Highlights:
- Market trends shifted in August: the S&P 500 gained 2.0%, Health Care rebounded, and small caps rallied, while Technology lagged.
- While long-term bond rates remained stable, short-term yields fell sharply, benefiting investors in the 2-4 year maturity range.
- Markets reacted to Fed Chairman Powell’s Jackson Hole remarks, with expectations growing for a September rate cut and possible second cut before year-end, despite inflation remaining close to 3%.
- Signs of weakness emerged in some of the mega cap technology stocks, with concerns over valuations, AI profitability, and costly data center build-outs.
As Wall Streeters took their August vacations, the stock market drifted higher, with the S&P 500 moving up 2.0%, taking the year-to-date return into double digits at 10.8%. The market gains were in many ways contrary to this year's trends, with the year’s weakest sector, Health Care, jumping 5.4% and Technology up just 0.3%. The Russell 2000 small-cap index, which had been dramatically trailing larger stocks with a flat year-to-date return, jumped 7.1%. Meanwhile, bond rates held steady at the long end of the curve while dipping sharply on the shorter end, which produced particular rewards for investors in the 2-4 year range.
The major driver of these trends was the anticipation of Federal Reserve action. Fed Chairman Powell's comments at the Jackson Hole meetings in late August raised expectations for a September cut to a near consensus. Odds for a second cut before the end of the year also rose. This is despite inflation remaining stubbornly close to 3%, with the prospect of tariff-induced price increases still looming. But Powell was clear that the board was focusing more on the second part of their mandate – the labor market. Softening employment numbers were now becoming the Fed's primary concern, stating "the downside risks to employment are rising...and if those risks materialize, they can do so quickly in the form of sharply higher layoffs and rising unemployment."
Some of the technology stocks riding the AI wave (NVIDIA, Meta, and Microsoft) showed signs of weakness in August, as extended valuations of the largest technology companies have induced considerable volatility. While AI spending and its subsequent expectations remain in place, there have recently been some tremors in the foundations. For instance, a mid-month paper from MIT concluded that while generative AI holds much promise, the vast majority of current implementations have not been additive to the bottom line. The massive build-out of multi-billion-dollar data centers has reminded some observers of the equally expensive boom in laying broadband-capable fiber optic lines in the 1990s. While the technology proved essential for today's technology demands, it produced mixed results for the companies involved.
Looking ahead, it's worth remembering that September has historically been a difficult month for stocks, with the S&P 500 dropping an average of -4.2% over the past five years. The backdrop is also concerning, as many Wall Street analysts, looking at the impacts of tariffs and other factors, have been lowering their earnings forecasts at a time when the overall market is at 22x earnings, well above its 30-year average of 17x. The rotation of sector returns in August suggests the possibility that the main drivers of trailing index returns could be in for a pause as investors begin to look to less-stretched areas of the market. This could bode well for the diverse, quality-centric portfolios we have always emphasized.