-to-back calendar years since 2005. Information Technology was the first, posting the highest total return in 2019 (+50.29%) and 2020 (43.89%). Energy was the second, posting the highest total return in 2021 (54.39%) and 2022 (65.43%), according to data from Bloomberg.

• The top-performing sectors and their total returns in Q2’24 were as follows: Information Technology (13.81%), Communication Services (9.38%), and Utilities (4.66%). The total return for the S&P 500 Index was 4.28% over the period. The other eight sectors generated total returns ranging from 1.35% (Consumer Staples) to -4.50% (Materials).
  
  
• By comparison, the top-performing sectors and their total returns in Q2’23 were as follows: Information Technology (17.20%), Consumer Discretionary (14.58%), and Communication Services (13.07%). The worst-performing sectors for the period were: Consumer Staples (0.45%), Energy (-0.89%), and Utilities (-2.53%).
  
  
• Propelled by continued advancements in Artificial Intelligence (AI), the S&P 500 Communication Services and Information Technology Indices surged by 44.87% and 41.78%, respectively, over the trailing 12-months ended June 28, 2024. For comparison, the total return of the S&P 500 Index was 24.54% over the same time frame.
  
  
• The 2024 expected earnings growth rates for the Communication Services and Information Technology Indices were 22.02% and 18.30% as of 6/28/24. For comparison, the S&P 500 Index earnings growth rate is estimated to total 9.59% during the calendar year. 
  
  
• Click here to access the post featuring the top-performing sectors in Q3’22, Q4'22, Q1'23 and Q2’23.

Takeaway: As we can observe from today’s chart, the top-performing sector often varies from quarter to quarter. Of the eleven sectors that make up the S&P 500 Index, the Communication Services and Information Technology Indices boast the highest total returns on a trailing 12-month basis (44.87% and 41.78%, respectively). Even so, they have only claimed the top spot in two of the last four quarters. Revenue expectations for these sectors remain elevated. On June 28, 2024, data from Bloomberg revealed that revenues for the companies that comprise the S&P 500 Technology and Communication Services Indices are forecast to grow by 10.27% and 6.64%, respectively, in 2024. The figures represent the first-and-third-highest year-over-year revenue growth estimates of the eleven sectors that comprise the broader S&P 500 Index. Revenue growth estimates for the S&P 500 Health Care Index, which is notably absent from today’s chart, came in second at 6.69%. Will a different sector rise to the top in the third quarter of 2024? We look forward to seeing what the data reveals.

This chart is for illustrative purposes only and not indicative of any actual investment. The illustration excludes the effects of taxes and brokerage commissions or other expenses incurred when investing. Investors cannot invest directly in an index. The S&P 500 Index is an unmanaged index of 500 stocks used to measure large-cap U.S. stock market performance. The respective S&P 500 Sector Indices are capitalization-weighted and comprised of S&P 500 constituents representing a specific sector.  

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View from the Observation Deck
 
For today’s post, we compare the delinquency rate on consumer loans issued by all U.S. commercial banks to the prices of the S&P 500 Consumer Discretionary Index, over time. We use data from the Board of Governors of the Federal Reserve System, retrieved from FRED, for the former set of observations.

At 42.30%, the S&P 500 Consumer Discretionary Index (Consumer Discretionary Index) boasted the third-highest total return of the 11 major sectors that comprise the S&P 500 Index in 2023. The Consumer Discretionary Index has not fared as well in 2024, posting a year-to-date (YTD) total return of 4.10% thru 6/25/24.

With a total return of -3.93%, Real Estate is the only sector in the S&P 500 Index with a lower total return than consumer discretionary stocks YTD through 6/25/24. Consumer spending appears to be weakening, which has had an impact on U.S. GDP. Data from the Federal Reserve Bank of St. Louis reveals that consumer spending (as measured by Personal Consumption Expenditures) has comprised 67.7% of U.S. GDP, on average, since the end of 2006. Notably, real GDP growth was revised downward from 1.6% to a tepid 1.3% in Q1’24, led by a decline in personal consumption and slower growth in inventories. Core sales, which are crucial for estimating GDP, were up just 0.1% on an annualized rate through the first five months of 2024 while sales at restaurants and bars were down 2.3% on an annualized rate over the same period, according to Brian Wesbury, Chief Economist at First Trust Portfolios, LP.

As revealed in today’s chart, after falling to an all-time low of 1.53% in Q3’21, the consumer loan delinquency rate surged to 2.68% at the end of Q1’24. Loan delinquency rates among credit cards and auto loans have risen as well. 

One important aspect of overall consumer health is the rate at which they are defaulting on their debt obligations. To be sure, not all delinquencies will become defaults, but a spike in the number of payments that are past-due could be an indication that the U.S. consumer is under increasing financial duress. The loan delinquency rate for credit cards issued by all insured commercial banks stood at 3.16% at the end of Q1’24, its highest level since the close of Q4’11. In addition, S&P Global reported that the percentage of U.S. auto loan delinquencies rose to 3.32% in 2023, marking the highest level for the metric since at least 2013.

Takeaway: The delinquency rate on consumer loans issued by all U.S. commercial banks, stood at 2.68% at the end of Q1’24. At current readings, delinquency rates are well below their historical average of 3.07% and even further below their all-time high of 4.85%. That said, the recent surge in delinquencies is notable and does appear to be a trend. Given their sizeable contribution to GDP, we maintain that a healthy U.S. consumer may play an integral role in the U.S. avoiding an economic recession. We will continue to monitor the delinquency rate among consumers and report on changes.

This chart is for illustrative purposes only and not indicative of any actual investment. The illustration excludes the effects of taxes and brokerage commissions and other expenses incurred when investing. Investors cannot invest directly in an index. The S&P 500 Consumer Discretionary Index is an unmanaged index which includes the stocks in the consumer discretionary sector of the S&P 500 Index. The S&P 500 Index is a capitalization-weighted index comprised of 500 stocks used to measure large-cap U.S. stock market performance. Consumer delinquency data is seasonally adjusted.

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View from the Observation Deck  

Today's blog post compares the performance of energy-related stocks to the broader market, as measured by the S&P 500 Index, over an extended period. Given that most developed and developing economies are dependent on oil, natural gas, and electricity for their growth, the prices of those commodities often (but not always) influence the valuations of companies involved in those sectors. Click here to view our last post on this topic.

The S&P 500 Energy Index (Energy Index) underperformed the broader S&P 500 Index in seven of the eight time frames represented in today’s table. For comparison, the S&P 500 Utilities Index (Utilities Index) underperformed the S&P 500 Index in all eight of the periods.

In a previous post, we noted that energy company valuations frequently exhibit a high correlation to the price movements of their underlying commodity, while the valuations of utilities companies often fluctuate based on prevailing interest rates. From our perspective, the recent total returns of energy and utility stocks continue to reflect these associations, with some caveats being applied to recent utility valuations. The price of a barrel of WTI crude oil rose by 12.67% YTD through 6/21/24. For comparison, the S&P 500 Energy Index increased by 8.04% on a total return basis over the same period (see table). By contrast, the Utilities Index increased by 10.57% despite no change to the federal funds target rate over the time frame. While it is true that natural gas and electricity prices have increased, surging demand for electricity, resulting from increased usage of Artificial Intelligence (AI) may offer a more compelling explanation for the recent increase in utility stock valuations, in our opinion.

Year-to-date, the Utility Index has outperformed the Energy Index by 253 basis points (see table).

The Utility Index outperformed the Energy Index in three other time frames in today’s table (10-Year, 15-Year, and 20-Year). Year-to-date through 6/21/24, the Utilities Index is the third-best performing sector in the S&P 500 Index, behind the Information Technology and Communication Services Indices, with total returns of 28.79% and 25.10%, respectively. For comparison, with a total return of -7.08%, the Utilities Index was the worst performing sector in the S&P 500 Index in 2023. We think that surging forecasts for electricity demand may explain this dramatic turnaround. In a recent report, Citi Research estimated that the peak utility power demanded by the world’s data centers will rise at a 15% compound annual growth rate from nearly 50 gigawatts in 2023 to over 130 gigawatts in 2030. Processing for AI applications is expected to account for more than 50% of total data center power usage in 2030.

Takeaway: With total returns of -7.08% and -1.42%, respectively, the Utilities and Energy Indices were the only S&P 500 Index sectors to post negative total returns in 2023 (not in table). So far in 2024, they are enjoying a significant turnaround. As of 6/21/24, earnings for the Utilities Index are forecast to increase by 13.41% in 2024, well above the 9.58% earnings growth rate of the broader S&P 500 Index. In our view, the earnings growth expectations of the Utilities Index can be largely attributed to burgeoning demand for electricity to power AI-centric data centers. In addition, most households will keep using their lights, air conditioning, stoves, and furnaces even if budgets are stretched and commodity prices fluctuate. Energy stocks, on the other hand, are forecast to see earnings decline by 5.4% in 2024. One reason for this could be slowing economic activity. In the U.S., real GDP increased at a pace of 1.3% in Q1’24, down from 3.4% in Q4’23. Lower economic activity means fewer deliveries, trips to the store, and travel, which can have a negative effect on the earnings of energy companies.

This chart is for illustrative purposes only and not indicative of any actual investment. The illustration excludes the effects of taxes and brokerage commissions and other expenses incurred when investing. Investors cannot invest directly in an index. The S&P 500 Index is an unmanaged index of 500 companies used to measure large-cap U.S. stock market performance. The S&P 500 Energy Index is a capitalization-weighted index comprised of 21 companies spanning five subsectors in the energy sector. The S&P 500 Utilities Index is a capitalization-weighted index comprised of 29 companies spanning five subsectors in the utilities sector. 

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View from the Observation Deck
 
Investors tend to utilize money market funds during times of uncertainty such as the financial crisis in 2008 – 2009, the COVID-19 pandemic of 2020, and the banking crisis in March 2023. Recently, investors have continued to pile cash into money market accounts despite compelling returns in the U.S. equity markets (see chart). A note about the chart: we use the federal funds target rate (upper bound) as a proxy for short-term interest rates, such as those offered by taxable money market funds and other savings vehicles. In our opinion, this proxy may offer insight into the potential effect of short-term rates on investor behavior.

• After growing to an all-time high of $5.98 trillion on 1/10/24 (the last time we posted on this topic), total net assets in U.S. money market accounts increased to a record $6.12 trillion in June 2024.

As of 6/12/24, total net money market fund assets stood at $6.12 trillion, approximately $2.20 trillion, and $1.33 trillion higher than their levels on 1/14/09 (peak during financial crisis) and 5/20/20 (peak during COVID-19 pandemic), respectively. 

• From March 2020 to March 2022, the Federal Reserve ("Fed") kept the federal funds target rate (upper bound) at 0.25%. Since then, the Fed initiated eleven increases to the target rate, raising it from 0.25% to 5.50% where it stands today. 
• Inflation, as measured by the 12-month change in the Consumer Price Index, stood at 3.3% on 5/31/24, down only slightly from 3.4% at the end of 2023, but well below its most recent high of 9.1% set in June 2022.
  
• As of 6/17/24, the federal funds rate futures market was pricing in less than two rate cuts for a total of 45 basis points (bps) in 2024. For comparison, the same market projected more than six rate cuts totaling 158 bps on 12/29/23.

We think that these three factors could account for the recent (post-COVID) surge in U.S. money market account assets shown in the chart. While inflation is still an issue, it has eased from its most recent high. This has led to positive real yields (yield minus inflation) across numerous fixed income classes. We wrote on this topic in August 2023 (click here to read “Finally, a Real Yield”). Moreover, as the likelihood of a late-year rate cut diminishes, so too does the probability that the yield offered by fixed income instruments will suffer a significant downturn in the near-term. The relatively stable net cash flows and high liquidity offered by money market funds have clearly been motivating factors to many investors, in our opinion.

Takeaway: Total net U.S. money market fund assets stood at a record $6.12 trillion on 6/12/24, representing an increase of $1.33 trillion since their peak during the COVID-19 pandemic. In our view, positive real yields brought on by higher interest rates and easing inflation, combined with the decreasing likelihood of multiple rate cuts in 2024, may be driving money market assets higher. We think it is healthy to see real yields trending upward, but investors should be aware that allocations to less-risky assets may come at a cost to positive returns. While money market funds may offer principal stability and income, their total return has lagged the S&P 500 Index, which surged by 26.26% on a total return basis in 2023, and 15.53% year-to-date through 6/17/24. Even accounting for the myriad of short-term risks that currently exist, we believe that an allocation to equities will continue to generate a higher return on capital than cash over time.

This chart is for illustrative purposes only and not indicative of any actual investment. The information presented is not intended to constitute an investment recommendation for, or advice to, any specific person. By providing this information, First Trust is not undertaking to give advice in any fiduciary capacity within the meaning of ERISA, the Internal Revenue Code or any other regulatory framework. Financial professionals are responsible for evaluating investment risks independently and for exercising independent judgment in determining whether investments are appropriate for their clients.  

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