Market Patterns and Heat Waves

Market Commentary | Q3 2024 

The recent heat wave in Berkeley has been disruptive and uncomfortable, particularly with most households not having air conditioning since we’ve historically seen more foggy days than heat records. When the weather takes a dramatic shift from normal patterns, it dominates daily conversation and can feel never-ending. One important characteristic of the current unusual weather: it’s temporary. 

When we look at the entire year, our weather can vary dramatically, but it is temperate most days. Similarly, when looking at financial markets over the long term, the performance or popularity of particular sectors can vary widely at different moments, but diversified portfolios deliver steady growth most of the time. Markets have been experiencing a heat wave recently, with stronger than usual growth over the past twelve months. While that growth continued in the third quarter, patterns shifted and a new array of sectors helped lead the broad market higher. 

In the first half of the year, we saw strong growth from major stock indexes, but under the hood, it was easy to see that only a few sectors and companies were responsible for all the gains. The growth was entirely concentrated among a handful of big tech stocks – colloquially named the “Magnificent Seven.” Many investors wanted to see growth from a broader array of companies and sectors to have confidence in the continued resilience of this market rally. That broad growth arrived in Q3. 

All major US market indexes gained positive ground in Q3, with the S&P 500 up +5.9% and small-cap stocks adding +10.1% during the quarter. International stocks also fared well, with the EAFE index gaining +7.3% and emerging markets gaining +8.7%. The US bond index gained +5.2% as the Fed cut interest rates in dramatic fashion, and US investment real estate rose by +16.3% as measured by the FTSE NAREIT index. This represents a significant reversal given the fact that small-cap stocks, US bonds, and investment real estate all had flat or negative year-to-date performance just three months ago.  

Looking further under the hood of US stocks, the top-performing S&P 500 sectors included utilities (+19.4%), real estate (+17.2%), and industrials (+11.6%). Underperformers include energy (-2.9%) and tech stocks (+0.02%).[1] After a strong first half of the year, crude oil prices fell by -18.2% in Q3, though prices have ticked back up a bit in recent days due to geopolitical concerns in the Middle East.[2] While mega-cap tech stocks have been losing momentum relative to other sectors, they are still a key driver of overall market performance since technology comprises roughly one-third of the S&P 500 Index. 

The breadth of market leadership is a healthy sign for both the economy and financial markets. It also underscores the value of broad diversification as the landscape of interest rates, politics, and geopolitical factors shift. Our investment strategy doesn’t attempt to predict exactly when a rotation will happen; rather, we remain committed to broad diversification paired with regular rebalancing. This systematic approach reduces risk in our client portfolios and keeps them well-positioned to participate in growth in whichever direction the market pivots. 

The other major storyline from Q3 was the Federal Reserve delivering a long-awaited rate cut. In mid-September, the Fed joined other global central banks in easing policy and announced a 50-basis point rate cut. Lower interest rates are positive for most businesses (lower interest payments on loans so cash can be more effectively allocated elsewhere) and all households carrying revolving lines of credit (such as a HELOC debt or credit cards.) The long-term impacts are more varied, but in the short term, lower rates should provide a boost to growth. 

While the Fed currently forecasts two more rate cuts this year, the pace of cuts will depend heavily on the incoming inflation and employment data. Today’s jobs report came in stronger than expected, and market expectations shifted immediately to reduce the likelihood of a large cut in November. Even if the Fed delivered on all forecasted rate cuts, interest rates will settle at a structurally higher level than the near-zero rates of the past decade to which the market had become accustomed. 

While many reminisce about the days of 3% mortgages, there is an element of ‘be careful what you wish for.’ The primary reason the Fed would lower rates back towards those historic levels is if unemployment rises, economic cracks emerge, and recession risks begin increasing. For now, the economy seems to be on a good path of cooling inflation and steady growth, and the Fed will try to thread the interest rate needle to keep it on its current trajectory. 

With the recent rate cut, the outlook for the US real estate market is brightening. Real estate prices broadly have started to stabilize after a difficult two years following the rate shock in 2022 and lingering distortions from the pandemic. As rates come down, lower financing costs and reduced yields on cash savings should boost real estate’s relative appeal. We saw this in Q3, with the real estate investments in client portfolios more than doubling the return of the S&P 500 during the quarter. 

In addition to interest rates, other structural forces may add to demand in the real estate sector in the coming years. Geopolitical fragmentation is pushing companies to bring production closer to home. New green building regulations are spurring energy-efficient refurbishments as well as sustainable mandates on many new builds. Perhaps most important is that housing supply remains woefully tight and underbuilt, which keeps prices high. For investors, the combination of resilient income and potential appreciation from limited supply make real estate a valuable piece of our diversified portfolios. 

Our investment approach doesn’t rely on timing the market, but rather, focuses on time in the market to provide long-term growth that supports our clients’ financial goals. 

Over the past three months, we’re happy to report the markets have been cooperating, but that can change just as quickly as the fall colors. Three times this year – in April, July, and August – we saw brief drops in the market as volatility flared up. Long-term investors who remained calm – or simply ignored the temporary headlines – and maintained their strategy fared just fine. Investors who were able to consistently add money to their portfolios or retirement accounts, especially when paired with rebalancing throughout the year, fared even better.  

Heading into Q4, we expect that markets and headlines will be anxiously focused on the US presidential election, signs of escalation or ceasefires in the Middle East, and the potential interest rate cuts that will emerge from the Fed’s two remaining meetings. We also expect that when we write our market reflection next quarter there will be impactful storylines that aren’t even on our radar at this point. For this reason, we continue to prioritize factors we can control: regular rebalancing and steadfastly remaining invested through the ebb and flow of market seasons. 

Resources

[1]  S&P Dow Jones Indices: U.S. Sector Dashboard S&P Global  

[2]  Weekly oil prices in Brent, OPEC basket, and WTI futures 2022-2024 Statista