Stembrook Market Review - Third Quarter 2024

Global equity markets continued to extend their gains in what has been a very profitable year for equity investors. Investors expressed relief over the Federal Reserve's decision to cut rates by 0.5% in September as markets continued to rally. Within the United States, real estate stocks had the strongest returns, up over 16.9% in the quarter. This follows a series of poor performance periods for the group.¹One of the main drivers of the housing market is interest rates, which directly impact mortgage rates.

Focusing on the chart below, titled Historical Rate Cuts and Returns, we can see that stock performance following the start of a Fed cutting cycles is mixed. For example, in 1995, stocks continued to rally as the economy avoided a recession. But if we look at returns in 2001 and 2007 we can see that stocks sold off as the economy entered a recession. We do not know exactly what will happen this time in equity markets, but we do know that valuations remain elevated, especially in technology stocks, which is why we remain cautious.

Counter to equity returns, fixed income returns are generally positive following a rate cut. One of the primary drivers of fixed income returns is interest rates. As we can see on the right-hand side of the chart below, fixed income returns tend to follow a more predictable pattern following the Fed's initial rate cut. The reason for this is that as market rates fall, the value of existing bonds increases, due to them having higher interest rates and investors receive more in coupon than if they were to purchase newly issued bonds. This was especially true in 1984, when the Fed cut from all-time highs. Investment grade bonds were up 5.2% in the quarter. ²

All eyes are on the upcoming U.S. presidential election in November. Historically, it has been very difficult to successfully base investment decisions around political elections. Our plan is not to try to game a certain outcome, but we are prepared to make adjustments to the portfolio if opportunities do arise.

Historical Rate Cuts and Returns

Equity performance is mixed post the start of rate cut cycle, but fixed-income performance is largely positive.

Our proprietary models forecast long-term, pre-tax returns ranging from 3% to 4% for fixed income-like asset classes and 9% to 10% for equity-like asset classes (see Expected Market Returns and Risks table). We maintain target-weight allocations to equities and fixed income. Our more detailed observations and current portfolio positioning are outlined in the following comments.

Expected Market Returns and Risks 7-10 Year Horizon

A sampling of return expectations produced by our models. Expected returns are projections and are not guaranteed.

Historical Market Returns

Historical market returns as of September 30th 2024. Note that looking backwards at recent returns is not a reliable method of predicting future returns.

Yields Across Asset Classes

Yields are an indicator of future returns. Orange dots show current yields, blue bars show historical ranges.

Economic Backdrop

In their July update, the IMF forecasted that world economic output would grow at a 3.2% annualized pace in 2024, and a 3.3% annualized pace in 2025, adjusted for inflation. This projection is roughly in line with the level of GDP growth in 2023.³
Despite a recent boom in Chinese equity markets, economic growth is expected to decelerate slightly over the next two years from 4.4% in 2023 to 4.3% in 2024 and 2025, with growth in China dropping to 5% and 4.5% this year and next. India remains the standout of the group with growth remaining between 6.5% and 7% over the next 2 years.³
Inflation is beginning to cool on a global level as most central banks have enacted tighter monetary policies. Economists expect the period of rising inflation to be behind us. Global inflation is expected to fall to 2.3% this year from a level of 3.1% in 2023.⁴
The pattern of disinflation continued in the U.S. Through the end of August, the rate of inflation has been 2.6% year-to-date. Prices have increased by 2.3% over the last 4 quarters, below the 10-year average of 2.8%.⁵

Currencies

The U.S. Dollar fell by nearly -4.8% in the third quarter, helping to boost returns in non-U.S. stocks.⁶

Equities

The 2024 stock market rally continued into the third quarter. The biggest change was in return leadership.
Emerging markets stocks led the charge on a global level, up 8.7%. This strong performance was driven by a resurgence of equity markets in China.⁷
Non-U.S developed stocks were up by 7.3% over the quarter.⁸
Within the United States, growth oriented NASDAQ stocks took a breather but still had positive returns, up 2.1% in the quarter.⁹
After lagging large cap stocks for several quarters, small cap stocks led the way in the U.S. in the third quarter, up 10.1%.¹⁰

Fixed Income

As interest rates fell, longer dated bonds outperformed cash. Long-term treasuries were up 7.8% in the quarter while cash returned 1.4%.¹¹
Non-U.S. bonds continued to build on strong performance, up 8.8% in the quarter.¹²
Municipal bonds continued to post positive returns, up 2.4% in the quarter.¹³

^{Global Asset Class Returns}

Returns are arranged in columns, by year. Each color represents a different asset class. Each year, the leaders and laggards tend to shift. Diversification across a range of asset classes can smooth returns and enhance growth.

Current Positioning

Out of an abundance of caution, we shifted our cash in traded money market funds from a prime fund (holds a combination of commercial paper, repurchase agreements, CDs and Treasuries) to one that holds only Treasuries, backed by the full faith and credit of the U.S. government. We sacrificed very little in yield by making this transition.
We have sold our inflation-linked bond positions for taxable and tax-deferred investors as the yields have become less attractive than nominal Treasuries on a relative basis.
We maintain our neutral duration position in fixed income portfolio as interest rates have risen to levels that are closer to historical averages.
After a run-up in prices driven by the Chinese equity market, we recently reduced our allocation to emerging markets and hold an underweight position. The proceeds from this trade were reinvested in core large-cap U.S. equities.
We maintain our overweight to developed non-U.S. equities, where valuations and long-term return potential remain attractive.
We also maintain our underweight to large cap U.S. equities.
We favor lower priced, value-oriented equities, both in the U.S. and abroad, which tend to outperform the broad market over time, with less volatility. While these stocks did not keep pace with some of the tech oriented growth names in the first half of 2024, they outperformed in the third quarter. We are optimistic about the return potential going forward.

We continue to focus our efforts on helping you meet your financial objectives by following our disciplined investment approach. Our approach uses return and risk models, incorporating fundamental valuations and tax-efficient strategies. This investment discipline is tailored to your individual situation in our continuing effort to craft and implement your customized investment solution.

We are keeping an eye on legislation related to the tax policies put in place through The Tax Cuts and Jobs Act. These changes are scheduled to sunset at the end of 2025, most notably the potential reduction in the estate and gift tax exemption. We will continue to keep you informed as we learn more about this.

As always, we thank you for placing your trust in our investment management and advice and welcome your questions and comments at any time.

Peter & Tom

Endnotes and Sources:

Text:

Morningstar: S&P 500 Sec/Real Estate NR USD. 6/30/24-9/30/24.
Morningstar: Bloomberg US Aggregate Bond Total Return. 6/30/24-9/30/24.
IMF World Economic Outlook Update: July 2024.
IMF World Economic Outlook: April 2024.
Bureau of Labor Statistics: CPI For All Urban Consumers. 8/31/24.
Barchart: $DXY—U.S. Dollar Index. 6/30/24-9/30/24.
Morningstar: MSCI EM NR USD. 6/30/24-9/30/24.
Morningstar: MSCI EAFE NR USD. 6/30/24-9/30/24.
Morningstar: NASDAQ 100 TR. 6/30/24-9/30/24.
Morningstar: S&P SmallCap 600 TR. 6/30/24-9/30/24.
Morningstar. Morningstar US 10+ Year Treasury Bond TR, Morningstar US Cash T-bill TR. 6/30/24-9/30/24.
Morningstar: FTSE WGBI Non-USD. 6/30/24-9/30/24.
Morningstar: S&P Intermediate Term National AMT Free Municipal Bond Index Total Return. 6/30/24-9/30/24.

Charts:

Historical Rate Cuts and Returns: As of 9/30/24.

Source: JP Morgan Guide to the Markets. FactSet, Federal Reserve, LSEG Datastream, S&P Global, J.P. Morgan Asset Management. Past performance is not a reliable indicator of current and future results. Excludes 1998 episode due to the short length of the cutting cycle and economic context for the cuts.

Expected Market Returns and Risks, 7-10 Year Horizon: As of 9/30/24.

Source: Stembrook Research.

(1) Volatility is measured in terms of Standard Deviation. Standard deviation is the statistical measurement of dispersion about an average, which depicts how widely a stock or portfolio’s returns varied over a certain period of time. Investors use the standard deviation of historical performance to try to predict the range of returns that is most likely for a given investment. When an investment has a high standard deviation, the predicted range of performance is wide, implying greater volatility. If an investment’s returns follow a normal distribution, then approximately 68 percent of the time they will fall within one standard deviation of the mean return of the investment, and 95 percent of the time within two standard deviations. For example, for a portfolio with a mean annual return of 10 percent and a standard deviation of two percent, you would expect the return to be between 8 and 12 percent about 68 percent of the time, and between 6 and 14 percent about 95 percent of the time. Source: Morningstar.

Historical Market Returns: As 9/30/24.

Source: Morningstar, Stembrook Research.

Indices: Bloomberg Barclays U.S Treasury Bills 1-3 Month Total Return, Bloomberg Barclays Municipal Bond 5 Year (4-6) Total Return, Bloomberg Barclays U.S. Aggregate Bond Total Return, Bloomberg Barclays U.S. Corporate High Yield Total Return, FTSE All Equity REIT Total Return, S&P 500 Composite Total Return, S&P SmallCap 600 Total Return, MSCI EAFE Total Return, MSCI EM (Emerging Markets) Total Return, Consumer Price Index – U.S., S&P 10 Year U.S. TIPS Total Return, Bloomberg Commodity (Total Return) Index.

Yields Across Asset Classes: As of 9/30/24.

Sources: Cash Equivalents Yields since March 1976. Ibbotson, Federal Reserve Bank, Thomson Reuters, Municipal Bond Yields since March 1988. Barclays Capital, Charles Schwab, BofA Merrill Lynch, Standard & Poor's/Investortools Municipal Bond Indices, Investment Grade Bond Yields since March 1976. Barclays Capital, High Yield since December 1984. BofA Merrill Lynch, Barclays Capital, Real Estate (Public) Earnings Yield since March 1976. NAREIT all Equity, Large Cap U.S. Equity Earnings Yield since March 1976. Standard & Poor's, BARRA, Mid Cap U.S. Equity Earnings Yield since June 1991. Standard & Poor's, BARRA, Small Cap U.S. Equity Earnings Yield since December 1993. Standard & Poor’s, BARRA, Developed Europe Equity Earnings Yield since March 1976. MSCI Europe, Standard & Poor's Europe 350, Developed Pacific Equity Earnings Yield since March 1976. MSCI Pacific, S&P/Citi PMI Asia Pacific, S&P Asia 50, Emerging Market Equity Earnings Yield since December 1998, Inflation-Linked Bond Real Yield to Maturity since March 1997. Citi Yield Book, Federal Reserve Bank. Note: Yields are not perfect predictors of future returns and should not be used in isolation.

Global Asset Class Returns: As of 12/31/23.

Source: Thomson Reuters, Bloomberg, Morningstar, Stembrook Research.

Indices: Consumer Price Index – US, U.S. 30-Day Treasury Bills, Bloomberg Barclays U.S. Treasury Bills: 1-3 Month Index, Citigroup Inflation-Linked Index, S&P 10 Year US TIPS Index, Bloomberg Barclays U.S. Aggregate Bond Index, BofA Merrill Lynch U.S. High Yield Cash Pay, Bloomberg Barclays U.S. Corporate High Yield Index, Dow Jones Wilshire REIT Index, FTSE All Equity REIT Index, S&P 500 Composite Total Return, S&P SmallCap 600 Total Return, MSCI EAFE Index, MSCI EM (Emerging Markets) Index, Dow Jones AIG Commodity (Totl Ret) Index, Bloomberg Commodity Index.

Disclosures

This material is intended to inform you of products and services offered by Stembrook Asset Management, LLC (“Stembrook”). Stembrook is a New Jersey Registered Investment Advisor.

This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument.

We believe the information contained in this material to be reliable but do not warrant its accuracy or completeness. The opinions, estimates, and investment strategies and views expressed in this document constitute the judgment of Stembrook, based on current market conditions and are subject to change without notice. The investment strategies stated here may differ from those expressed for other purposes or in other context.

Past performance is not indicative of future results.

The obligations and securities sold, offered, or recommended are not deposits and are not insured by the FDIC, the Federal Reserve Bank, or any governmental agency.

The views and strategies described herein may not be suitable for all investors. This material is presented with the understanding that it is not rendering accounting, legal or tax advice. Please consult your legal or tax adviser concerning such matters.

Important note regarding Stembrook’s capital market expectations.

The capital market expectations developed by Stembrook Asset Management are estimates of both a central tendency of asset class behavior and a probable range of asset class behavior over a long-term horizon. These estimates are one of many inputs used in the portfolio construction process, and should not be used independently. These expectations should not be construed as the returns that will be achieved, but merely those that may be achieved if certain assumptions hold true. Also note that each client's portfolio may differ given specific goals and constraints applied to the portfolio construction process.

Additional information is available upon request.