Is a market correction coming?

With 2024 more than half completed, the U.S. stock market is on pace for its second consecutive year of strong gains. The primary market indices, the S&P 500, the Dow Jones Industrial Average and the NASDAQ Composite have all hit new highs. Strong investor sentiment today is fueled by speculation that the Federal Reserve (Fed) may be close to cutting interest rates for the first time since the onset of the COVID-19 pandemic in March 2020.

Outside of a brief market setback in April, stocks appear to be on their way to generating gains in six of the first seven months of the year.

Fed interest rate policy has been a driving force in the markets, particularly since the Fed began an aggressive series of rate hikes in early 2022. The Fed bumped the federal funds target rate from near 0% to a peak of 5.50%. Entering 2024, capital markets priced in several federal funds target rate cuts, anticipating them to begin early in the year. Yet for more than a year, inflation (as measured by the Consumer Price Index or CPI) stayed in the 3% to 3.7% range,¹ exceeding the Fed’s comfort level. However, in recent months, CPI and other inflation measures have trended modestly lower, an encouraging sign that the Fed may be ready to initiate rate cuts soon. “Markets have quickly adjusted expectations from one 2024 rate cut to the possibility of as many as three rate cuts,” says Rob Haworth, senior investment strategy director at U.S. Bank Wealth Management.

Fed Chair Jerome Powell cautiously opened the door to impending rate cuts, saying that although the Fed wants greater confidence that inflation will move lower from here, “What increases that confidence is more good inflation data, and lately here, we have been getting some of that.”²

The delay in Fed stimulus did not thwart investor enthusiasm, according to Eric Freedman, chief investment officer for U.S. Bank Wealth Management. “Consumer spending and business capital expenditures continue, and that’s a big reason why markets remain bullish.” Freedman notes that much corporate spending is focused on technology, particularly with businesses seeking ways to incorporate artificial intelligence (AI) advances.

Smaller stocks bounce back

Investors have been waiting for the market’s wealth, concentrated to this point on large-cap stocks, to extend to mid-cap and small-cap issues. In July, small stocks came to the forefront. Over the first half of July, the Russell 2000 Small-Cap Index gained 10.59%, compared to 3.84% for the large-cap S&P 500.³ “With prospects of Fed rate cuts on the horizon, we’re seeing at least a short-term pivot into smaller stocks,” says Haworth.

Prior to now, the environment has been less beneficial for smaller stocks. “The Fed’s interest rate policy matters meaningfully to smaller companies that likely must borrow more to fund operations and business growth,” says Haworth. “Interest costs for the typical small company are significantly higher, relatively speaking, than for large companies, and small company debt usually needs to be refinanced more frequently, which means borrowing costs go up due to higher rates.”

Investors appeared to recognize this based on stock market results in 2023 and 2024, comparing the S&P 500 to the Russell MidCap Index and the Russell 2000 small-cap stock index.³

Technology remains dominant

Earlier in the year, the market appeared to transition from one driven mainly by technology-oriented stocks to a market featuring broader participation by sectors that, in 2023, significantly lagged technology’s performance. Yet in May and June, market momentum reverted back to a familiar pattern, with information technology and communication services stocks far outpacing the rest of the market.⁴ “Stocks in June rallied on narrowing breadth,” says Haworth. “If the current rally is to extend, it’s likely to occur because other sectors of the market begin to perform well.”

“There’s still an advantage for companies that are insensitive to persistently higher interest rates,” says Haworth. “Large companies like Nvidia, Microsoft, Amazon and Google that hold a lot of cash and have low borrowing needs are not greatly affected by changes to the interest rate environment.”

Other sectors that lagged technology in 2023 have made gains in 2024, including financials, industrials, utilities, and energy stocks, all up more than 12% year-to-date. While those represent respectable returns, they still significantly trail the leading tech-related sectors.³

The impact of higher interest rates is reflected at the bottom end of the scale for S&P 500 sector performance. The interest-rate sensitive real estate sector, for example, is the only S&P 500 sector in negative territory year-to-date.

“The market has rallied since October 2023 without a sizable correction,” says Haworth. A market correction is considered an index value decline of 10% or more. “A key is whether companies continue to have a constructive view about revenue and earnings growth going forward. So far, the signs look favorable.” Haworth says that doesn’t rule out occasional market pullbacks, but a significant correction may not be on the immediate horizon, given the underlying strength of current fundamental factors.

Key stock market drivers for the remainder of the year

What are the keys to a sustained bull market? Three primary considerations deserve attention:

• Inflation trends and future Fed policy moves. Given that recent inflation data appears to be trending lower, as markets and the Fed hoped to see,¹ the Fed ais likely closer to beginning a rate cutting cycle. Freedman says, “The current fed funds target rate over 5% is not sustainable.”
• Consumer and business spending. “Consumers’ willingness to maintain reasonable spending growth has been an economic linchpin,” says Haworth. This is likely due in part to the strength of the labor market and more significant wage growth. While the latest estimate of first quarter 2024 economic growth showed an expansion rate slowdown, just 1.4% annualized during the period,⁵ consumer spending remains the main growth driver. Freedman is optimistic. “Earnings forecasts seem achievable given expectations for ongoing strength in consumer and business capital expenditure spending.”
• Corporate earnings and stock valuations. First quarter earnings reports mostly met or exceeded expectations, and Haworth says the outlook for the rest of 2024 is trending favorably. “At this point, the earnings story remains a positive one.” This may be critical for the direction of stocks, says Haworth, as stock valuations can be considered elevated at current levels. “Valuations levels today imply a positive attitude about the future,” says Haworth.

External risks can always be a concern. Current issues include the impact of global tensions highlighted by the Israel-Hamas conflict and the Russia-Ukraine war. The heated lead-up to what appears likely to be a contentious presidential election may ultimately draw more investor attention.

Equities still offer opportunity

“It remains a constructive stock market,” says Haworth. “Earnings are still moving in a positive direction, consumer spending has held up, and it still seems clear that a rate cut is the Fed’s next interest rate move.” In addition, Haworth points out that a higher inflation environment featuring continued economic growth tends to benefit equities.

The biggest potential concern in the current environment is valuation. “Valuations are on the rich side, particularly for the largest stocks that have generated the strongest performance,” says Haworth. “Yet many of these ‘rich’ stocks are backing it up by growing their earnings.” Haworth says investors may consider diversifying with an equal-weighted S&P 500 exchange-traded fund. Such a fund puts less emphasis on the largest stocks in the Index compared to a traditional S&P 500 fund, seeking to capitalize on opportunities in what have been underperforming stocks in the index.

Freedman encourages investors to view markets with a long-term lens. “Timing the markets and trying to be precise on when to be in and when to be out is challenging,” says Freedman. “Markets will do things at the exact opposite time you expect them to.” Freedman says investors can follow a more productive path. “Our best advice is having a plan, a programmatic approach to investing. That takes the emotion out of it.”

Haworth says for those who still have a sense of caution about the stock market, “consider putting a portion of your portfolio to work in equities in a systematic way, such as dollar-cost averaging available cash over a series of months.”

Check in with a wealth planning professional to make sure you’re comfortable with your current investments and that your portfolio is structured in a manner consistent with your time horizon, risk appetite and long-term financial goals.

The S&P 500 Index consists of 500 widely traded stocks that are considered to represent the performance of the U.S. stock market in general. Diversification and asset allocation do not guarantee returns or protect against losses. The Russell MidCap Index provides investors with a benchmark for mid-sized companies. The index, which is distinct from the large-cap S&P 500, is designed to measure the performance of mid-sized companies, reflecting the distinctive risk and return characteristics of this market segment. The Russell 2000 Index refers to a stock market index that measures the performance of the 2,000 smaller companies included in the Russell 3000 Index.