The third quarter finished with something occurring that we haven’t observed in quite some time: smaller cap stocks outperforming their larger cap brethren. While the S&P 500 rose a respectable 5.6% in the 3Q, both the small-cap Russell 2000 Index and the Russell Midcap Index nearly doubled that return, appreciating by 10.2% and 10.1%, respectively. Generally, it’s a bullish sign when smaller cap stocks outperform larger caps since the former far outnumber the latter, meaning the breadth of the market is improving (i.e. a broad number of stocks are participating in the advance, as opposed to a concentrated group of large caps). As we’ve discussed here in the past, since early 2023, the performance of the S&P 500 has increasingly been attributed to just a handful of stocks (the “Magnificent 7”). Perhaps this recent surge in smaller-cap interest by investors indicates a healthy rotation away from a select few mega-caps. And it’s worth mentioning that smaller cap stocks tend to be more economically sensitive, inferring that the economy may have indeed achieved a so-called “soft landing.”
In September, with inflation continuing to subside and indications of the economy slowing, the Fed decided to (finally) cut interest rates by 50 basis points. In response, interest-rate-sensitive sectors like real estate (REITs) and utilities took off in the quarter, as REITs rose by nearly 18% and utilities gained just over 20%. The Fed’s rate cut was not a surprise as the 10-year Treasury yield declined from its 2024 peak of 4.7% in late April to 3.8% by the end of the 3Q. Also faring well in the quarter were higher-duration-sensitive fixed income investments, such as corporate bonds and long-term Treasuries, both rising by nearly 10%. The worst performing asset class in the quarter was commodities, primarily due to waning inflation, easing of economic growth and arguably an oversupply of crude oil.
Despite smaller caps exhibiting renewed life this past quarter, further fueling already-elevated bullish market sentiment, several bearish developments unfortunately remain in place which should give one pause. For example, as shown in the following chart, during the quarter, defensive or risk-off sectors (utilities, REITs, health care, consumer staples) outperformed the S&P 500, while technology, the best performing sector since the COVID market bottom in 2020, was flat.
Typically defensive sectors do not lead the way in a bull market, and often such an occurrence is foreboding for troubling times ahead.
In addition, the unemployment rate is “quietly” trending higher, as shown in this next chart:
When the unemployment rate (red line) rises above its moving-average (blue line), indicating a trend change higher, the S&P 500 (green line) has tended to suffer thereafter.
I’ve discussed this next chart in past quarterly letters and it merits another mention.
The chart dates back to 1998 and it shows the yield curve (green dotted line) and the S&P 500 (red line). When the yield curve inverts, it is below the orange 0% line. Although yield curve inversions have a very good track record for predicting future economic recessions, it’s actually when the yield curve un-inverts or rises back above the orange line that has triggered sell-offs in stocks as the economy struggles. Note the blue arrow in the chart, depicting the yield curve likely bottoming and un-inverting or working its way higher.
Finally, the following is another chart I’ve discussed in the recent past, it shows the fed funds rate (red line) and the S&P 500 (green line):
When the Fed eventually pivots and cuts rates, it has not been bullish for stocks (as denoted by the orange dashed lines). And with the 50 basis point cut in September, it appears the Fed has indeed pivoted with investors expecting several more rate cuts in the near future.
With respect to client portfolios, we remain defensively positioned as we are always being as mindful and vigilant about preserving capital as we are about striving to achieve significant relative gains. Given the discussion in this quarterly letter, we believe now is not the time to get overly aggressive.
As always, if you have any questions, please feel free to call or email.
The entire team at Measured Wealth wishes to thank you for entrusting us to deliver on your financial goals.
Edward Miller, CFA, CMT
Chief Investment Officer
Measured Wealth Private Client Group
Important Disclosures
Historical data is not a guarantee that any of the events described will occur or that any strategy will be successful. Past performance is not indicative of future results.
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