By: John Osterweis, Gregory Hermanski, Nael Fakhry
The S&P 500 has generated double digit returns so far in 2023, but the gains have been narrowly focused. Heading into the second half, we will be watching to see whether the rally broadens or the market capitulates.
Beware the Narrow Market
With the S&P 500 up nearly 17% year-to-date through June 30, 2023, one might assume that we are in the midst of a broad rally underpinned by a healthy and growing economy. However, stock market gains have been unusually narrow so far this year. In fact, through the end of May 2023, just seven companies – each of which benefited from recent excitement around artificial intelligence (AI) – had driven all the gains in the market. Excluding those companies, as of 5/31, the S&P 500 was down year-to-date, and there are many crosscurrents in the economy that are creating significant uncertainty:
- Inflation is clearly easing, but it remains double the Fed’s target
- Unemployment is near multi-decade lows, which means jobs are plentiful, but tight employment may contribute to elevated inflation and thus higher interest rates
- The overall economy continues to grow, but we see indications of severe stress in key sectors
The question going forward is whether we are in the midst of a “soft landing”— in which case the recent market gains will almost certainly broaden out — or if we are facing a “hard landing” whereby the narrow market capitulates. Regardless, we believe that the best course of action for equity allocations is to own a concentrated portfolio of Quality Growth companies that generate significant free cash flow and growing dividends to help protect against downside risk while still participating in potential market upside.
Less than Meets the Eye
On the surface, it appears that the economy is as healthy as ever, with risks rapidly receding after a bout of rampant inflation in 2021 and 2022. For instance, the most recent report from the Bureau of Labor Statistics reported year-over-year headline inflation at 4.0% as of May 2023, down from 8.6% in May 2022. Unemployment of 3.7% as of May 2023 reflects a very tight labor market near multi-decade lows. And real GDP growth in the first quarter of 2023 came in at a tepid, but respectable, 1.3% year-over-year.
However, scratch the surface and the picture is a little less clear. While inflation has certainly come off the 2022 highs, it remains double the Fed’s 2% inflation target. This has forced the Federal Reserve to hike its key interest rate to over 5% and signal that it may further raise rates in 2023. And while low unemployment is a welcome boon for workers and supports wage gains, the tight labor market has been a key support to stubbornly high inflation and thus persistently high interest rates. These elevated interest rates have played an influential role in a rash of regional bank failures, leading to tightening credit conditions across the economy. We have also seen a marked increase in bankruptcies of troubled retailers and office real estate properties as liquidity has dried up (in fact, the running joke in real estate circles is that Class B office values are now measured by land value less demolition costs). As for corporate earnings, these are on track to be down 2.1% year-over-year for the first quarter of 2023. In addition, key metrics from companies we carefully track indicate that low-income consumers are facing significant economic stress, while middle income consumers are increasingly reliant on credit card debt.
The Magnificent Seven
Overall we think risks remain elevated for the economy. So why is the S&P 500 up so much this year? As mentioned above, a big part of the answer lies in a very narrow market supported by a small handful of large technology companies that have rallied significantly. Shares in Nvidia, Meta (Facebook), and Tesla have rallied well over 100% so far this year, and Apple is up over 40% — we do not hold any of these companies in our core equity or income portfolios. Microsoft, Alphabet (Google), and Amazon, all of which we own in size, have been bid up as well.
In fact, excluding these seven companies, which have been dubbed the “Magnificent Seven,” the S&P 500 was down year-to-date as of 5/31/23. These firms now account for about 30% of the index and have generated the largest year-to-date outperformance for the cap-weighted index vs. the equal-weighted index on record.
All is Not Lost
While we are cautious about the near term, it is important to remain level-headed. The economy appears to be slowing, but with low unemployment and inflation grinding lower — albeit at a gradual pace — it is possible that we are in the midst of a “soft landing,” whereby the economy slows without crashing into a recession.
Interestingly, in roughly the last week and a half of June, the rally has broadened to include a larger swathe of the market. If this trend persists, it could indeed reflect a soft landing.
And counterintuitively, the fact that a recession is so widely expected may actually drive companies to take actions that reduce recession risk. The Conference Board recently noted a 99% chance of recession in the next twelve months. Bloomberg has even called this “the most-anticipated downturn ever.” With such broad anticipation of a recession, companies have laid off workers and significantly slowed hiring, which may actually create a release valve for tight employment and thus help alleviate inflation, potentially enabling the Fed to back off on future interest rate hikes. The fact that unemployment has crept up to 3.7% vs. a low of 3.4% may reflect a gradually loosening labor market in the context of a growing economy.
Regardless of where the market is headed, we view a defensive quality tilt within equities as the prudent course of action: If the market rally broadens out, remaining invested should reward investors; and if the rally ends, owning quality assets should help mitigate downside risk.
Do Not Chase the Market
As always, we think it is dangerous to simply chase the companies that are driving the latest stock market gains. Rather, more than ever we believe that investing in a concentrated portfolio of Quality Growth companies represents the right course of action. Quality Growth companies have durable competitive advantages that allow pricing power and/or market share gains, enabling growth in earnings and free cash flow through most environments, including through inflationary periods. And Quality Growth companies are often well capitalized, usually pay growing cash dividends, have good management, and benefit from secular tailwinds. Investing in a concentrated portfolio of these companies at attractive valuations and having a long-term view should enable solid participation in market rallies while protecting against market turmoil.
We have also found that this narrow market has created dislocations in great businesses that we believe are temporarily out of favor, and we are actively taking advantage of sell-offs in the share prices of individual companies. As the economy stabilizes and eventually grows at a healthier pace, we anticipate broader participation in market gains and a recognition of the value of many of the Quality Growth companies we hold.
Please reach out should you have questions.
Originally Posted July 21, 2023 – Third Quarter Equity Outlook
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