My wife, Sari, and I love old movies and one of our favorites is the Long, Long Trailer, staring Lucille Ball and Desi Arnaz. Desi and Lucy are newly-weds who decide, instead of buying a house, to purchase a trailer home which they hitch onto the back of their car and set off on their adventures. Soon, without any idea of how to drive such a contraption, they find themselves ascending into the Sierra Nevada mountains, driving up steep, narrow and twisty mountain roads. Unbeknownst to Desi, Lucy decided to collect rocks as souvenirs along the way which she hid all over the trailer, adding extra weight to an already dangerously unwieldy vehicle. The funniest part is watching them making small talk, pretending nothing is going on, as their car engine roars, gears squeal and little rocks spit out from their tires, over the cliffs and out into the abyss below. The contrast between the nonchalance of their conversation and the terror in their eyes is priceless and it only increases as they head over the peak and begin to descend.
The most dangerous time, both for oversized trailers and central bankers, is when you begin to descend from a peak. Recent data suggest the Fed should, finally, begin to cut rates in September. This operation could work out OK. However, it is a delicate one and, particularly, when both markets and portfolios appear to be overconcentrated, it is important that investors take what steps they can to maintain or regain balance in their portfolios.
The Economy and the Fed
On Wednesday, the Federal Reserve will wrap up its fifth FOMC meeting of the year and, while we don’t expect a change in policy at this meeting, their communications should bolster expectations for a September rate cut.
The most important issue for the Fed is confidence that inflation, as measured by the personal consumption deflator, is heading back to 2.0%. Data released last week show that PCE inflation fell to 2.5% year-over-year in June from 2.6% in May and down sharply from a peak of 7.1% in June 2022. Higher-frequency data suggest that, after staying at 2.5% year-over-year in July, inflation could resume its decline over the rest of the summer, potentially touching the Fed’s 2.0% year-over-year target as early as September.
Recent data on economic growth have remained resilient, with last Thursday’s GDP release showing the economy grew at a robust 2.8% annualized pace in the second quarter. But if the first-quarter real GDP reading of 1.4% understated economic momentum, due to a sharp reduction in inventory growth, the second-quarter number suffered from the opposite defect, due to an acceleration in inventory accumulation. The path of real final sales, which excludes inventories. paints a clearer picture, with real growth of 3.5% in the year ending in fourth quarter, slipping to 1.8% annualized in the first quarter of 2024 and 2.0% in the second.
Other data from last week confirm this moderation, with new and existing home sales and durable goods orders showing monthly declines for June. Conversely, however, automakers will likely announce a surge in July light-vehicle sales late this week, in payback for a June sales slump that was partly caused by a software issue impacting dealerships.
The July jobs report, due out on Friday, is also likely to show an economy that is slowly cooling both in growth and inflation. We expect a solid gain in non-farm payrolls of between 150,000 and 200,000, with the unemployment rate edging back down to 4.0% from 4.1% in June. However, the growth in average hourly earnings could fall to 3.7% year-over-year from 3.9% in June, still well above CPI inflation, but still compatible with consumer inflation drifting down to 2%, given the very solid second-quarter productivity growth we expect to see reported on Thursday. Finally, moderating economic growth and inflation also appear to be compatible with still strong earnings gains. With just over 40% of S&P500 market cap reporting through last Thursday, pro-forma earnings per share are tracking a 9.8% year-over-year gain. This week will see reports from a further 171 S&P500 companies, providing further clarity on earnings trends.
Dealing with Concentration Risk
While all of this represents a very positive backdrop for U.S. stocks, its important to recognize that very strong stock market gains both last year and so far this year may well have more than fully priced in the value of good economic news. As we show in our daily update of the Guide to the Markets, (which can be found in the insights section of JPMorganfunds.com), even with a pullback in the market since mid-July, the forward PE on the S&P500 ended last week at 20.8 times, more than one standard deviation above its 30-year average.
More importantly, equity markets are exhibiting very high degrees of concentration:
- Within the S&P500, growth stocks have a P/E ratio of 28.1 times, 74% higher than the same metric for value stocks, compared to an average premium since 1998 of 49%.
- The top 10 stocks in the S&P500 account for a huge 35.5% of market cap and carry a forward P/E ratio of 30.9 times, compared to 17.4 times for the rest of the index, and,
- U.S. stocks, which now account for 65% of global equity market cap, have a forward P/E ratio which is 56% higher than for the rest of the world, compared to an average premium, over the past 20 years, of 21%.
The rise in equity valuations above their long-term averages, the concentration of global equity wealth in U.S. equities and the concentration of U.S. equity wealth within mega-cap growth stocks all imply an increasing level of risk in portfolios.
Moreover, for many investors, this risk is being amplified by a lack of rebalancing. As a stylized example, an investor who started last year with an allocation of 40% to U.S. large cap stocks, 20% to non-U.S. stocks and 40% to U.S. fixed income would today have 46% in U.S. large cap, 20% in non-U.S. equities and 34% in fixed income, assuming no rebalancing and the reinvestment of dividends and coupons into their respective asset classes.
For most investors, of course, this reflects a significant and very welcome increase in wealth. However, it has also likely left them over-concentrated in an asset class that is already over-concentrated in mega-cap U.S. growth stocks.
Current market and portfolio concentration does not imply that investors should immediately rebalance back to their previously optimal allocation percentages. It may be that, with greater wealth or other changes in circumstances, investors have different risk tolerances from a few years ago. It is also important, when rebalancing, to minimize capital gains taxes which, for more affluent families, amount to a hefty 23.8% even on long-term gains. Moreover, expert financial advice on the re-investment of income, tax-loss harvesting, tax-sheltered accounts and the allocation of new capital can all help achieve balance more efficiently.
However, the unbalanced nature of markets and portfolios does suggest that investors need to pay increasing attention to risk mitigation even as the economy, so far, appears to be on the right path. As with Lucy and Desi, the risk doesn’t so much lie in narrowness of the road as the unbalanced nature of the vehicles with which investors are travelling it.