MARKET OUTLOOK
Since the beginning of the year, there have been three common themes in the headlines - inflation, the breakthroughs in artificial intelligence, and the upcoming Presidential election. We expect these themes will continue to dominate the headlines for the remainder of the year. How might these issues impact the markets? What could this mean for investors?
Let's first address inflation and interest rates. According to the U.S. Labor Department, the rate of inflation in the U.S. (for the 12 months ending in May) was 3.30%. It has eased since its high of 9.1% last June, although its descent has stalled and continues to remain above the Federal Reserves' target rate of 2.00%. Many feel it could take several years to get to the Fed's targeted inflation rate. Though the Fed's first rate cut is expected to come this year, future cuts may come at a slow pace. What has been unique with this inflationary period is how differently it has impacted the U.S. consumer. The higher wage earners have not felt the pinch. Their incomes were high enough to absorb price increases, and they have benefited by recent gains in stock prices. Because they are not dependent on debt, higher interest rates did not impact their spending. The middle wage earners continued to hold jobs or were able to find better ones, if necessary, though they now have less to no discretionary income. Fortunately, those with mortgages are locked in at historically low rates and didn't have to worry about higher mortgage rates. Conversely, it was the lower income earners who are more dependent on debt and have less to no discretionary income that have taken the brunt of higher rates. Despite persistent inflation, the overall U.S. economy has shown remarkable resilience, primarily due to a robust labor market, strong consumer spending, and healthy corporate fundamentals.
Moving forward, we see both risks to, as well as opportunities for, both stocks and bonds. It is a delicate balance the Federal Reserve must take in how they handle monetary policy to tackle inflation. If they're too restrictive (keeping rates too high), it could cause a sharp economic slowdown. If they're too loose (dropping rates too low), it could cause an upswing in inflation. Bond markets have navigated rough terrain in recent years as the Fed raised rates and yields moved higher. But falling interest rates pose a real opportunity for existing bond holders in that lower rates should push current bond prices higher. As for stocks, the key driver is corporate earnings. In 2023, healthy corporate earnings realized by primarily the tech giants drove the stock markets to their current all-time highs. Issues that could negatively impact earnings would be a resurgence of inflation, a significant increase in oil prices, geopolitical tensions that trigger escalated trade wars, or other unforeseen events. For 2024, Wall Street analysts are expecting earnings of companies in the S&P 500 Index to grow by more than 10% with further acceleration in 2025. Additionally, stock market valuations don't appear to be particularly stretched, even after market rallies. The price-toearnings ratios for most markets were near or modestly above their 10-year averages as of May 31, 2024. There are also opportunities for stocks overseas where there are more attractively priced companies. The seven top non-U.S. companies in industries such as aerospace, pharmaceuticals, and luxury goods outpaced the top seven tech giants of the U.S. since 2022. Finally, there are still mountains of cash on the sidelines. According to the Investment Company Institute, there was $6.7 trillion held in U.S. money market funds as of May 29, 2024. As rates decrease and money market yields decline, investors will be searching for a more permanent home for much of this cash by deploying it into both stocks and bonds. This could give a boost to both markets.
As for artificial intelligence ("AI"), the arms race has kicked into high gear. Breakthroughs have captivated the world and sent stock prices soaring for a handful of mega-cap tech companies in 2023. With its open-ended potential to transform industries and how people do their work, AI represents compelling investment opportunities. Currently, the primary players in the AI space are most of the "Magnificent 7". This phrase was coined by Bank of America analyst Michael Hartnett in 2023 when commenting on the seven companies commonly recognized for their market dominance, their technological impact, and their changes to consumer behavior and economic trends. Included in this group are Microsoft, Apple, Alphabet, Amazon, NVIDIA, Meta, and Tesla. When it comes to AI, investors must keep in mind that there are opportunities beyond just the tech companies. AI is in its infancy so we have yet to discover the industries it will impact and the companies that will be formed as a result of the technology. In the meantime, stock prices of these companies will likely be more volatile. In 2022, the Magnificent 7 were some of the worst performers, losing nearly half of their collective value. Therefore, it goes without saying that diversification beyond these companies is important.
Lastly, we'll touch on the U.S. Presidential election and how the outcome might impact the markets. Historically, the party that prevails has had little impact on long-term market returns. Since 1936, the 10-year annualized return of the S&P 500 at the start of an election year was very similar when Republicans prevailed versus when Democrats did. As mentioned earlier, the health of corporations and their earnings is the primary catalyst or driver of the stock markets. But the party who prevails could potentially lead to policy changes that are likely to affect sectors of the economy differently. Much will depend on whether either party can take control of the U.S. Senate and the House of Representatives. For example, it is expected that a Republican sweep, or red wave, could benefit banks, health care providers, and oil and gas companies, primarily through deregulation. Whereas a Democratic sweep, or blue wave, could provide a boost to renewable energy initiatives, industrial stimulus spending, and telecommunications projects. If neither party dominates, a gridlock scenario could prevail, with little change expected. Regardless of how it plays out, investors should expect occasional bouts of market volatility in the months leading up to Election Day.
FORM CRS (CLIENT RELATIONSHIP SUMMARY) FROM TRUSTMONT
In the financial services industry, there is a wide range of professionals who differ in the products and services they are qualified to offer and the fees they may or may not charge (which determines how they are compensated). As a result, there is also a difference among financial professionals in the guidelines they are required to follow, depending on those products and services. That has always posed a challenge for investors to understand the fees they are paying for the products and services.
Over the past several decades, our industry has worked to more clearly define those differences, provide more transparency for investors, and standardize regulatory requirements and guidelines for all financial professionals. In June 2019, the Securities and Exchange Commission (SEC) adopted Regulation Best Interest (Reg BI), which went into effect on June 30, 2020. The rule was intended to improve the quality and transparency of relationships between broker-dealers, investment advisers, and dual registrants and their retail clients. Reg BI is a principles-based standard of conduct that imposes four main obligations, one of them being disclosure. As a result, it required broker-dealers, such as Trustmont Financial Group, and Registered Investment Advisers, such as Trustmont Advisory Group, to develop and distribute a document called Form CRS or Client Relationship Summary. The CRS document is important because it contains important information about a firm's services, fees, costs, conflicts of interest, and the standard of conduct to follow.
When Reg BI went into effect in 2020, Trustmont Financial Group/Trustmont Advisory Group mailed our clients a copy of its initial Form CRS. (You received the document from Trustmont because they are the firm that oversees our activities to make sure we are in compliance with all the rules and regulations of FINRA and the SEC.) Hereafter, we are required to provide the document to you each time we either open a new account or recommend a new investment strategy involving securities or whenever the document is updated. Recently, Trustmont emailed you the Form CRS due to an update. Clients who haven't elected electronic delivery will be receiving it via postal mail in the coming weeks.
As investors, it is important you understand the investment costs you are incurring and the services being provided. There is a difference, depending on whether you hold advisory accounts or brokerage accounts. We published an article in our July 2023 newsletter titled "Understanding Investment Fees and Costs" to discuss some of the differences. Trustmont's Form CRS also describes those differences. If you have questions about the type of products you hold, the fees you are incurring, the services you are receiving, or the Form CRS you received or will be receiving from Trustmont, please call our office. Lastly, you can go to www.investor.gov/CRS for more information on Reg BI and the Form CRS.
UNDERSTANDING BEHAVIORAL FINANCE
What is behavioral finance? It is the study of the influence of psychology on the behavior of investors, including the subsequent effects of that behavior on the markets. It focuses on the fact that investors are not always rational, have limits to their self-control, and are influenced by their own biases, which explains why we allow fear, greed, the need for control, or recency bias to influence our investment decisions. But that can lead to making poor decisions like timing the market, chasing returns, having unrealistic expectations about returns, and moving to cash during market downturns.
Many have studied the subject of behavioral finance and have written about it, such as Morgan Housel who authored "The Psychology of Money". He writes that what you've experienced is more compelling than what you learn second-hand; until you've lived through it and personally felt its consequences, you may not understand it enough to change your behavior. Take inflation for example. If you were born in the 1960s you would have lived through a period of inflation that sent prices up more than threefold. But if you were born in the 1990s, inflation was nearly non-existent and likely never crossed your mind. The same goes for the stock market. If you were born in 1970, the S&P 500 increased almost 10-fold over the next 20 years. If you were born in 1950, the market went literally nowhere for that same amount of time. Two groups of people went through life with completely different experiences and likely ended up with two different viewpoints on inflation and the stock market.
Understanding behavioral finance can help us to recognize, understand, and mitigate irrational financial decision-making tendencies in order to stick to the following sound principles and avoid making poor investment decisions:
Avoid the herd mentality – Warren Buffet has told investors to be "fearful when others are greedy and greedy when others are fearful".
Avoid choosing a mutual fund or stock because it had the highest return in the recent past - Good investing isn't necessarily about earning the highest returns. It's about earning pretty good returns, which are appropriate for your goals and risk tolerance, so that you can stick with the strategy and repeat it over a long period of time.
Focus on a long-term approach to investing - It's time in the market not timing of the market that builds wealth. Most of the time the events of today are not that important. The impact of what happens in the short term diminishes with time. Besides, more losses have been incurred preparing for a (possible) bear market than the bear market itself.
Maintain realistic expectations - Nothing is ever as good or bad as it seems. You don't have to earn the highest return all the time; you can be right half the time and still build wealth.
Use the proper benchmark to gauge your investment return - Comparing the performance of your portfolio to that of the S&P 500 is like comparing apples and oranges. No balanced portfolio should be 100% invested in stocks, so you shouldn't compare your portfolio to an index of purely stocks.
Don't overlook the importance of diversification – The majority of holdings in an index, ETF, or mutual fund delivers either no return or mediocre return. It is usually a handful of holdings that are winners and provide the majority of the return. Additionally, the best performing sector changes from year to year. Diversification gives you a better chance to achieve long-term success without knowing in advance who the successful companies or sectors will be.
All Sources: Capital Group/American Funds, Investment Company Institute, U.S. Securities & Exchange Commission, "Psychology of Money".
Disclaimer: The opinions expressed herein do not necessarily reflect those of Trustmont Financial Group/Trustmont Advisory Group. Additionally, the information contained herein has been obtained from sources believed to be reliable but the accuracy of the information cannot be guaranteed. Lastly, reference to any product, service or concept in no way implies that it is suitable for everyone. There may also be risks and costs associated with any product, service or concept mentioned herein. Where applicable, a prospectus should be read for complete details. The material presented here is neither an offer to sell nor a solicitation of an offer to buy any securities. Past performance is not a guarantee of future results. Dollar cost averaging does not assure a profit or protect against a loss. Diversification may help an investor manage and reduce the volatility of an asset's price movements; however, no matter how diversified a portfolio is, risk can never be eliminated completely.