The S&P 500 Index recorded five consecutive weeks of gains during the second quarter, the longest rally since the fall of 2021. The index is up almost 17% YTD, 24% since the October low and is only 9% from its record high in January 2022.
This is a remarkable run. It occurred in the face of decade-high interest rates, an inverted yield curve, rising bankruptcies and a tightening of corporate lending standards. All of these economic indicators normally signal a potential recession, or, at the very least, increased financial stress on the balance sheets of households and businesses. Falling inflation and a strong labor market, however, have driven both hope that the US avoids a recession and higher asset prices in equity markets.
Exuberance regarding AI technology also had a significant impact – we cannot currently state with confidence who the benefactors of this technology will be or when it will contribute to higher productivity and greater economic growth.
The current stock market rally is concentrated. Although the YTD S&P 500 return was 17% at quarter-end, the gains were driven by fewer than 9% of stocks within the index (this number was ~1% as of mid-May). The average US stock (shown in the chart below by the green line), is only up 7% for the year. This is in stark contrast to the stocks news pundits have named The Magnificent Seven – Apple, Microsoft, Amazon, Nvidia, Alphabet, Tesla, & Meta – which make up over 27% of the S&P 500 market capitalization and are up almost 90% (blue line) on average in 2023.
By extending the holding period for these stocks to 18 months, it becomes clear that their magnificence comes with a cost – in 2022 the average performance for these companies was -46.2%. Coincidentally, the market peak in 2022 and the market low in 2023 both occurred during the first week of January. The equity market pendulum can swing dramatically in both directions, especially for growth stocks.
Both the drawdown in 2022 and the subsequent rally in 2023 were heavily driven by valuation contraction/expansion. These seven stocks are currently trading at an average +30x forward earnings. At the extreme end of the spectrum are Amazon, Tesla and Nvidia with forward P/E ratios of 74x, 60x and 46x, respectively, compared to the S&P 500 Index at 19x. Momentum may drive prices of these stocks higher, but there is little (if any) margin of safety. Valuations become more important in a high interest rate environment and remain the best forward indicator of expected returns.
Growth stocks had the strongest performance in the first half of the year. The table below shows performance and valuation information for domestic equity markets by style and size, and the disparity is wide.
Returns as of June 30th are shown on the left and valuations as a percent of their 20-year historical averages are indicated on the right. US Large Cap Growth has outperformed US Small Cap Value by over 26% YTD. It’s evident that all asset classes have not participated equally in the current upswing and there are opportunities in asset classes “left behind”.
Within the US equity market, small and mid-cap value stocks are trading at lower valuations than their historical averages. Small cap value stocks in particular, are inexpensive. These companies remain depressed from underlying concerns about profitability, issues within the regional banking sector and the impact of a recession. We also continue to see opportunities within international equity markets.
When we compare the forward expectations for US stocks to the outlook for consumers and businesses, there seems to be a disconnect. Our domestic equity allocations are positioned away from broad market indices in favor of Berkshire Hathaway and ETFs that screen each company based on current prices, profitability and book equity before investing.
Economic data is important, but only useful in explaining where we are and have been, not necessarily where we are headed. Capital markets adopt a forward-looking perspective, extrapolating known information and factoring in the probability of future outcomes in an inherently unpredictable world.
Consider the most recent ISM reported index levels. The ISM (Institute for Supply Management) indices are a set of economic indicators used to gauge the health and direction of the manufacturing and services sectors of our economy.
A reading below 50 indicates a sector is contracting, while a reading above 50 indicates growth. Manufacturing has been contracting for roughly eight months. On the other hand, services represents 68% of our economy and has been growing for three years. It’s not uncommon for some parts of our economy to be contracting while other parts are expanding. Consumer spending has clearly transitioned from goods to services since the dark days of COVID, which has increased pressure on an already tight labor market.
Consumer spending, driven by stimulus, higher wages, strong job growth, and a high savings rate, has offset sluggish business investment. In the aggregate, our economy is still growing, albeit at a slower pace and not without challenges ahead.
Inflation, although falling, could remain stubbornly above the Fed’s 2% target. This may lead to higher interest rates (which is what the Fed is currently communicating despite the June skip/pause) that remain elevated for longer, which could strain the economy.
Alternatively, the “soft landing” narrative, meaning the US economy avoids a recession following the tightening of monetary policy, has recently become more prevalent. The Fed’s goal has always been to bring inflation down without causing major damage to the economy. Considering the Fed’s monetary policy has triggered a recession in eight of the last nine rate-hike cycles, it would be a remarkable feat given the recent challenges our economy has faced, starting with COVID. This scenario remains a possibility, but we are doubtful.
It appears investors are finally listening to Jerome Powell and the Fed regarding their commitment to increase interest rates and reduce inflation. Throughout the course of this rate cycle, there has been a notable divergence between projections issued by the Fed and the expectations of investors.
Last quarter (Q1-2023 letter linked here) we included a chart in our market commentary that showed projections for short-term interest rates compared to implied yields from the interest rate futures market. Just three months ago the market expected rates to peak during Q2 with 0.50% in rate cuts by year-end 2023.
As of June 30th, there has been a convergence of market expectations and the projections for interest rates. Interestingly, although the market expectations (green line) for interest rates is lower than the Fed projections (blue line) through the end of next year, the market expectation for interest rates is higher in 2025.
Interest rates will likely be volatile and remain high, but there is no doubt we are closer to the end of this rate hiking cycle than the beginning. The cumulative effect on the economy caused by higher interest rates will grow as the impact cascades through the economy. We expect financial stress will become more pronounced in the upcoming quarters as real interest rates (interest rates minus inflation) continue to rise. Even so, if the terminal interest rate ends up closer to 6% instead of the current level, the broader economy is resilient and will adapt to a higher cost of capital.
The Fed will remain data-driven and their forecasts will likely change at subsequent meetings. If you look back at the Fed’s record of projecting what “sufficiently restrictive” means when it comes to interest rates, they have not been accurate, and neither has the futures market for that matter (see our 2Q-2022 letter for the Fed and market expectations just 1-year ago). With every Fed meeting since the first hike, interest rate projections have moved higher.
Then again, a year ago inflation was 9.1%. A lot of progress has been made. The predicament markets and the Fed are trying to grapple with is two-fold. One, is inflation coming down due to monetary policy or other factors? Two, can the Fed toe the line enough to reduce inflationary forces without destabilizing the labor market and broader economy? We expect inflation will continue on its downward trend, but we don’t know (and neither does the Fed) how long it will take to achieve the 2% inflation target OR what the full impact of this rate cycle will have on the US economy.
Even if there are further rate increases, fixed income has become more appealing for goals-based investors. After a challenging year in 2022, higher interest rates mean bonds are a more reliable source of portfolio stability, income and diversification. The more bond coupons and yields trend higher, the more effective they are at buoying portfolios when capital markets become volatile and risk averse.
Yields on government money market funds and Treasury Bills are attractive for clients with short-term liquidity needs. We have been diligent about investing excess cash in client portfolios. The following graph shows the opportunity cost of cash and cash equivalents.
Times change, and so will tomorrow’s headlines. We recognize the shift in economic narratives between Q1 and Q2 2023 is striking. In Q1, three large regional bank failures were being compared to the Great Financial Crisis in 2008-09 with news headlines warning of contagion, plummeting interest rates and collapsing equity markets. Instead, the opposite occurred, with resilient economic growth, rising interest rates and higher equity valuations.
As we have said repeatedly, it’s important to have a financial plan and disciplined investment strategy. We expect unexpected events to occur, for better or worse, and capital markets will generally overreact to them. The volatility throughout the last three years has certainly provided ample evidence to that point.
The economy and capital markets often diverge unexpectedly, driven by seemingly inexplicable or irrational factors. Today that dispersion of expectations has never been wider. The sentiment regarding inflation, recession, corporate profits, geopolitical events, and most notably, the Federal Reserve’s eventual shift from a tight to accommodative policy have impacted markets in unpredictable ways.
We make it a point to avoid making economic projections. Although we see some risks ahead, we remain optimistic, especially for long-term investors. We stick to the notion that the economy as a whole is cyclical, yet basic investing principles will endure. Simply said, the economy expands more than it contracts and markets go up a lot more than they go down.
As Warren Buffett stated in the 2021 shareholder letter, “Despite some severe interruptions, our country’s economic progress has been breathtaking. Our unwavering conclusion: Never bet against America.” We do not believe this time is different, and we are staying the course with each client’s investment portfolio, consistent with their risk tolerance and financial goals.
We are grateful for your trust and confidence. Please let us know if you have questions, would like to discuss your financial plan or review your investment portfolio.
The JRM Investment Counsel Team
Jack, Phil and Lauren