October 2024 Market Commentary

The bull market in risk assets continues to roar as we enter the late stages of 2024 (Chart 1). Asset prices seem convinced that the Federal Reserve’s easing campaign has all but assured a soft landing for the economy.

S&P 500: Past Year

(Chart 1) Source: Bespoke

Markets are extremely momentum driven in the short-term, but over the long term are driven by fundamentals. We believe we are at a critical juncture where the short-term price action is not aligned with the long-term macroeconomics. In our view, this misalignment provides opportunity. Tactical management is essential to navigating these time periods.

We believe there is a high probability the consensus soft landing narrative is wrong, and when a catalyst emerges, could severely weigh on elevated stock prices and other risk assets. Valuations are at extreme levels and it would not take much disappointment from this starting point to provoke a drawdown.

Over the past couple months, we began to de-risk our fundamental and blended portfolios. Market momentum has kept the majority of our rules-based portfolios risk-on and is a testament to how the approaches can complement each other.

Starting Points Matter

By any measure, US equity markets are expensive today. By the Warren Buffett indicator, the ratio of market capitalization to GDP, US equities are now in the top 5% of their historical range (Chart 2) (which may explain why Berkshire Hathaway is sitting on record amounts of cash). On a simpler price-to sales-ratio, US equities are also breathing rarefied air (Chart 3).

US Equity Market Capitalization is now 1.9 times US GDP

(Chart 2) Source: Gavekal Research/Macrobond

...and relative to sales, the S&P 500 is looking dangerously elevated

(Chart 3) Source: Gavekal Research/Macrobond

Meanwhile, for the last few months most US economic data points have come in on the soft side of expectations—and the expectations weren’t that firm to begin with (Chart 4).

In short, given stretched valuations, middling growth (with potential downside risk), and electoral uncertainty thrown in on top, we believe it is practical to begin shifting money out of equities and towards bonds over the coming weeks and months.

For the last four months, US economic data has been surprisingly weak

(Chart 4) Source: Gavekal Research/Macrobond

Ultimately it could be the markets Wile E. Coyote moment. Like the coyote, the US economy has run off the cliff; but rather than noticing the canyon below, investors are preoccupied by the shiny light of Fed easing.

Cracks in the Economy

Leading indicators are down significantly in the past six months; a rate of change only observed previously in the context of recessions (Chart 5).

Leading indicators are down significantly in the past six months

(Chart 5) Source: Bespoke

We believe cracks have already formed in the labor market and among the health of the consumer that are in danger of becoming recessionary. If US equities pull back, with the pull back weighing on US economic activity in what could rapidly become a self-reinforcing feedback loop.

Hold the Champagne

Stocks cheered after the Fed’s decision to cut rates by 50 basis points in September. The market’s reaction was similar to January 2001 and September 2007, which also marked the start of the two biggest easing cycles this century (Chart 6). In both cases, the Fed surprised investors by cutting rates by 50 basis points. In 2001, the S&P 500 gained 5.0% on the day of the unexpected rate cut. In 2007, it gained 2.9%. However, in both cases, stocks fell significantly over the subsequent months as recessions followed.

US FED fund rate 1990 - now

(Chart 6) Source: Federal Reserve. Note: Shaded areas denote nber-designated recessions.

In short, although never obvious, the Fed is usually behind the curve and we do not expect this time to be any different. When the Fed starts cutting rates, it is usually time to sell, not buy.

Election 2024

Meanwhile, we have a polarizing US presidential election within a month that is sure to elevate market volatility. If you are a long-time reader of ours, you know we typically like to downplay politics as an important part of our process. However, we will provide an oversimplification as to how the election pertains to the market: a Republican sweep would mean corporate tax cuts; a Democratic sweep would mean higher tax rates. Overall, on the margin, a Republican administration could be positive for equities while a Democratic administration would likely be neutral.

In recent days, opinion polls in the key battleground states for November’s US presidential election have firmed in favor of Donald Trump. As of October 15th, polls in six of the seven most important swing states—Pennsylvania, North Carolina, Georgia, Arizona, Nevada, Michigan—gave Trump the edge, with Wisconsin the only outlier (Chart 7).

While Trump has gained momentum, most indicators still predict the race to be extremely tight. A Republican sweep is far from a given and could provide volatility into the end of the year given market expectations.

Trump is now leading in six of the seven key battleground states

Trump is now leading in six of the seven key battleground states

(Chart 7) Source: Gavekai Research / Macrobond

Conclusions

In markets, financial stability breeds instability. Stability encourages more leverage, which plants the seeds of potential squeezes and brutal collapses. We believe there are elevated odds of a mild global recession in the next 12 months, and that will weigh on the price of risk assets. While price action has ignored the deteriorating economic numbers, bear markets can turn quickly.

We believe starting points matter. Valuations of mega cap stocks and AI darlings have continued to build up even as cracks in the surface began to form. They are trading at extremely elevated valuations only seen in the 2000 technology bubble. Even a valuation reset back to the average of the last decade could move markets much lower.

We believe bonds will outperform stocks over the next 12 months. We believe bonds will hedge equity drawdowns and now provide yield.

We believe that tactical asset allocation will be critical to clients meeting their long-term objectives. Therefore, we continue to stress the importance of tactical management. In today’s environment, advisors are challenged to rethink foundational elements of investor portfolios – which means seeking out strategies that bolster the “core” going forward. We will continue to provide solutions for the next generation of investing.

Fundamental Portfolios

As we enter the end of 2024, our portfolios are positioned underweight to risk. We removed overweight positions in equity (specifically riskier areas) and are prepared to move positioning even more defensively as the year evolves. This will include larger allocations to tactical fixed income investments across the term premium.

Recently, at the beginning of the 3rd quarter, we continued to transfer equity exposure into value-oriented areas of the market, specifically dividend stocks. We expect to increase duration across our overweight fixed income positions.

We will adapt as the facts change and focus on catalysts for investment regime change.

Changes to Holdings 10/3/2024
(Positioning as of 10/28/2024)
Global Tactical Model Exposures as of 10/28/2024
Global Tactical Model Allocations as of 10/28/2024

Rules Based Portfolios

The technical picture for equities remains positive with long-term trends remaining intact.

Our Momentum strategy remained fully invested in equities throughout the quarter and was able to take advantage of the risk-on environment. The strategy’s performance ranked in the top 3% in its category YTD, and in the top 5% of its category for 1-year trailing performance. The technical picture for growth stocks remains in an uptrend and would likely need to see quick price deterioration to trigger a more defensive posture.

Our Dividend strategy remained fully invested in equities throughout the quarter and was able to take advantage of the risk-on environment. The technical picture for value remains in an uptrend and would likely need to see quick price deterioration to trigger a more defensive posture. We believe dividend stocks are poised to outperform broader equities for the remainder of 2024.

Our Treasury strategy remained in shorter duration instruments for the entirety of the quarter. Rate volatility is still significant and we have avoided long duration bonds. We expect to allocate to longer duration bonds more frequently for the remainder of 2024.

(Positioning as of 10/28/2024)
Global Tactical Model Exposures as of 10/28/2024

Blended Portfolios

The blended portfolios are a proprietary mix of our fundamental macro portfolios and our rules-based quantitative portfolios.

Through this combination, we were able to take advantage of the sanguine risk environment in the third quarter of 2024. Our top-down asset allocation mirrored our fundamental outlook as we overweighted our tactical allocation and tactical income funds in the strategies, where we are now underweight risk in equities & credit. Our momentum fund was a powerful driver of performance.

Heading into the rest of 2024 our top-down asset allocation mirrors our fundamental outlook – positioned underweight to risk. Our equity rules-based strategies are currently fully invested, and our risk managed income fund is positioned in high yield bonds and floating rate securities. We recently decreased allocations to our equity funds, selling out of our momentum fund, and increased allocations to tactical fixed income funds.

We will adapt as the facts change and focus on catalysts for investment regime change.

(Positioning as of 10/28/2024)
Blended Model Exposures as of 10/28/2024
Blended Model Allocations as of 10/28/2024

You can get more information by calling (800) 642-4276 or by emailing AdvisorRelations@donoghueforlines.com.

Photo of JohnBest regards,

John A. Forlines III

Chief Investment Officer

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John A. Forlines, III
Chief Investment Officer

August 2024 Market Commentary

2024 is starting to produce volatility and we wanted to share our quarterly Market Commentary that incorporates all of our SMA product offerings (fundamental, rules-based, & blended strategies).