Q2 Market Overview:
“Sentiment vs. Fundamentals”
July 31, 2023
During the first half of 2023, the equity markets performed remarkably well. The S&P 500 Index had a total return, including dividends, of 16.9%. Technology stocks, as represented by the NASDAQ 100 Index, posted a return more than double the S&P 500 generating a return of 39.1%. It has been an extraordinary and unusual six months for the popular equity indices.
A review of the key components of this extraordinary rise is revealing. Attribution analysis demonstrates that approximately 75% of the total returns through the first half of the year were driven by a very small number of technology stocks, essentially seven AI (Artificial Intelligence) related companies: Nvidia, Meta (Facebook), Microsoft, Apple, Amazon, Tesla, and Alphabet (Google). As shown below, the remaining four hundred ninety-three (493) companies within the S&P 500 Index were essentially flat for the first six months of the year. If you were not market weighted in these seven AI related technology holdings or the Exchange Traded Funds (ETF’s) of the indices, investment returns significantly lagged during the year’s first two quarters.
This degree of market concentration is nearly unprecedented as highlighted in the chart below. Markets this narrowly defined have not been witnessed in over 60 years.
Price moves such as these have a dramatic impact on market sentiment. Not surprisingly, many investors have been pouring capital into AI types of holdings, perpetuating their advances. There is a FOMO (“Fear of Missing Out”) perspective present as shown in the chart below.
How long this trend will last is unknowable, but history has not been kind to asset markets that are as concentrated as witnessed thus far in 2023. There is a large “reversion to the mean” component in economics indicating that future returns over the next six to twelve months may be disappointing.
From a fundamental perspective, the recent advance in stock prices has not been accompanied by a corresponding growth in corporate earnings. Virtually all the returns have been generated by the expansion in Price/Earnings (P/E) multiples as shown in the chart below. While the P/E ratios of the largest fifty (50) stocks in the S&P 500 have increased by over 30%, their earnings are trending lower.
Ignored for now, it is important to note S&P 500 earnings estimates for 2023 and 2024 have been lowered 4.7% and 2.5% respectively since the beginning of the year. The S&P 500 P/E ratio is 20.2 for 2023 and 18.1 for 2024, well above the long-term average of 15.5-16 times. Regardless, market sentiment will most likely remain high until interest wanes after the initial AI frenzy.
While the equity markets are reflecting an ebullient period ahead, global bond markets are signaling a continued slowdown in economic growth. Below is a chart of the U.S. Treasury yield curve highlighting its current inverted maturity structure. Investors can capture essentially risk-free yields of nearly 5.5% in short-term U.S. T-Bills. Note that an inverted yield curve results from shorter term maturities having higher yields than longer dated ones.
Inverted yield curves have historically served as important economic indicators. Since 1955, an inversion proceeded every recession by six to twelve months. Over the past seventy years, an inverted yield curve offered only one false signal. As noted below, as the second quarter ended, the level of inversion between the 2 Year U.S. Treasury and the 10 Year was nearly 110 basis points, or 1.10%. The yield curve has now been inverted for over a year.
Broad economic indicators are also indicating slowing growth. The LEI Index (Leading Economic Indicators) tumbled for the 15th straight month in June. In general, these types of declines are indicative of an economy in, or near, a recessionary period.
Conversely, economists surveyed by the Blue Chip Financial Forecasts have an average 2023 GDP growth forecast of slightly more than +1%. The Atlanta Fed GDPNow estimate has moved up slightly to +2.4% as of July 19th.
Regardless of the degree of economic slowing, the primary issue for the financial markets has been and will continue to be the level and trajectory of inflation, and subsequent Federal Reserve interest rate policies. Whether the upcoming Fed meeting will provide the last or the penultimate interest rate hike is merely one factor. Importantly, we view the market consensus that the Fed will shortly reverse course and begin to cut interest rates as misguided. Given a wide assortment of price data, we think it likely the Fed and other global central banks will continue their “higher for longer” mantra.
Expectations for lowered inflation rates were bolstered by the recent June CPI report showing a modest 3.0% price rise. This marked the twelfth month in a row the CPI has declined. The following chart outlines that the June report was heavily influenced by the basic math calculations used to derive monthly CPI statistics. For the recent June report, recall in June of 2022 the CPI was 9.1%, the highest level in over forty years. Note that monthly CPI reports are based upon the Bureau of Labor Statistics’ Year-over-Year (YOY) methodology. The June 2023 CPI is calculated by comparing the price changes within a “basket” of goods and services with that same “basket” measured twelve months ago. There is a dominating “base effect” in generating YoY numbers with this June’s basket since it is computed relative to one exhibiting the highest price increase in recent history. This base effect will diminish over the next couple of months as highlighted by the following chart. Note that unless the month-over-month CPI remains below 0.2%, the overall CPI index will steadily rise. The only question is to what degree.
Sterling’s “higher for longer” viewpoint is based on several inflation measures that remain significantly above the Fed’s 2% inflation target. For instance, the Core CPI inflation rate (ex: food and energy) remains near 5%.
The service sector, the largest segment of the U.S. economy, has continued to generate inflation rates near 4%. Recently energy, commodity, and agricultural prices have reversed higher as well.
Importantly, the labor market has been more resilient than the Fed anticipated. Recent labor negotiations, such as those involving airline pilots and truck drivers, have seen workers gain substantial increases in salaries and benefits. This trend in wage growth is highlighted below by the Atlanta Fed Wage Growth Tracker.
For most investors, market sentiment dictates investment decisions over short term time horizons. Over the long term, business fundamentals determine total returns. For investment portfolios, the opportunity set for the remainder of this year will be extensive yet require patience. It is highly likely the Fed and their central bank counterparts will remain vigilant in their quest to tame inflation expectations. “Higher for longer” interest rate policies will continue to hamper domestic and global economic growth. This investment mosaic will present challenges to a wide assortment of asset classes.
We view the risk profile of the financial market environment as highly asymmetrical. The potential for higher upside in equity prices appears dwarfed by the degree of downside risk given equity prices are near all-time highs and market valuations are well above historic norms during a period of persistent inflation, elevated interest rates, and declining earnings. In terms of equity portfolio management, we remain defensively positioned and anticipate an increase in price volatility in the near future. In the interim, we have built positions in businesses that possess very attractive risk-adjusted return expectations over a reasonable time frame. Similar to our existing equity positions, we have built an extensive list of companies with excellent business characteristics and pricing power we will add to our equity book as their price levels become more favorable.
Our fixed income positions, the largest allocation in most portfolios, continue to be comprised of high quality, short duration securities. Interest rates have steadily risen over the past several quarters, particularly on the short end of the yield curve, and we continue to trade up in yield by purchasing short maturity U.S. T-Bills, now yielding nearly 5.5%. It is highly likely yield levels are near their peak for this cycle. This presents an opportunity to slowly extend the duration of our fixed income book to capture higher current yields in an assortment of high quality notes of various issuers.
All the best,
John H. Payne, CFA
Managing Partner
Chief Investment Officer
Arumayta M. Arguello, CFA
Partner
Portfolio Manager
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