Six Charts Showing the Quarter That Split the Market

The second quarter of 2024 was marked by market activity that simmered beneath the surface. While the S&P 500 index rose by 3.9%, the Stoxx Europe 600 and Japan’s Topix saw smaller gains, mostly maintaining their first-half increases. However, these modest headline figures hide some significant trends.

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Artificial intelligence has been the driving force behind the market's momentum since late 2022, and this trend continued in the second quarter of 2024. Companies within the S&P 500 related to AI saw their market value surge by 14.7% in the last quarter, while the rest of the index declined by 1.2%. Nvidia, a major player in AI, briefly became the world’s most valuable company in June. These movements are not purely speculative; substantial investments in AI have bolstered earnings, keeping AI-related price-to-earnings ratios relatively stable.

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Earlier in the year, AI valuations moved in tandem with the broader market. However, starting in April, a shift occurred. Investors grew wary of the high P/E ratios in the S&P 500, causing a selloff that affected both AI and non-AI sectors. Since then, the AI segment has surged ahead, driven by heightened earnings forecasts, while valuations in other sectors have remained below their March peak.

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This divergence is also evident in sector performance. In the second quarter, technology led the way, followed by communication services, which includes telecoms and media companies. Utilities, now seen as benefiting from AI due to expected increases in electricity demand for data centers, also performed well. However, six out of 11 sectors, including healthcare, real estate, financials, energy, industrials, and materials, lost market value.

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The performance of "consumer staples" versus "consumer discretionary" companies further highlights this trend. Essential household products and food brands outperformed more cyclical firms like apparel retailers, restaurants, and carmakers. This shift suggests that investors are becoming more cautious, perhaps recognizing that previous economic optimism was overblown.

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The low volatility of the S&P 500 index indicates a market relatively free of major concerns, with daily price movements becoming less pronounced and nearing pre-pandemic levels. However, individual stocks have experienced much higher price swings, creating an unusual gap between index and single-stock volatility. This discrepancy may be due to investors betting against volatility, which has historically kept actual volatility misleadingly low. Structured products popular among American investors may also be amplifying this effect at the index level, as top-down market views increasingly dominate due to widespread use of tracker funds.

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Market participants have had to accept that central banks, particularly the Federal Reserve, are unlikely to embark on a significant rate-cutting spree as previously anticipated. In early April, expectations for borrowing costs to drop by 1 percentage point or more by March next year fell sharply, from over 60% to less than 20%, although they have since ticked up slightly.

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Despite these higher rate expectations, sector impacts have not followed traditional patterns—tech has not suffered, nor have banks particularly benefited. Yet, the effects are still noticeable. Investors have favored large-cap companies with strong balance sheets, punishing those with weaker financial positions. Among U.S. mid-sized firms, those with current liabilities exceeding liquid holdings lost 5% of their market value in the quarter, compared to a roughly 1% drop for financially stronger peers. Smaller companies have generally struggled, with financial strength rather than size correlating more closely with performance due to the impact of higher borrowing costs, as evidenced by the performance of high-yield bonds from companies rated triple-C or lower.

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The Stoxx Europe 600 has not matched the S&P 500's tech-driven rally but has held its ground, offering diversification through sectors like pharmaceuticals and luxury goods. Political risk has reemerged in France, where potential legislative victories by either a euroskeptic party or a leftist alliance could impact markets. The CAC 40 ended the quarter down 8.9%, providing overseas investors a reason to avoid broad European equity investments.

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Some pessimists predict a market correction once the AI rally loses momentum. However, a more optimistic view suggests that given the strength of the global economy, the current lower valuations for most stocks compared to three months ago could set the stage for broader gains once interest rates begin to decline.

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