Transcript
Jeff Schulze: Thanks for having me.
Host: Jeff, let’s get right to it. In the last update, you mentioned that the ClearBridge Recession Risk Dashboard moved to an overall green color. Have you seen any additional progress during the month of July?
Jeff Schulze: Well, the dashboard for the first month of this year did not see an individual indicator upgrade, so that streak has come to an end. But I will say that underneath the dashboard, you continue to see progress and there’s a couple of indicators that are on the cusp of getting an upgrade. Jobless claims I could easily see going to green next month. Commodities I could see improving its color next month as well. But there just wasn’t enough to get an individual upgrade. But, you know, for those that are concerned about the lack of progress from a color standpoint, when you got GDP for the second quarter, it was a really good print. It came in at 2.8% on an annualized basis, which is basically double what you saw in the first quarter. So it does appear that that soft patch that we saw to kick off 2024 is in the rear view, but also consumption accelerated moving up to 2.3%, which obviously is the lifeblood of the US economy.
And one thing that I like to look at is private sales to final domestic purchasers. What that really is, it’s kind of a core GDP concept. It strips out some of the more volatile areas like inventories, government spending and trade. So it kind of gives you an idea of what the real trend is, and it came in at a very healthy 2.9%. So, although we didn’t have any progress in July, the economy continues to be on solid footing.
Host: Jeff, let’s transition to the capital markets, specifically equities. The S&P 500, as a proxy, has been under pressure in the month of July. What are your thoughts about the recent selloff?
Jeff Schulze: Well, believe it or not, even with some of the volatility that we’ve seen, the overall benchmark is up 1.1% on the month, but it doesn’t really feel like that. But, you know, in thinking about corrections, it’s not surprising we’re getting some volatility here. You get a correction of 5% or greater three times on average per year, going back to 1936. And we had exactly a 5% correction in April, and we haven’t had any real selling pressure since October of last year. So we’re probably overdue for some volatility.
But what really kind of struck me with this selloff is the resilience of the index, because you had a pretty steep sell off in the Magnificent Seven stocks, which is a bit surprising that the index only went down from its peak to 4% after yesterday’s close. But ultimately this is a welcome development, because you’ve seen the laggard areas of the equity market start to gain back some ground.
You’ve seen smaller caps perform really well, and the rotation that we saw in the back half of July is something you rarely see to this magnitude outside of a major market low, which occurs after recessions and bear markets. So we’ve been waiting for this rotation. This is a really good dynamic and it’s a healthy correction, if you can call it that, as rotation tends to be the lifeblood of a healthy bull market. And I’m just going to throw out a real quick stat to you, which I thought was remarkable. The percent of S&P 500 companies that are above their 200-day moving average, it has moved from 65% in the middle of the month to nearly 80%, which is really a strong level of participation or breadth that’s usually indicative of a really healthy bull market. And you’ve seen that increase of breadth even with the index declining by 4% as of yesterday’s close. So, again, if you’re thinking about this correction, I actually think that this is something that helps sustain this bull market and creates an opportunity for further gains as we look out over the next 12 to 24 months.
Host: So clearly you’re not concerned about the sell-off. You’re speaking about it as a healthy dynamic and that it’s good for the longer-term health of the equity markets. Let me ask you two questions in follow up. First, what caused the rotation? And then the second is, is there any additional detail you can provide relative to positioning?
Jeff Schulze: Well maybe put some numbers around it. Since the peak of the Magnificent Seven on July 10th, they’re down around 9% through the end of the month. Russell 2000 is up close to 10%. So that’s almost a 20% differential in performance. Russell 1000 Value has outpaced the Russell 1000 Growth by 10% again since July 10th. And the equally-weighted benchmark has outperformed the cap-weighted by about half that percent. So this has been a pretty aggressive rotation, and positioning certainly is one of those things that has caused this rotation. And, prior to June’s CPI data, 2024 had largely been marked by a continuation of what we’ve seen over the last couple of years where the Magnificent Seven stocks have dominated the equity markets. And because this has been going on for so long, it’s drawn in a lot of flows into these names and it’s really resulted in skewed positioning.
And most investors really crowded into one side of the metaphorical boat here, because that’s really what’s been working. And while investors are moving to other sides of the boat in the back half of July, this positioning hasn’t been fully unwound quite yet. So I believe that the initial round of this kind of short covering is closer to its end, but I do think that there’s probably more unwind as we look out on a more intermediate-term basis. But positioning certainly did have something to do with the magnitude and the speed of the rotation that we witnessed.
Host: Very interesting. Are there any other drivers that have caused this rotation?
Jeff Schulze: Yeah, there, there’s been a couple of catalysts. So, another one has been elevated valuations and heavy index concentration for the mega-cap growth stocks. And that’s again an outgrowth of this performance bifurcation that we’ve witnessed over the last 18 months. So at the end of the second quarter, multiples for the S&P 500 appeared stretched at 21 times forward earnings with a historical average going back to the mid-90s of around 16 and a half. But when you peel back the onion and you look underneath the surface, this is really a function of the largest companies in the index with the top 10 largest stocks having a multiple of over 29 times forward earnings and the other 490 trading at a much more reasonable 17.8 times earnings. So elevated valuations is one of these other catalysts.
The other, as I mentioned, is heavy index concentration. The top 10 names at the end of the second quarter were about 38% of the index, which easily surpassed the levels that you saw in the late 1990s, which created some concentration risk. And when you have high valuations and you have concentration like this, it really creates kind of a shaky environment where really elevated expectations can give way to selling pressure on any perceived weakness from investors. And we did see that when we got Tesla and Alphabet’s earnings a couple of weeks ago.
And I’ll take Alphabet for example. Beat consensus expectations, but investor concerns were kind of amplified by the realization that AI spending may have to be ratcheted higher near term with a more uncertain timeline to monetization. And one thing really stuck out to me. The CEO of Alphabet highlighted that the risk of underinvesting is dramatically greater than the risk of overinvesting when thinking about the AI investment cycle. So, maybe for the first time since ChatGPT’s release, investors may be pondering when exactly are you going to get that payoff from the AI investment.
So, ultimately, I think that these concerns are overblown, but this perspective has really kind of created the incentive for profit-taking for some investors. And then the other catalyst here is that the Magnificent Seven has had superior earnings versus the broader equity universe in 2023 and 2024.
Host: Okay. How about the US Federal Reserve and their monetary policy? What kind of a role do they play here?
Jeff Schulze: A huge role, right? We just had the FOMC meeting today. Again, nothing to see there. The Fed wants to see a couple more inflation prints, wants to see a couple more payroll prints before embarking on the cutting cycle. But I think maybe the most important spark out of all of these was that this rally really started and this rotation after that soft CPI print on July 11th, because that paves the way for the Fed to cut in September, now that it’s clear that that impulse of inflation that we saw in Q1 was more of an aberration. And the Fed recognizes that if it waits too long until they see broad-based labor weakness, they’re already going to be behind the curve given the traditional lags of monetary policy. So with no obvious catalyst on the horizon right here for re-acceleration of inflation, inflation continues to move down.
Policymakers can start to fine tune policy and lower rates, which will extend this expansion in our opinion. And if right now, if you’re looking out at the Fed Fund futures, investors are pricing about three and a half cuts by January and should that come to fruition, our opinion is it’s going to create an economic re-acceleration next year because that was the same magnitude of cuts that were necessary to create the soft landings that you saw in 1995 and 1998. So lower rates, it’s going to promote a more resilient economic backdrop. But as I mentioned earlier, a broader earnings recovery for a lot of these companies and areas of the market that have been in an earnings recession over the last year and a half. And also another driver here is if you have lower rates, that’s going to lower the interest expense of smaller companies who are much more likely to have floating rate debt rather than fixed rate debt. And smaller companies, again, are more exposed to domestic forces as well. So again, I think that this is arguably the most important catalyst that we’ve seen that’s sparked this rotation.
Host: Okay, Jeff, so you’ve actually now mentioned a number of drivers or catalysts that have sparked this rotation in the equity markets. Is it a fair question for me to ask you which ones have kind of played out and which ones actually still have some sustainability to them to help the rotation continue to drive forward?
Jeff Schulze: Well, I think positioning, at least at the moment has probably played out, at least in the short term. I mean in the intermediate term, you know, you could see positioning continue to move into smaller caps or value or the average stock in the S&P 500. But again, I think that that is, you know, maybe done for the near term. From a valuation perspective, valuations are still pretty elevated for these companies. So you could see some helium come out of that balloon over the next 12 months. That earnings convergence story I think is going to continue, especially the Fed cuts and we have that re-acceleration of economic activity and that again goes along with the soft landing expectation on our end. So, although some of these catalysts feel like they’ve kind of run out of gas, there’s still a little bit more at play for some of these other ones.
Host: So still more at play. I mean, I hate to hold you to this, but how sustainable is this rotation?
Jeff Schulze: That’s a fair question, because you’ve seen a lot of head fakes this cycle when it seems like this rotation was going to occur and then it peters out and everybody goes back to the perceived bulletproof leaders of the Magnificent Seven. But I can’t stress enough that was due to earnings superiority. They were the only game in town when it came to earnings. The rest of the broader equity universe was dealing with this Fed hiking cycle. But in trying to think about the sustainability of this rotation, nothing moves in a straight line. Like today, we saw a very strong rotation back into large growth and we think that there’s going to be some leadership oscillation between the Magnificent Seven, or the mega-cap growth names, and the broader equity universe over the back half of the year, especially if we get an economy that cools down and spurs that flight to quality that we’ve seen for the most part of this bull market. But, given the fact that we are expecting that cutting cycle to create an economic reacceleration next year, on a more intermediate term we think that the rotation that we saw in the back half of July ultimately will be the one that plays out. But I think it’s going to come in fits and starts. It’s going to be more like a tug of war, which may frustrate some investors over on a shorter-term basis.
Host: So maybe to that point, any additional thought or perspective for our listeners about what we’ve seen over the past month that they can carry forward the rest of ‘24?
Jeff Schulze: Yeah, I think maybe the most important takeaway is that the recent price action that we’ve seen in the back half of July really should be a reminder of the significance of a diversified portfolio. Now I’m sure there’s a lot of people that were frustrated that they’ve had small caps or they’ve had value in their portfolio over the last year and a half when you saw large cap growth scream to the upside. So I think this is just a reminder that you do go through periods where that diversification really does help you out. And then also when you have strong outperformance of a particular equity market style or capitalization, so large caps versus small caps, you need to periodically realign your portfolio back towards its long-term strategic allocation. So I think, you know, this is a good reminder to be able to do that on a periodic basis, whether that’s every six months, every year, what have you. You know, that’s something that is necessary when you’re putting portfolio allocation together. And then lastly, I really think that July highlights the competitive advantage that active managers possess, especially when market concentration reaches extreme levels. Because passive investors, they can’t sidestep a lot of areas that are potentially in an overvaluation situation and expectations are just too lofty in the major indices.
Host: Jeff, last question. Any final thoughts on the capital markets or the economy for our listeners?
Jeff Schulze: Yeah, it wouldn’t be a surprise if you see some choppiness in the markets as we lead up to the election. Usually volatility increases pretty dramatically once you get to September and then into October. That would just be historically a normal type of environment. But I think the key takeaway, should we see any type of sell-off because of that choppiness, you should think about buying the dip from a longer-term perspective, because historically you have a relief rally after the election regardless of whether the incumbent party or the opposition party take the White House, because investors can now focus on the certainty from the election and then price in that new reality.
Then from an economic perspective, one of the concerns that people have is that the unemployment rate has risen from 3.4% at the lows up to 4.1%. So it’s been a 0.7% rise, and we’re close to violating what’s called the Sahm rule. And what that really means is, is that whenever you’ve seen an increase of the unemployment rate by a half a percent or more versus its low over the last 12 months, on a three-month moving average basis, you’ve always had a recession. And right now the unemployment rate has moved up by 0.43%. So we’re a hair away from triggering that.
But not all rises in the unemployment rate are equal. And just like many things have gone off signaling a recession this cycle that haven’t materialized, the Sahm rule might be triggered this time as well because the rise of the unemployment rate, about half of it is because people coming back into the labor market, whether it’s re-entrance or new entrance. So that’s a good dynamic because these are people that didn’t have income previously and if they get a job, they’re going to be spending and they’re going to grow the economy. So that’s going to increase the speed limit of potential growth as we look out on the horizon. The real problem comes when people get laid off and they stop consuming. And then when you hear about friends that get laid off, you stop consuming. And that creates a snowball effect where that ultimately creates more layoffs and a recession. So you’re going to hear a lot about the rise of the unemployment rate, but we’re not concerned because this is really more of a function of people coming into the labor market rather than people losing their jobs.
Host: Jeff, thank you for your terrific insight as we continue to navigate the capital markets here in the second half of 2024. To all of our listeners, thank you for spending your valuable time with us for today’s update. If you’d like to hear more Talking Markets with Franklin Templeton, please visit our archive of previous episodes and subscribe on Apple Podcasts, Google Podcasts, Spotify, or any other major podcast provider.
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