The Same but Different
Third quarter stock market performance was strong, and it looked a lot like the second quarter’s, at least at a high level. U.S. stocks, as measured by the S&P 500 Index, returned nearly 6% in the third quarter compared to 4.3% in the second quarter, including dividends. This brings the year-to-date return to a very strong 22%, well above the long run returns for the S&P 500 over the past thirty years of 7.9% adjusted for inflation. Third quarter performance highlights the ongoing momentum from the previous quarter. Investors found much to celebrate with strong earnings reports and steady, though slightly slowing, economic growth. The encouraging signs of disinflation further fueled optimism, nurturing hopes for lower interest rates and the possibility of achieving a soft landing without triggering a recession. Said another way, improving market sentiment drove valuation multiple expansion by roughly 6% which is similar to what we saw in the second quarter. The S&P 500 Index now trades at nearly 21x 2025 earnings estimates versus 19.7x three months ago and 17.4x at the beginning of the year.
Three months ago, Howland Capital’s Investment Committee felt that chances for rate cuts by the Federal Reserve in 2024 were dwindling. Our view was based on strong economic data combined with higher-than-expected inflation readings, suggesting rates could and needed to remain high. Since then, however, inflation data has reverted to the expected decelerating trend while a few economic indicators – including employment data – came in slightly worse than expected. Rising economic uncertainty supplanting fears of persistently high inflation gave the Fed just the cover it needed to start cutting short-term rates. Cue the applause on Wall Street.
A closer look at the results from the third quarter compared to the second unveils some interesting differences. Notably, the range of gains expanded significantly in the third quarter. While the performance of mega-cap technology stocks showed considerable variability, their overall contribution was modest. The average return of the largest ten companies in the S&P 500 Index – nine of which are technology companies – was 3.6%, in-line with the market. In addition, the Index’s equal-weighted third quarter return was 9.6% was higher than that of the actual Index, which is market capitalization weighted and therefore dominated by the larger tech companies.
Year to-date market results are still consistent with the years-long trend we have been seeing and directly contrast to what we saw in the third quarter. The average 2024-to-date return of the largest ten companies by market cap is roughly 37%, and the S&P 500 Index’s 15% return on an equal-weighted basis continues to meaningfully lag the Index’s actual performance of 21%. These dynamics beg the question: are market leadership changes underway, or is this just noise?
Spoiler alert: we do not know. But what we do know is that it is tough to imagine what could possibly derail the long-term earnings and free cash growth prospects of the large cap technology stocks given demand growth trends behind cloud computing, AI, digitization, and technological innovation. However, nothing lasts forever and the stronger these companies get, the more they invite regulatory scrutiny and/or capital chasing higher return investments in the technology space.
Fortunately for our clients, Howland Capital’s investment process is not dependent on market timing, nor is it dependent on trying to pinpoint shifts in sentiment from one investment style to another. We are simply focused on buying high-quality stocks with durable competitive advantages, strong management teams, and sustainable cash flow growth. We believe such stocks are likely to outperform the market over the course of an economic cycle. Close inspection of our clients’ portfolios certainly reveals several technology stocks, but along with them one will find far more variety than is currently represented in the S&P 500 Index.
Outlook
The market’s year-to-date performance can largely be attributed to improving sentiment and expanding valuations. Forward earnings estimates in aggregate have been stable, which is encouraging, given that investors started the year with high expectations. For the market to appreciate meaningfully from here, at least one of the following needs to happen.
One, multiples appreciate further.
Two, earnings estimates go up.
Three, both one and two happen.
While we are not counting on further multiple expansion, it is feasible for this to happen if interest rates fall in the absence of an economic downturn, as lower yields make bonds less attractive and equities more attractive.
Beyond multiple expansion, stronger earnings growth would help send stocks higher. With estimated 2024, 2025, and 2026 market EPS (earnings per share) expected to grow 10%, 15%, and 12%, respectively, earnings estimates look fairly optimistic at current levels. While we do not see significant upside potential in the near-term, we are encouraged by the U.S. economy’s resilience and a high likelihood of long-term productivity improvements driven by technological innovation. Now that the Fed has started cutting short-term rates, we are more hopeful that the previously mentioned “soft landing” is in the works, and that too is bullish for stocks.
In closing, it’s clear that while rising valuations and steady earnings estimates suggest limited prospects for substantial short-term gains, stocks remain a favorable option. With falling yields diminishing the appeal of bonds, many U.S. investors are cautious about venturing into international equity markets due to ongoing geopolitical tensions and slower economic growth abroad.
You may notice that we are not predicting an outlook for stocks under various presidential election outcomes; we have looked at the data and find it to be inconclusive. Other than buckling our seatbelts for potential volatility around November 5th, we are not changing our clients’ portfolios due to the election. We see no reason to stray from Howland Capital’s core, long-term approach, but are always happy to answer any questions our clients might have.
