Buy Low, Sell High: Evaluating Undervalued Market Segments

We are beginning to see some encouraging trends in recent economic data, including metrics like the Consumer Price Index (CPI), Producer Price Index (PPI), and retail sales.

The Consumer Price Index (CPI), which measures the average prices consumers pay for goods and services, showed a stronger-than-expected performance in the first few months of the year. This surge impacted the bond markets, causing bond prices to drop and yields to rise. However, May’s CPI was benign, remaining unchanged from the previous month. Core CPI, which excludes food and energy, rose by 0.2% in May. Over the past year, CPI increased by 3.3%, slightly below the anticipated 3.4%.

While prices are still rising, the pace has slowed, indicating the slowing of inflation rather than deflation. Despite this overall moderation, certain fixed expenses, such as homeowners and auto insurance, continue to exert pressure on consumers. Prices have still risen by 3.3% year-over-year on top of previous inflation, posing challenges, especially for some low-income families.

The Producer Price Index (PPI), reflecting the prices domestic producers receive, has also shown a deceleration in monthly price increases. This is a further trend of slowing inflation that aligns with the Federal Reserve (Fed)’s objectives. In addition, May retail sales were weaker than expected. While this would normally be unwelcome news, a weakening economy gives investors hope that the Fed will have room to cut interest rates in the future.

Overall, the U.S. economy remains robust compared to much of the world. In a high interest rate environment, Americans benefited from $3.7 trillion in interest and dividends, a significant increase from $770 million four years ago. This boost in consumer income has been substantial and has helped to keep consumer spending strong. Federal government fiscal spending also plays a role in supporting the U.S. economy. Despite the Fed’s monetary tightening measures, the federal government has implemented various spending initiatives, including the Inflation Reduction Act and the CHIPS and Science Act, both of which have injected capital into the economy.

Employment remains exceptionally strong, influencing the Fed’s cautious stance on immediate rate cuts. The Fed has emphasized its data-dependent approach, and emerging data points suggest a potential rate cut before year-end if current trends persist.

In contrast, the European Central Bank and the Bank of England have already initiated rate cuts, leading the easing cycle due to the relative weakness in their domestic economies vs. the U.S. Despite the U.S.’s outperformance over the past decade, international exposure remains valuable. Among the world’s fifty largest companies, 72% are overseas, and international stocks currently offer lower valuations and higher dividend yields.

Regarding the strong showing YTD in the S&P 500, investor sentiment shows a bifurcation in market performance. The S&P 500’s impressive year-to-date gains largely stem from the performance of three stocks—Nvidia, Apple, and Microsoft—which comprise 20% of the index. Notably, Nvidia alone accounts for about one-third of the S&P 500’s return. An equally-weighted S&P 500 reveals that the index is actually at a similar level to two and a half years ago, providing a more accurate representation of the broader market.

Volatility has eased somewhat, offering investors a welcomed break. However, as the election season approaches, volatility may resurface. The skewed composition of the S&P 500 necessitates caution. Our focus includes other market segments like small-cap stocks, which are poised for growth as interest rates decline. Small caps, currently at one of their cheapest valuations since the financial crisis, have underperformed year-to-date, with the Russell 2000 Index showing a -3.5% annualized return over the past three years (as of 5/31/24).

In this bull market in large U.S. stocks, only a few leaders dominate while many other companies lag. This scenario underscores the timeless investment principle: buy low and sell high. While the market shows signs of strength, a diversified approach and attention to undervalued segments are crucial. If you have any questions about your portfolio, please contact your advisor at The Wealth Alliance.