A rip current is a strong, narrow jet of water that moves away from the coastline.
If you’re an ocean swimmer caught in one, the best strategy is not to fight it, but relax, go with the flow, and try to swim parallel to the beach. Eventually, you’ll move out of the rip current and be able to swim back to shore.
In mid-July, the first rip current began to move through the financial markets.
Tech stocks, which had been leading the broader stock market higher throughout 2024, stumbled. But small company stocks, which have lagged performance-wise for years, soared.
Below is a snapshot of financial market performance for July.
US Small Co = Russell 2000 Index; Foreign Stocks = MSCI EAFE Index; US Bonds = Bloomberg US Aggregate Bond Index; US Large Co = S&P 500 Index; Tech Stocks = Russell 1000 Technology Index
While political developments grabbed lots of headlines—including an assassination attempt of a former US President and the announcement that the sitting US President wouldn’t seek a second term—these weren’t events that had a large impact on financial markets.
The July outperformance of small company stocks appears to be linked to expectations for short-term interest rates.
Small companies rely mainly on banks for financing, whereas big companies have more borrowing options, including issuing bonds. Interest costs associated with bank debt float up or down with short-term interest rates.
Because of this reliance on bank loans, the thinking goes that small companies will get a financial boost as short-term interest rates fall. Many market participants believe that the Federal Reserve will reduce interest rates sooner rather than later, so demand for small company shares increased markedly in July.
Financial market prognosticators are referring to this preference to favor small company stocks over large company stocks a “rotation trade”. For investors with well-balanced portfolios, this phenomenon with the wonky name may be interesting to observe but needn’t be viewed as a call to action.
A second more consequential rip current also began moving through the financial markets in July.
This rip current has to do with the anticipation of an economic slowdown, and the feeling that the Federal Reserve has waited too long to bring down its target for short-term interest rates to provide financial relief to business and consumer borrowers.
The Employment Situation Report, released by the US Bureau of Labor Statistics on Friday, August 2, seemed to validate this concern, because it showed less robust US jobs growth and a higher unemployment rate.
From the recent peak on July 16 through August 2, US large company stocks have declined by 5.5%, and technology shares approached correction territory, having fallen by 9.5%.
Financial market choppiness, which we experienced in the second half of July, and which accelerated in early August, likely will be with us for the next few months.
August, in particular, has historically been one of the more volatile months for stocks.
Also, the US election cycle has moved into high gear, with more to come regarding policies (potentially good or bad) that might affect the economy and financial markets.
However, the US economy continues to be in a good place:
- companies are still hiring
- businesses are generally holding onto employees
- corporate profits are rising
- inflation is decelerating
- the Federal Reserve is likely to bring down short-term interest rates soon
These economic positives should help investors ride through the financial market rip currents.
The chart below, published by the Hartford Funds, provides some perspective on what has happened to stocks in the past when the Federal Reserve (the Fed) reduces interest rates.
Hartford Funds identifies twenty-two periods of Federal Reserve interest rate reductions (when the Fed cuts rates) since 1929. In sixteen of these instances (72% of the time) stocks rose during the year of the Fed cuts.
Most pertinent to today’s situation: in all six instances when interest rate reductions occurred during times of economic expansion (grey bars in the chart above), stocks have finished higher by year end.
And the average annual gain during periods of economic expansion paired with Federal Reserve interest rate reductions has been 11%.
-RK