Why the stock market rose even without Fed rate cuts

The Federal Reserve has disappointed investors this year, but it doesn’t matter. Markets have adjusted.

Even without any interest rate cuts so far in 2024 – and with the likelihood of only a small rate reduction by the end of the year – the stock market has been purring. This is quite an achievement, given expectations in January that the Fed would cut rates six or seven times in 2024 – and that interest rates across the economy would now be much lower.

As dynamic as the stock market may seem, when we look closely, it’s clear that the S&P 500’s recent returns are on a precarious foundation.

AI fever — based on the belief that artificial intelligence is ushering in a new technological era — has spread among investors, and that has been enough so far to keep global stock market averages rising. But the rest of the market has been pretty dull. In fact, if we remove the biggest companies, especially technology companies, the overall market performance will not be impressive.

One stock in particular has led the market higher: Nvidia, which makes the chips and other associated infrastructure behind the talking, image-generating and software-recording AI applications that have captured the popular imagination. Over the past 12 months, Nvidia shares have risen more than 200 percent, bringing its total market value to more than $3 billion, putting it in elite territory shared only by Microsoft and Apple in the consumer market. USA.

Other giant companies with a compelling AI flavor, like Meta (the holding company of Facebook and Instagram) and Alphabet (owner of Google), along with chip and hardware companies like Super Micro Computer and Micron Technology, have also had superlative performances lately. .

But the narrowness of the stock market rally becomes clear when we compare the standard S&P 500 stock index with a version that contains the same stocks but is less top-heavy.

First, consider that the standard S&P 500 is what’s known as a capitalization-weighted index — meaning $3 trillion stocks like Microsoft, Apple and Nvidia have the most weight. So when these giants rise by, say, 10%, they pull up the entire index much more than a 10% gain from a smaller company in the index, like News Corp, with a market capitalization of about 16K. million dollars.

The standard-cap-weighted S&P 500 is up nearly 14% this year—a spectacular gain in less than six months. But there is also an equal-weight version of the S&P 500, in which gains of 10% – for giants like Microsoft and just big companies like News Corp – have the same effect. The equal-weighted S&P 500 has gained only about 4% this year. Likewise, the Dow Jones Industrial Average, which is not cap-weighted (it has many of its own idiosyncrasies, which I won’t go into here), rose less than 3%.

In short, bigger is better in the stock market these days. A recent study carried out by Bespoke Investment Group, an independent financial market research company, demonstrates this. Bespoke divided the S&P 500 into 10 groups, based solely on market capitalization. It was found that the group containing the largest companies was the only one to have positive returns over the 12 months up to June 7th. At the same time, the group with the smallest stocks in the index had the biggest losses.

This pattern held true when Bespoke looked only at AI companies. Giants like Nvidia have had the strongest returns. Smaller companies have generally lagged behind.

During this calendar year alone, stock indexes that track the largest companies are beating those that follow small-cap stocks: the S&P 100, which contains the largest stocks in the S&P 500, is up more than 17%. The Russell 2000, which tracks the universe of small-cap companies, is up less than 1% for the year.

Even among technology stocks, the bull market does not treat all companies equally. Ned Davis Research, another financial market research firm, said in a report on Thursday that although companies that design, manufacture or manufacture equipment for chips (also known as semiconductors) in the S&P 500 have performed splendidly, all other technology sectors have lagged the index this year. .

While I pay close attention to these developments, I try not to care about them as an investor. In fact, I see the current market concentration as justification for my long-term strategy, which is to use low-cost, broadly diversified index funds to own a portion of all stock and bond markets. The global market’s dependence on a small group of large companies is good for me, but that’s only because I’m well diversified. So I don’t worry too much about which part of the market is strong and which part is not.

When it comes to my own portfolio, I’m also not too worried about the problems that inflation and high interest rates are causing in the bond market.

Note that bond interest rates are set by traders who responded to the Fed’s tight monetary policy and stubborn inflation this year by offering higher long-term interest rates — not lower ones, as had been widely anticipated.

Higher rates are a problem because when bond yields (or rates) rise, their prices fall, as a matter of basic bond math. Bond mutual fund returns are a combination of income and price changes. While higher yields generate more income, they hurt bond prices. Many investment-grade mutual funds are treading water this year, as is their main benchmark, the Bloomberg Aggregate Bond Index.

My own funds track this index. I’m not making any real money with my bond funds, and haven’t for several years. But they usually provide support and stability to my portfolio. I’m not happy with what’s happening with the titles, but I can live with it.

On the other hand, if you’re an active investor betting on individual asset classes, stocks, or sectors, there’s a lot to think about right now. You can bet on continued momentum in the biggest stocks – or even just one, Nvidia. Of course, you may believe it’s smarter to go the complete opposite route. You may want to look for stocks that have been overlooked in this narrow bull market – stocks with lower market capitalizations and what appear to be higher value based on metrics like their price-to-earnings ratio.

Historically, small-cap value stocks have outperformed large-cap growth stocks over long periods, although they have not done so recently. Maybe it’s time for a twist? As you make changes to your investments, you may also conclude that bonds and bond funds are a waste of time compared to the stock market and its more spectacular gains.

Make the right decisions on any or all of these issues and you could make a lot of money. Some people undoubtedly will. But if you make a mistake now – or later, even after making some extremely profitable bets – you could easily end up losing most of your money.

What the Fed does next will also matter a lot if you’re inclined to make active market bets. Persistent inflation convinced policymakers last week that they needed to keep the federal funds rate at about 5.3 percent — high enough, in the central bank’s estimate, to gradually reduce inflation further. There was some good news in this regard, with producer prices falling and the Consumer Price Index falling slightly in May to an annual rate of 3.3%, down from 3.4% – but too high for comfort from the Fed.

The futures market predicts that at the Fed’s July meeting, which takes place right between the Republican and Democratic conventions, it will keep rates where they are. But most traders are betting the Fed will cut rates in September. That could trigger a broader rally in the stock market as well as bonds. With national elections in November, a Fed cut in September would undoubtedly delight President Biden and, I suspect, displease former President Donald J. Trump, who is known for expressing his feelings vehemently about him.

There is a lot to think about, so much so that it is impossible to know in advance what the best short-term moves are.

So I’m playing with the long-term percentages, based on a lot of academic research that suggests that most people, most of the time, would be better off letting global markets make their money for them. Keep costs low with index funds; hold stocks and bonds at all times, in reasonable proportion to your needs and risk tolerance; and try not to worry too much about all these complex issues – at least not in your investing life.

I don’t know what the Fed will do next, and while I care, I won’t let it influence me financially. The bond market has been weak. The stock market isn’t completely stable, but that’s okay too. I hope there are some painful losses ahead, but greater gains for those who simply stay the course.