Third Quarter Review: The Fed Cut Rates - Small and Value Stocks Finally Outperform
The U.S. economy showed resilience during the third quarter of 2024, with GDP growth projected at 1.9%. This represents a slight slowdown from the 3.0% growth in the second quarter but still indicates a solid economic foundation.
Inflation continued its downward trend, with the Consumer Price Index (CPI) reaching 2.5% year-over-year in August, the lowest level since the June 2022 peak of 9% (a 40-year high). In response to moderating inflation, the Federal Reserve began easing its monetary policy, with the Federal Discount Rate dropping from 5.5% to 5.0% in September.
Investors were treated to a bumpy ride in the third quarter, but stocks are at record highs as the final three months of 2024 get underway, and bonds are solidly in the green. The Federal Reserve’s long-awaited reduction in interest rates played a crucial role in the solid returns on stocks and bonds. But under the hood, there was much more going on with stocks than the headline performance numbers might suggest.
The S&P 500, a proxy for U.S. Large Cap stocks, returned 5.9% in the quarter despite tech stocks running out of steam and the Magnificent Seven trailing overall. While Apple (AAPL) and Meta Platforms (META) rose respectively 9.8% and 13.3%, artificial intelligence darling Nvidia (NVDA) fell 1.7%, while Microsoft (MSFT) lost 3. 6% and Alphabet (GOOGL/GOOG) fell 8.8%. That cleared the way for value stocks and small caps to shine amid a long-awaited rotation as investors shifted out of the rally’s winners and into the laggards in a complete reversal of the 2nd quarter:
Source: Morningstar Direct. Data as of Sept. 30, 2024.
However, a selloff in August, sparked by renewed fears of a recession and the sudden unwinding of big bets in Japan, saw stocks fall roughly 3% in one day. World equities have since clawed their way back and ended the quarter up 6.6%.
Non-U.S. (+7.3%) and Emerging Markets stocks (+8.7%) also outperformed the S&P 500. Real estate (+16.3 %) had some of the best performance across global markets in the third quarter.
As mentioned, the U.S. bond market also saw gains, with the Bloomberg U.S. Aggregate Bond Index returning 5.2% in Q3. Investors now expect the U.S. central bank to continue pushing rates lower quickly, helping push bond markets into positive territory during the quarter. Yields on the 10-year U.S. Treasury note fell from 4.5% at the beginning of July to 3.7% by the end of the quarter.
Against that backdrop, we started progressively moving your portfolios out of cash, T-bills, and shorter-dated bonds to capture a potential appreciation in intermediate-dated bond funds—those with roughly three to seven years average maturities. We are also continuing to reallocate your capital from the more esoteric “Other Assets” category into more traditional bond investments.
Large Cap Value (LCV) Review
(Not all Bristlecone clients are invested in our Large Cap Value Equity portfolio strategy, depending on the overall portfolio size and the client's objectives and constraints.)
During the quarter, the LCV portfolio outperformed the S&P 500 significantly but trailed the Russell 1000 Value by a small margin. The best-performing stocks during the quarter were HanesBrands (HBI +49%), U-Haul (UHAL +25%), and Howard Hughes (HHH +25%), while the worst performers were Nutrien (NTR -6%), Adient (ADNT -9%) and Intel (INTC -24%). When looking at the impact on the overall portfolio growth (adjusting individual stock returns by the investment size), the same three holdings also had the most detrimental effect. On the other end, Meta Platforms (META), HanesBrands, and Johnson Controls (JCI) were the top three contributors to the portfolio’s positive performance.
After testing our patience for a long time, HanesBrands is undergoing a significant transformation, as highlighted by the $900 million sale of its Global Champion business, which will reduce debt and enhance financial stability. Exiting the U.S. outlet store business further streamlines operations, positioning the company for more consistent growth, higher margins, and improved cash generation. Investors finally recognize the company’s efforts and believe in its turnaround.
During the quarter, we were more active than usual. We sold some recent spinoffs (Fortrea and Sandoz) and a long-term holding (Cisco) to make room for increased investment in AGCO (AGCO). You may remember that AGCO is a global manufacturer of agricultural equipment. The farm sector is struggling primarily due to cyclical rather than secular trends. In the long term, we believe AGCO is well-positioned to drive greater technology adoption and productivity among farmers. The company possesses strong brands and an extensive dealer network. We felt that the current valuation offered an opportunity to increase our commitment.
Finally, we must confess to a poorly timed investment decision: After adding to our Liberty Broadband (LBRDK) investment during the 2nd quarter, we decided to sell it entirely in August. Although this unplanned short-term trade had a positive result, our timing was miserable. A few weeks later, the company announced what we had been waiting years for (we started building a position in 2018): a potential merger with Charter Communications. The stock price promptly increased by 25% to 30% above our sale price.
We refer you to prior discussions, including in our 2nd quarter commentary, of our thesis in Liberty Broadband. So why did we sell? Remember that Liberty was mainly an investment in Charter, a video and cable internet subscription services provider under the Spectrum brand.
As early as 2021, T-Mobile and Verizon started offering a competing wireless internet connection with the rollout of 5G because they had excess capacity. The technology is referred to as “Fixed Wireless Access” or FWA. The cable companies, including Charter, did not believe it would be a competitive threat to their internet business in the long term because, as more people signed up, it would impact service to all mobile wireless customers due to broadband and spectrum limitations.
Although this assessment appeared accurate originally, this is no longer the case as FWA is taking on more customers from cable companies. The issue that concerned us the most during the third quarter and prompted us to revise our thesis was based on recent announcements from communication equipment providers. The technology is getting better at jamming more users in the existing spectrum, improving speed, and freeing up capacity. We grew increasingly concerned that FWA sellers will keep capturing market share because they will continue to be able to offer faster connections for less than cable companies currently charge.
The bottom line is that we believe that these improvements in FWA technology will likely further pressure Spectrum's pricing power. Considering the amount of debt on Charter’s balance sheet, a small revenue change can lead to a much lower business valuation. We no longer felt comfortable holding on to that investment.
United States Vs. the Rest of the World: Is It Worth Investing Overseas?
In a recent research meeting, we discussed the increasing dominance of the U.S. stock market within global equity markets, as reflected in the MSCI All Countries World Index, the benchmark we use in our quarterly reports to track the performance of your portfolios’ equity allocation. Since the 2008 financial crisis, the U.S. share has surged from just over 40% to more than 60%. This development has not gone unnoticed; some have questioned the benefits of investing in international markets.
The chart below from the UBS Global Investment Returns Yearbook 2024 provides some historical context. It shows that the U.S. market share is currently the highest since the "Nifty Fifty" era of the late 1960s and early 1970s. 
Today's U.S. tech giants are once again the key drivers of U.S. stock returns. However, few remember that after the Nifty Fifty boom, the U.S. entered a prolonged bear market in 1973, with the S&P 500 index taking over 20 years to recover in real terms (adjusted for inflation).
In the 1960s, when the U.S. last held more than 60% of global market capitalization, the country made up 40% of global GDP (see below). The U.S. accounts for just 26% of global GDP today, close to the last 50-year average. Yet, its share of the worldwide stock market has risen to more than 60%.
United States Share of Global GDP (1960 – 2023)
This disconnect gives us reason for pause: blindly tracking the weights within global indexes is likely to lead to overpaying for U.S.-based earnings. As investors, we feel that it is important to recognize such risks. Our clients’ portfolios are positioned more conservatively: not only do we believe that international diversification is worth pursuing, but our allocation to U.S. stocks remains lower than the MSCI All Countries World Index by about 10%.
We remain steadfast in adhering to our fundamental investment principles: diversification across and within asset classes, and regular rebalancing to manage risk and reward.
"Those Who Cannot Remember the Past Are Condemned to Repeat It.”
One of Bristlecone Value Partners’ principles is to communicate frequently, openly and honestly. We believe that our clients benefit from understanding our investment philosophy and process. Our views and opinions regarding investment prospects are "forward looking statements," which may or may not be accurate over the long term. While we believe we have a reasonable basis for our appraisals, and we have confidence in our opinions, actual results may differ materially from those we anticipate. Information provided in this blog should not be considered as a recommendation to purchase or sell any particular security. You can identify forward looking statements by words like "believe," "expect," "anticipate," or similar expressions when discussing particular portfolio holdings. We cannot assure future results and achievements. You should not place undue reliance on forward looking statements, which speak only as of the date of the blog entry. We disclaim any obligation to update or alter any forward-looking statements, whether as a result of new information, future events, or otherwise. Our comments are intended to reflect trading activity in a mature, unrestricted portfolio and might not be representative of actual activity in all portfolios. Portfolio holdings are subject to change without notice. Current and future performance may be lower or higher than the performance quoted in this blog.References to indexes and benchmarks are hypothetical illustrations of aggregate returns and do not reflect the performance of any actual investment. Investors cannot invest in an index and returns do not reflect the deduction of advisory fees or other trading expenses. There can be no assurance that current investments will be profitable. Actual realized returns will depend on, among other factors, the value of assets and market conditions at the time of disposition, any related transaction costs, and the timing of the purchase.Economic factors, market conditions, and investment strategies will affect the performance of any portfolio and there can be no assurance that a portfolio will match or outperform any particular index or benchmark. Past Performance is not indicative of future results. All investment strategies have the potential for profit or loss; changes in investment strategies, contributions or withdrawals may materially alter the performance and results of a portfolio. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will be suitable or profitable for a client's investment portfolio.This content is developed from sources believed to be providing accurate information, and it may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security.