Second Quarter 2023 Market Recap
Global equities continued to rally in the second quarter of the year, led again by surging U.S. mega-cap tech/growth stocks, particularly anything artificial intelligence (AI) related.
The S&P 500 index gained 6.6% in June and 8.7% in the second quarter, driving its year-to-date return to 16.9%. Developed international stocks rallied 4.6% in June, gaining 3% for the quarter and 11.7% YTD. Emerging markets stocks rose 3.8% in June, resulting in a 0.9% gain for the second quarter and a 4.9% return YTD.
Tech stocks continued their incredible comeback after a terrible 2022. The Nasdaq 100 Composite gained 38.8% for the first half of the year, the most in its 40-year history. The Russell 1000 Growth Index is up 29% on the year, versus 5.1% for the Russell 1000 Value Index.
The market-cap-weighted S&P 500 Index’s rally this year has been the “narrowest” on record, with less than 28% of the index’s constituents beating the overall index return (through June 14). As shown in the Ned Davis Research chart below, in an average year, around 49% of the index’s 500 companies beat the overall index. (The only other year comparable to this year was 1998, as the Tech/Internet stock bubble was inflating. That didn’t end well, but it took another 15 months before it started to burst.)
The “Narrowest” Stock Market in At Least 50 Years
More granularly, with the sudden frenzy in all things AI, the average YTD return for Amazon, Google, Meta, Microsoft, NVIDIA, and Tesla is 96%, contributing almost the entire S&P 500 return for the year. The combined market cap of the seven largest companies in the S&P 500 (all the above plus Apple, the so-called “Magnificent Seven”) now comprises over 27% of the total index, the largest share in history for the top seven.
However, in a possible indication the market rally is broadening, the small-cap Russell 2000 Index shot up 8.1% in June, while the large-cap Russell 1000 Value and 1000 Growth indexes had similar ~7% returns in June. It remains to be seen whether this extremely narrow market rally resolves via the rest of the market catching up or the so-called Magnificent Seven “catching down,” but improved market breadth would be a positive indicator for the market’s continued bull run.
Moving to the fixed-income markets, core bond returns (Bloomberg U.S. Aggregate Bond Index) were slightly negative for the quarter as interest rates slightly rose/prices fell. The benchmark 10-year Treasury yield ended the second quarter at 3.8%, up from 3.5% at the end of March. Riskier high-yield bonds gained 1.6% for the quarter and are up 5.4% YTD. Municipal bonds were generally flat on the quarter and up 1.2% YTD.
Portfolio Performance and Key Performance Drivers
In the second quarter, most of our model portfolios outperformed their strategic benchmarks, with some variation depending on the specific portfolio type. Absolute returns for the period were positive across the board, with higher returns from our more growth-oriented models, as would be expected in a strong period for equity returns. For the year-to-date, most of our portfolios are also ahead of their benchmarks, with absolute returns ranging from the mid-single digits to the mid-teens, depending on the portfolio type.
We are pleased to see our active equity managers, in aggregate, outperforming the equity market indexes this year, particularly given how narrow the market has been. That has been offset a bit by a few areas in the international stock markets, which have trailed the U.S. market so far this year.
In terms of our fixed-income allocation, our positions in flexible, actively managed bond funds continue to add performance relative to core bonds from which the positions are funded. With higher starting yields across the fixed-income universe, our bond managers have been finding lots of attractive investments with relatively low downside risk.
Macro Outlook for the Next 6-12 Months: Recession Remains our Base Case with Still a Chance of a Soft Landing
The current macroeconomic data are sending some mixed signals. On the one hand, the U.S. economy has been more resilient expected through the first half of the year. GDP has grown, albeit at a sub-par rate; the labor market has remained very strong, supporting consumer spending; and headline inflation has dropped meaningfully, thanks largely to a sharp decline in energy prices and consumer goods disinflation as supply and demand normalize after the pandemic disruptions.
On the other hand, key leading indicators of an impending recession are still flashing red (e.g., Conference Board LEI, deeply inverted yield curve, tightening credit conditions). And although the Federal Reserve paused its aggressive interest rate hiking campaign in June, core inflation (excluding food and energy) remains stubbornly high, with the Fed signaling it will resume rate hikes later this year, further raising the likelihood of a recession.
As we read the muddy economic tea leaves through our cloudy crystal ball, we maintain our view that a recession is the most likely outcome over the next few quarters. Historically, the odds are unfavorable for the economy avoiding a recession after the Fed has been aggressively tightening. And we have yet to see the full (lagged) impact of this cycle’s monetary tightening on the real economy.
However, a near-term recession is not a certainty. (1) There are not a lot of historical data points: this is just the 14th Fed tightening cycle since WWII. (2) Each cycle is somewhat different, and this one is considerably so due to the pandemic dislocations. And (3) there have been three instances (out of 13) where the Fed tightening cycle ended without a recession.
So, a more benign near-term outcome is certainly possible, and the current growth and inflation trajectory is not inconsistent with that.
But even if it is pushed out beyond the next 12 months, a “normal” business cycle recession is inevitable. We don’t expect a severe 2008 or 2020 type of recession. Household and corporate balance sheets are in good shape, and by raising rates to 5%, the Fed now has room to cut them again in the next recession, softening the downturn.
But the business cycle has not been repealed. And as an investor, that’s okay. In fact, it is healthy to periodically clear out speculative excesses and reset expectations and market valuations. As with past cycles, we are confident the economy and financial markets will survive the next recession and go on to higher highs in subsequent cycles, albeit with bumps and dips along the way.
Financial Markets Outlook and Portfolio Positioning
There are always multiple factors driving the markets, but we think key drivers of this year’s market strength include the following: (1) the economy has held up better than expected, reducing investor fears of an earnings recession; (2) corporate earnings, in aggregate, have come in better than expected; (3) market sentiment (a contrarian indicator) entered the year very pessimistic, creating opportunity for money to flow back into stocks as pessimism turned to optimism; (4) with inflation dropping, markets are optimistic the Fed will end its tightening; (5) the regional bank crisis in March subsided with no obvious systemic damage; (6) the debt-ceiling circus left town (until 2025); and, (7) AI euphoria has super-charged a handful of mega-cap growth stocks, driving the overall market index sharply higher (i.e., it’s been a very narrow market advance).
As to the last factor, we’d make the point that while it is likely AI will have a huge impact on society and the global economy, that doesn’t necessarily mean the current AI stock frenzy is justified by these companies’ underlying earnings fundamentals. It may be in some cases. But we can also remember the tech/internet stock bubble in 1998-2000. The internet obviously has had a huge economic impact over the past 25 years, but very few tech stocks were priced appropriately in early 2000.
As an example, a poster child for the current AI exuberance is Nvidia, a graphics chip maker used in AI applications. The stock is up over 200% this year (as of 6/30/23), pushing its market cap over $1 trillion and into the top 10 largest constituents of the S&P 500. Nvidia has strong fundamental earnings growth potential, but its stock is currently trading at a P/E ratio of more than 220x! (The overall S&P 500 index has a P/E of around 20x, currently.)
This reminds us of Cisco stock’s valuation during the tech bubble. You don’t hear much about Cisco today, although it is a $200 billion company. But back then, it was a large-cap tech/telecom superstar. It was the third-largest company in the S&P 500 (after Microsoft and GE) and sported a P/E above 200x in early 2000. Cisco’s stock price peaked at $56 (adjusted for subsequent stock splits) in March 2000. Today it is around $52, with a P/E of around 18x. That’s a 23-year return of less than 0% – although we doubt anyone who bought Cisco at $56 held on during its gut-wrenching 90% decline to October 2002.
The lesson: Buyer beware of mega-cap stocks with triple-digit P/Es!
Corporate earnings and valuations ultimately drive equity returns
Although the markets can be driven by investor sentiment and momentum in the shorter-term, ultimately, it is corporate earnings – “fundamentals” – and the price one pays for those earnings that drive stock prices and investor returns over the medium to longer term.
Our assessment, as well as that of many investment strategists we respect, continues to be that consensus/analyst earnings expectations for the remainder of 2023 may be too optimistic given the likelihood of an economic recession. Put differently: We do not believe the S&P 500 at current levels is adequately pricing in the likelihood and magnitude of a near-term earnings recession.
An economic recession implies a corporate earnings recession as profit margins compress and sales growth slows. In fact, it is the compression in profits that typically lead companies to lay off workers, which further exacerbates the recessionary impulse from shrinking demand for goods and services.
International and EM stocks
In a recession scenario, we’d also expect developed international and EM equity markets to fall – probably around the same percentage as the U.S. market. Although foreign markets are much less expensive than the U.S. market – reflecting low earnings expectations and depressed sentiment – that probably won’t do much to prevent short-term fear from pushing all global equity markets lower. In addition, the dollar would likely strengthen as it is a “flight-to-safety” currency, which would have an added negative impact on foreign equity returns for dollar-based investors.
However, while we maintain a slight underweight to global equities overall, we continue to wait for a favorable entry point to increase international stocks based on their attractive valuations.
When the U.S. stock market declines to levels that offer more compelling medium-term returns and adequately discount shorter-term risks, we will look to add back exposure by selling more-defensive assets (e.g., bonds). This almost always happens during a recession when investor pessimism and fear are widespread. Stocks bottom out as value investors start to scoop up bargains and then continue to rebound as other investors anticipate an economic and earnings recovery, kicking in a positive self-reinforcing cycle.
Unlike U.S. equities, our view of the U.S. fixed-income markets – looking more broadly than just core bonds – is positive. With rising yields over the past year, most bond market sectors now offer attractive expected returns relative to their risk.
For example, the yield on the core U.S. Aggregate Bond Index is currently around 4.7%. With inflation very likely to drop below 4%, core bonds are finally providing a positive real (after-inflation) yield. With a duration of around 6 years, the core bond index will also generate strong price gains if interest rates fall during a recession.
In addition to our core bond exposure, we continue to have a meaningful allocation to higher yielding, actively managed, flexible bond funds run by experienced teams with broad investment opportunity sets. There are many fixed-income sectors outside of traditional core bonds that offer attractive risk-return potential, and we want to access them via our active managers. These funds are currently yielding in the high single-digits. While the higher yield indicates they carry more credit risk than core bonds, all our active bond managers are very attuned to risk management, especially heading into a late cycle/recessionary period. And they have the flexibility to tactically vary their portfolio exposures in response to market risks and return opportunities.
The Equity Risk Premium continues to drop
Higher core bond yields along with higher stock market valuations have made U.S. stocks relatively less attractive compared to core bonds. This relationship is known as the “equity risk premium” (ERP). There are many ways to calculate the ERP, but they are all a variation on taking the stock market’s “earnings yield” (which is simply the inverse of the P/E ratio) and comparing it to a “risk-free” bond yield (e.g., Treasury bonds or 3-month T-bills). They all point in the same direction: a below-average ERP versus the past 20-plus years. To revert to a more normal, i.e., higher, equity risk premium will require either a decline in equity valuations, lower bond yields, or some combination of the two.
Finally, where appropriate, we recommend core positions (5% in a typical balanced portfolio) in private credit and other alternative strategies. Private credit strategies were positive overall in 2022, while traditional bond and stock investments fell double digits. This year has seen sharp reversals in traditional stocks and bonds; however, private credit strategies are expected to deliver high single digit returns with lower volatility.
While a recessionary bear market is still our near-term (12-month) base case, it may be a relatively moderate one given the strength of the labor market, ample household savings and solid business balance sheets. The Fed’s response will also be critical in terms of the timing and magnitude of when it starts cutting rates.
It is also quite possible the U.S. economy avoids recession this year, with inflation coming down towards the Fed’s 2% target accompanied by only a mild increase in unemployment – i.e., with the brunt of the Fed tightening impacting job openings rather than actual employment.
Even in our recessionary base case, the stock market could rally further in the very short-term on (misplaced) optimism that the worst is over, and recession has been avoided. But at some point, earnings will start getting revised lower, and a recession will be priced into the market. The timing and magnitude are never certain, but the weight of the evidence supports sooner than later and the S&P 500 index at least revisiting its October 2022 low of 3600. That would be roughly a 20% decline from current levels.
However, as we extend our time horizon to the medium term (five to 10 years), we see reason for optimism, or at least comfort. While the U.S. stock market in aggregate is vulnerable to earnings disappointment, there are companies and sectors within the U.S. market that are reasonably priced, e.g., areas not swept up in the current AI frenzy. The fixed-income landscape is also attractive, thanks to higher yields and inefficiencies that can be exploited by skilled active managers.
We also see strong total return potential from international and emerging market stocks, which have been out of favor and underperforming for more than a decade. These markets are not “priced for perfection” as the U.S. market seems to be. Instead, they are susceptible to “upside risk” – better-than-expected earnings growth and valuation expansion. While foreign markets will get hurt in a near-term recession, we don’t want to try to time getting out and getting back in, given their attractive five-year return outlook.
We’re investors, not short-term market traders. Strong short-term market trends can trigger investors’ emotions and make them want to act – either chasing (buying into) a rising market or fleeing from (selling) a falling one. That is not the path to successful long-term investment outcomes. In addition, we have exposure to disciplined trend-following strategies that complement our longer-term valuation-based tactical approach.
Successful investing requires a balance between offense and defense. Earning superior long-term returns does require one to take calculated risks when opportunities present themselves, but also to exercise caution during periods of market exuberance. By maintaining a disciplined and balanced investment approach, we are well-positioned to weather the inevitable market storms and capitalize on the opportunities that are also sure to arise.
Thank you for your continued trust and confidence.
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