Q3 2024 Quarterly Market Outlook: A Summer to Remember

By Liz Levy, CFA, Director of Investment Research

Greetings from one of Clean Yield’s two new Directors of Research! We have spent the past few months diving in to apply our investment philosophy and practices, as we discussed in our Outlook last quarter (if you missed it, you can find it here). This quarter, we will get back to reviewing the quarter that was and prognosticating on the quarter to come.

Despite volatility and uncertainty, we remain committed to the heritage and ethos that have
driven Clean Yield for more than 40 years, which attracted both our clients and our team to the
firm.

We strongly believe in the positive impact that Clean Yield can have in the public markets through our impact investing, shareholder advocacy, and proxy voting practices, and in the right and responsibility of our clients to align their investments with their values.

The Macro Context

At the start of the third quarter, we observed that investors were sailing into summer in a good mood, with stock markets near record highs, investors focused on expected rate cuts by the Federal Reserve, and the soft landing versus recession debate raging. That high-level overview hasn’t changed much since the end of June. The S&P ended the quarter up 5.5%, at an all-time high. Investors are still focused on expected future rate cuts, and the discussion about whether the Fed can pull off a soft landing, taming inflation without triggering a recession continued through the end of the quarter.  

So what happened this quarter? A lot! The Fed, and its leader Jerome Powell, have repeatedly said their decisions would be driven by data, meaning they would use economic data and statistics in their decision-making as they become available. The questions during the third quarter were when rate cuts would start and how much the Fed would cut in its first move, with expectations of either a quarter or a half percentage point. 

Data and outlooks swung wildly throughout the third quarter, increasing equity market volatility as well.

Data released in July added to the narrative of slowing inflation, giving the Fed confidence to begin lowering rates from the higher levels they had been set at to combat post-COVID inflation. But the Fed cutting rates is generally indicative of an economy losing steam, if not outright contracting. Economic data did in fact show slowing consumer spending, which spooked markets in July. That month’s weak monthly employment report showed rising unemployment, which triggered recession fears, drove equities markets down globally, and caused chatter of an emergency rate cut. But markets subsequently recovered quickly on better-than-expected weekly jobs data, resulting in a quick and dramatic reversal. By the end of the quarter, positive data and indicators were increasing, leading Treasury Secretary Janet Yellen to suggest in the last week of the quarter that she believes the economy is on track for a soft landing; the September jobs report also pointed that direction.

One economic measure that is often discussed is the yield curve, which compares interest rates on U.S. Treasury debt across different maturities. In general, borrowing money for a longer time costs more, so the yield curve slopes upward on the long-dated side. However, when there are expectations of falling interest rates intended to prop up the economy, the curve can invert, with shorter dates having higher yields, as investors expect to be paid lower rates in the future. Inversion is therefore generally considered to be a harbinger of recession. The yield curve had been inverted since July 2022, and just “uninverted” in September in anticipation of interest rate cuts. 

The yield curve and the equity market act as leading economic indicators because they both reflect investors’ expectations of future economic conditions. So as it became clear over the summer that the Fed would definitely lower interest rates, investors repositioned portfolios accordingly in anticipation. The Fed, as you likely heard, did cut interest rates by half a percent, or 50 basis points, during its September meeting. This was the first in what is expected to be a series of cuts by the Fed over the next year.

The financial markets continue to debate the pace at which the Fed will cut and how far rates will fall, but it’s likely that the Fed will continue cutting rates at the remaining meetings this year and into next year. 

In the political realm, well, the quarter included a candidate switch, two assassination attempts, and a groundswell of donations. Yet somehow, the presidential race is still a statistical tie, as early and mail-in voting begin. 

Equity Market Details

Looking under the hood of the equity market’s third quarter performance, U.S. small-cap stocks, as measured by the S&P 600, performed better (+9.7%) than the mid-cap S&P 400 (+6.6%), which performed better than the large-cap S&P 500 (5.5%). Within large-cap stocks, the S&P 500 Value (+8.4%) outperformed the S&P 500 Growth (+3.6%). Both of these trends are reversals of the themes of the last several years, as large-cap growth stocks, particularly a small group of very large, rapidly growing internet stocks, have dominated the markets.  

Within the S&P 500, all but three economic sectors outperformed the headline index: Information Technology, Communication Services, and (fossil fuel-based) Energy. The latter was the only sector that declined, as oil fell 16% despite increasing unrest in the Middle East. The impact of the strength of the small group of large tech companies over the last few years can be seen in those results, as the Tech sector is now close to 30% of the weight of the S&P 500 and Communication services (which includes Meta and Alphabet/Google) is more than 8%.  

Taken together, these results show a market that rotated from the big tech stocks that have dominated in recent years, and broadened out, specifically into value and smaller stocks, which have not fared as well. 

The cyclically adjusted price-to-earnings (CAPE) ratio now stands at 36.9x—higher than last quarter when it was at 36x, and at a historically high level.  As the CAPE ratio is often used to judge whether a market is overvalued or undervalued, we continue to be mindful of stretched valuations.

On the fixed-income side of the market, as interest rates fall, bond prices generally rise. Indeed, the S&P Aggregate Bond Index also had a positive return for the quarter of 4.8%.

Now where?

Where does this all leave us? For starters, while we do not expect a severe economic downturn, we remain ambivalent about whether the economy is headed for a soft landing or mild recession. We believe our portfolios are well positioned for either outcome. During the quarter, our clients’ portfolios benefited from our preference for value stocks and smaller companies, as well as our overweight to defensive sectors and industries. As we noted above, markets are forward-looking, and we believe this is the right time to build long-term portfolios, taking advantage of opportunities that a volatile market may bring us. We are continuing to diversify our portfolios, in some cases rotating from positions that have benefited from recent price moves into new positions in attractively valued stocks that we are excited about for the long term.  

The election outcome will have significant implications across multiple dimensions, of course, and financial markets are one of the dimensions.  A federal election with two very different outcomes and no clear expected winner is an additional factor in market volatility.

Although it feels as though times are always uncertain, now is a time of particularly elevated uncertainty. On the economic side, we are awaiting an inflection point, but the influence of the real world on markets is undeniable as well.

We believe that now, more than ever, is the time for taking a long-term perspective to investing in companies seeking to meet the challenges of tomorrow, in alignment with our firm’s values and heritage, and using our voice as investors.