Downsides Become Upsides

By Bruce Thompson on June 23, 2023

Client Letter July 2023

SUMMARY

• The market data presented is as of June 19, 2023, unless otherwise noted.

• Market performance this year may reflect a gradual realization that the economy is doing better than feared. Inflation has declined to 4% from an annual rate of 10% since last June.

• The cyclical nature of our economy and markets means that downsides eventually become upsides. The process of bringing interest rates back to more normal levels has been painful, but there are reasons to think that the investment risk-reward proposition is more favorable for clients.

• Stocks (MSCI ACWI Index) are up 14.2% this year and bonds (BB US Aggregate Bond Index) are up 2.2% (see Market Recap). Stocks have rebounded 25% since the bear market bottom last September 30^th, but they are still down about 7% from the previous market top. 

• Technically, stocks are in a new bull market but have rallied on the performance of a handful of stocks. A confirmed, sustainable bull market would require participation of more stocks and sectors. This may rely on clarification of the interest rate picture but also may spell opportunity for broader gains if and when that happens. 

• We look at which equity segments have been out and underperforming this year and why. 

Downsides Become Upsides

A year ago, when inflation was skyrocketing, the Fed was raising interest rates sharply, and stocks and bonds were mired in a bear market, many thought the best case to be hoped for was a “soft landing,” a mild recession. Many analysts predicted a deeper recession, as discussed in our April letter, March Madness: What Can We Learn?

In that context, the performance of the markets so far this year reflects a gradual realization that the economy is besting expectations. That doesn’t mean we’re entirely out of the woods, but no matter how one parses the recent mixed data, as summarized in this Boston Globe article, the resilience of the economy through this period of adjustment has been pretty amazing. 

The Fed probably erred in waiting so long to raise rates in 2021, allowing inflation to take hold. But so far it seems to have been correct that the economy was strong enough to withstand the process of bringing interest rates back to more normal levels, after keeping them extremely low for a decade to ensure full recovery from the 2008-09 mortgage crisis.

To be sure, that process hasn’t been without pain as evidenced by the correction in stock and bond priceslast year and recent stresses in the banking system. While the future is still and always rife with known and unknown unknowns, the cyclical nature of our economy and markets means that downsides eventually become upsides.

• Inflation, which was running at an annualized rate of nearly 10% at this time last year, declined to 4%for the twelve months ending in May. Next month’s reading should show more improvement simply because it will no longer include the big spike in CPI last June (see chart below). Over the last three months, inflation rose at an annual rate of just 2.4%. It’s too soon to declare victory on inflation, but the progress has been better than feared.

• Accordingly, the Fed skipped on hiking rates in June, but also upgraded its forecast for the economy, while making it clear that it may hike rates a few more times and is on guard if inflation begins to rise again. The view on the economy engenders confidence, as does the continued vigilance on inflation. That shouldn’t, however, be interpreted as an “all clear” signal; the Fed may never give an explicit signal because it may be concerned about sparking a new round of speculation in markets. 

• While market volatility might have you feeling that market risks are higher, they actually may be lower. At the prior low interest rate levels, the Fed had little room to respond to adverse economic developments. After the increase in short-term rates from near zero to about 5%, the Fed now has ample room to lower rates to spark the economy if a recession should occur, a margin of safety that wasn’t there eighteen months ago. 

• The ability to now earn a real return on lower-risk investments reflects a healthier and more balanced asset allocation environment. For much of the last decade, with rates so low, there was no alternative to stocks (see our January 2023 article, Goodbye TINA). While we continue to believe that stocks may provide the best way to grow assets and stay ahead of inflation over the long run, the real returns available in fixed income and alternative investments may provide effective diversification and lower overall portfolio risk. 

• Lower stock prices may also imply the possibility of higher future returns — at least compared to pre-2022 levels. As discussed in our Market Recap, the headline cap-weighted stock indexes have clawed back toward even on the performance of a handful of mega-cap tech stocks, while the broader market hasn’t fully participated. Currently, the S&P 500 forward price-earnings ratio is 18.9 compared to about 22 pre-bear market, which is more reasonable but still not cheap from a long-run perspective. If you exclude the 8 largest (tech) companies, the rest of the S&P 500 has a current p/e ratio of just 15.6.

Beyond the S&P 500, the S&P Small and Mid-cap stock indexes each have forward p/e ratios of 13.5, around the lowest levels for the last ten years. That’s compelling considering that small and mid-caps historically have had higher multiples than the S&P 500. 

The MCSI World Ex-US Index has a p/e of 12.9, also close to the lowest in the last decade, offering good risk/reward. We discussed the attractive valuations of international stocks in our January letter, Diversification: Your Long Lost Friend.

Market Recap: Tale of Two Stock Markets in 2023

How are the markets doing this year? 

Through June 19^th, the core equity MSCI All Country World Index (ACWI) has returned 14.2%. The core fixed income Bloomberg US Aggregate Bond Index is up 2.22%.

When reviewing your Q2 Portfolio Report, you’ll notice that domestic equity returns have varied widely by size (large vs small cap) and style (growth vs value). The large-cap S&P 500 Index is up 15.78%, while the more value-oriented Dow Jones Industrial Average is up just 4.6%, and the growth-oriented Nasdaq Index is up 31.35%. Small and Mid-Cap stocks are up about 7%. 

International stocks as measured by the MSCI Al World Ex-US Index are up 11.8%. The large cap developed country MSCI EAFE Index is up 14.1%, while the MCSI Emerging Markets Index is up 9%. 

Have investments fully recovered from last year’s bear market?

Not yet. Since the Bear Market Bottom on 9/30/22, the ACWI index has rebounded 25.35% after declining 25.63% during the nine month 2022 Bear Market. Since the Bear Market Began, the index is down 6.77%.

Historically, it has taken an average of two to three years for stocks to recover fully from a bear market. From that perspective, there has been much progress in just nine months.

US Large Cap Value stocks, which declined less during the bear market, have about fully recovered, while the Large Cap Growth, and Small and Mid-Cap equity classes are still down more than 10% from previous highs. 

In fixed income, the US Aggregate Bond Index has returned 4% since last September but is still down about 11% since the end of 2021. Short-term bonds, which declined much less during the bond bear market, are down about 2.5% since the end of 2021.

Are we in a new equity Bull Market?

Maybe. The commonly accepted definition of a bull market is when stock prices rise by 20%. Headline stock indexes have risen about 25% since the bottom last September, so technically stocks have entered a new bull market. 

However, any practical definition of new a bull market requires a broader rally. As Jurrien Timmer, Head of Global Research at Fidelity points out, the market this year has a case of “bad breadth,” meaning most stocks and sectors haven’t fully participated. In the S&P 500, 60% of the stocks are trading below their 50-day averages. As noted, small, mid-cap and international stocks are still well below peak valuations. 

The broader market has to catch up for the nascent bull market to be confirmed. This is reason to reserve optimism but also may spell opportunity if and when the rally broadens, which may rely on a clearer interest rate picture.

What’s behind the differences in equity performance this year? 

Given the uncertain outlook, it makes sense for large-cap stocks to be outperforming as investors look to the financial resilience and relative trading liquidity of larger companies. Plus, smaller company profits are more sensitive to interest rates and investors may wait for more clarity on rates from the Fed.

Large Cap Growth stocks, in particular, are rebounding from much larger drawdowns compared to Value stocks which held up much better during the bear market. Value Stock indexes (the DJIA is a reasonable proxy) include bigger allocations to energy and industrial commodity sectors which were boosted by last year’s spike in inflation, but that impetus is waning with inflation. The S&P Energy sector returned 35% during the bear market but is down 6.64% this year. Given this year’s banking concerns, the worst-performing S&P sector is financial services and that makes up nearly 20% of the Value Index and the DJIA, but only 6% of the Growth Index. 

The invariable performance differences among equity classes provide opportunity for diversification over time and each have a place in a well-constructed portfolio.

As noted, the S&P 500 Index is a capitalization-weighted index meaning that performance is skewed by the largest companies. The ten largest companies in the S&P 500 account for 28% of the index; seven of those are technology companies (Apple, Microsoft, Amazon, Alphabet A&B (Google), Invidia, and Meta). With the addition of Tesla, these same companies account for about 47% of the Large Cap Growth Index. 

Those stocks have moved higher, partly fueled by excitement over AI. Nouriel Roubini, known as “Dr Doom” for his past dark prognostications on the economy, believes AI will unleash significant gains in productivity, and he cites a new McKinsey study which estimates that AI could contribute over $2 trillion in annual economic benefits within ten years. Professor Robert Shiller of Yale posits the belief that many investors may be buying into technology stocks as a way of subconsciously hedging employment fears due to AI, robotics, self-driving cars, etc. Of course, it is important to recognize that there are significant regulatory and other risks facing AI commercialization. 

To be sure, technological innovation is a defining trend of bull markets but, nevertheless, a healthy and sustainable market advance requires more boats rising with the tide.

On that nautical note, in closing, we hope you have some wonderful plans this summer! If you have any questions about your investments or are simply in need of a lighthouse, please don’t hesitate to send up a flare to your advisory team! We thank you for your confidence and our valued relationship.