- The S&P 500 index saw a total return of 15% through June, marking one of the strongest starts to a year since the late 1990s. However, this impressive return has primarily been driven by just a handful of stocks. Over the first six months, just five stocks - Nvidia, Microsoft, Apple, Meta, and Amazon - contributed nearly 60% of the S&P 500’s total return. In the second quarter, the S&P 500 returned 4.3%, with Nvidia, Microsoft, and Apple accounting for 90% of that gain, indicating a narrowing of leadership. On an equal-weighted basis, the S&P 500 fell by 2.6% in the second quarter.
- Like last year, it has been a tale of two markets. Companies with strong ties to AI have led the market. The outperformance has been justified, as these companies have shown earnings growth that surpassed the overall market and expectations. However, their stock price returns have significantly outpaced earnings, driving up P/E multiples. In contrast the equal-weighted S&P 500 Index P/E multiple is currently at its largest discount to the S&P500 Index since at least 2020.
- Since the new bull market began in October 2022, market leadership has been narrow. This period has been characterized by the Fed tightening monetary policy. In the previous cycle, initiated by significant Fed easing during the depths of the global pandemic, market participation was much broader. We also note how the quality factor underperformed when the Fed eased but has outperformed as the Fed raised rates.
- As we look to the second half of this year, we anticipate the start of another Fed easing cycle. The key question is what will drive this policy shift. Will it be better inflation reports or worse data on the economy? We believe it will be the former, but regardless of the reason, the Fed will be moving in a direction that will likely be favorable for the broader market, not just a few stocks.
Above, we discussed how just a handful of stocks associated with AI have led the market. It just so happens that those are all Growth stocks with very large index weights. The top five performers represent 46% of the Russell 1000 Growth Index and 36% of the S&P 500 Growth Index; just five stocks.
- Excluding these five stocks, the remaining stocks in the Growth indexes performed similarly to those in the Value indexes. Does it make sense to remove those names? Probably not, but it does highlight that the recent rally is not broadly based across Growth stocks but is concentrated in a small group of AI-related stocks.
- AI is an important theme and will likely remain so for years. However, the primary beneficiaries are expected to evolve over time. Currently, we are in the “picks and shovels” phase, focused on building capacity and speed. Eventually, the focus will shift toward AI applications, which may reach well beyond the Growth universe. This evolution could resemble the late 1990’s dot-com boom, where the internet ultimately benefited all businesses, which may have helped spur Value style outperformance through 2007.
- We are still in the early stages of AI development; too early for the market to anticipate a shift toward widespread AI integration. However, it is noteworthy that Value stocks, which include many labor and process intensive businesses, could become significant AI beneficiaries.
- In the meantime, there is substantial risk (both upside and downside) associated with the current AI leaders. Their stock valuations leave little room for error, and their continued upside depends on exceeding already high expectations (albeit, which they have managed to do so far).
- In the first half of the year, small caps have underperformed mid caps. The S&P 600 Index had a total return of -1% and the Russell 2000 Index returned 2%. Meanwhile, the S&P 400 Index had a total return of 6% and the Russell Mid Cap index rose 5%.
- The difference in performance can largely be attributed to earnings and earnings revisions. Small caps have struggled due to slowing economic conditions as the Fed has maintained a restrictive monetary policy stance. Earlier this year, we removed a slight small cap overweight as expectations for a Fed pivot were pushed out into the second half of the year.
- The economic response to higher interest rates has been bifurcated. Larger companies have been less affected due to greater cash holdings, strong cash generation, and lower interest expense with locked-in lower borrowing costs. In contrast, smaller companies are more economically sensitive and are more likely to have floating rate debt.
- The divergence can be seen in survey data. The NFIB optimism survey, representing small businesses, remains depressed. In contrast, the US Duke CFO survey, which includes some small businesses but skews larger, is painting a much more optimistic picture.
- We believe the economy will continue to slow into the second half of the year, potentially leading to further downward revisions in small cap earnings. However, we also anticipate a slowdown in inflation, which should pave the way for Fed rate cuts. A pivot toward easing should improve the outlook for small caps.
- As noted, mid caps have outperformed small caps, though they trailed the S&P 500. As discussed on the first page, a handful of stocks have driven large-cap performance. Still, mid caps have performed in line with the S&P 500 equal weighted index, supporting our decision to maintain our mid cap overweight while downgrading small caps.
Equity Indexes Characteristics
The Indexes mentioned are unmanaged statistical composites of stock market or bond market performance. Investing in an index is not possible.
The Touchstone Asset Allocation Committee
The Touchstone Asset Allocation Committee (TAAC) consisting of Crit Thomas, CFA, CAIA – Global Market Strategist, Erik M. Aarts, CIMA - Vice President and Senior Fixed Income Strategist, and Brian Cheyne, CFA, CIMA - Senior Investment Strategy Specialist, develops in-depth asset allocation guidance using established and evolving methodologies, inputs and analysis and communicates its methods, findings and guidance to stakeholders. TAAC uses different approaches in its development of Strategic Allocation and Tactical Allocation that are designed to add value for financial professionals and their clients. TAAC meets regularly to assess market conditions and conducts deep dive analyses on specific asset classes which are delivered via the Asset Allocation Summary document. Please contact your Touchstone representative or call 800-638-8194 for more information.
A Word About Risk
Investing in fixed-income securities which can experience reduced liquidity during certain market events, lose their value as interest rates rise and are subject to credit risk which is the risk of deterioration in the financial condition of an issuer and/or general economic conditions that can cause the issuer to not make timely payments of principal and interest also causing the securities to decline in value and an investor can lose principal. When interest rates rise, the price of debt securities generally falls. Longer term securities are generally more volatile. Investment grade debt securities which may be downgraded by a Nationally Recognized Statistical Rating Organization (NRSRO) to below investment grade status. U.S. government agency securities which are neither issued nor guaranteed by the U.S. Treasury and are not guaranteed against price movements due to changing interest rates. Mortgage-backed securities and asset-backed securities are subject to the risks of prepayment, defaults, changing interest rates and at times, the financial condition of the issuer. Foreign securities carry the associated risks of economic and political instability, market liquidity, currency volatility and accounting standards that differ from those of U.S. markets and may offer less protection to investors. Emerging markets securities which are more likely to experience turmoil or rapid changes in market or economic conditions than developed countries.
Performance data quoted represents past performance, which is no guarantee of future results. The investment return and principal value of an investment in the Fund will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance may be higher or lower than performance data given. For performance information current to the most recent month-end, visit TouchstoneInvestments.com/mutual-funds.
Please consider the investment objectives, risks, charges and expenses of the fund carefully before investing. The prospectus and the summary prospectus contain this and other information about the Fund. To obtain a prospectus or a summary prospectus, contact your financial professional or download and/or request one on the resources section or call Touchstone at 800-638-8194. Please read the prospectus and/or summary prospectus carefully before investing.
Touchstone Funds are distributed by Touchstone Securities, Inc.*
*A registered broker-dealer and member FINRA/SIPC.
Touchstone is a member of Western & Southern Financial Group
Not FDIC Insured | No Bank Guarantee | May Lose Value
