I began last quarter’s commentary with the observation that stocks seemingly threw a party in the 2nd quarter, and most of the first half of 2023 for that matter. In the 3rd quarter, markets looked more hung-over as market indices stumbled and bumbled their way to a lackluster and directionless finish. Right on cue, the 3rd quarter suffered from seasonal weakness as August and September are historically the worst months for stock market performance. Stocks finished the 3rd quarter down 3.3%1. Year-to-date, however, stocks are up 13% and have bounced about 21% higher than the market bottom set in October 2022. Bonds have been slower to recover, gaining only about 1% from their lows last year. Bond prices may never fully reach the premiums we saw in 2021, but they will recover some ground as their prices slowly march higher toward their maturity values. A reversal of Fed interest rate policy would definitely hasten the process.
Inflation and actions from the Federal Reserve still control the macroeconomic picture. This is what matters in our opinion. Regardless, the laundry list of concerns (noise) is growing and dominating headlines, which has hampered markets. A few biggies include rising oil prices (inflation), debt ceiling “theater”, and union strikes. A thorough review of historical stock market performance alongside union strikes and government shutdowns reveal little to no correlation and no negative market impacts. Although we do pay attention to short-term economic impacts like job losses, it will likely not impact our long-term investment strategy.
The US economy continues to surprise most experts with its resiliency. The “Barbenheimer” frenzy that seemed to save the movie industry this summer coupled with Beyonce and Taylor Swift concert madness were a reminder that Americans are still in a spending mood. However, anomalies like Taylor Swift and Travis Kelce jersey sales probably can’t carry the economy indefinitely. We are starting to see some slight economic cracks, and it remains to be seen how these risks play out.
The bread and butter of the post-pandemic economy has been the job market. Several union strikes, both actual and threatened, from the auto, film, and delivery industries show just how much leverage workers possess in a tight labor market. However, the pendulum may be starting to swing in the other direction as small business leaders are starting to indicate a drop in both their need and willingness to hire. Notably, the drops are still not significant enough to sound alarm bells as jobs remain plentiful in most industries. But it’s plain to see that the “frenzy” of hiring may be coming to an end.
Student loan repayments that were deferred through the pandemic restart for many borrowers on October 1st, but we don’t think this will represent a major economic impact in the aggregate. Under an income-driven repayment plan2, many borrowers will still enjoy a limit on their required monthly payment commensurate with their level of income.
The median price of a home in the U.S.has fallen 13% since the peak in Q4 of 2022 but is still 30% higher than just three years ago. Newly constructed home sales are down from the cycle peak but have rebounded over 20% since July 2022. While this growth rate has been impressive, new homes make up a small percentage of total home sales. As the chart below illustrates, sales of existing homes are down considerably. Homeowners with mortgage rates in the 3% range are reluctant to sell their current home for fear of having to reset to a rate over 7%. Inventory remains historically low in most regions so unlike the 2007-2009 housing crisis, a meaningful decrease in home values in a short period of time seems unlikely.3
Higher interest rates
The consumer has begun to burn through their reserves from government stimulus checks and “revenge spending.” Those looking to finance a new car or home purchase will confront interest rate levels not seen in over two decades.
Nevertheless, there are 9 million available jobs and wages are rising, so the consumer doesn’t yet look to be completely vulnerable.
Just Get It Over With?
Many clients have asked us what it will take for the broad stock market to fully recover losses from the highs of 2021. As of this writing, the market has still leaned primarily on seven stocks (orange in chart below) for the bulk of 2023’s gains. As you can see below, without these juggernauts, the stock market (blue and white below) has provided no meaningful returns.
We see two scenarios that could potentially turn things around for stocks (and bonds). One, ironically, is a brief recession. So widespread is the current anticipation of slowing economic activity, that it’s difficult for most market participants to be buyers of stocks. This “looming” recession has had the same effect on stocks for nearly two years. However, a run-of-the-mill or brief recession would allow for the Fed to cut rates without inflation increasing. Although it would take some time, this could encourage the cash sitting on the sidelines to finally flow into stocks for two reasons: The first is that interest on cash won’t be as attractive as it is now. The second is that investors tend to buy stocks in anticipation of an economic recovery alongside an accommodative Federal Reserve. This is by no means a suggestion that a recession is “no big deal” for affected workers, but in a sense, the market would love to “get it over with” and move on.
The second scenario involves a “soft landing” whereby inflation subsides and the economy remains strong. So strong in fact, that corporate earnings catch up to the prices that have been assigned to their stocks making them appear relatively cheap. This scenario is a bit harder to imagine but we have to submit that while unlikely, it’s possible. Either scenario could take several quarters to reveal itself and only time will tell. Patience will certainly be a virtue in the coming months.
Stock Prices–Expensive or Not?
It’s the question the market asks itself minute by minute and day by day. By historical standards, the S&P 500 is above average, trading at a price to earnings ratio of 19 versus a 25-year average of 17. However, one must consider that the index has become dominated by technology names with higher growth potential and profit margins. For this reason, investors place a higher multiple on tech stock earnings when contemplating a fair value. Interestingly, when technology stocks are taken out of the equation, the market’s price to earnings ratio drops to 17.4
What Does Seasonality Suggest About How 2023 Might End?
Historically speaking, a strong market into the end of July coupled with a seasonally weak August/September timeframe tends to end with a strong rally into year-end5. We don’t make tactical moves or predictions based on seasonality, but it’s important to view current market moves through a seasonal lens, since August and September are statistically weak months.
What We’re Doing
During the summer doldrums, we took the opportunity to rebalance portfolios to their target allocation while markets were relatively calm. In most cases, this meant trimming gains from stock funds and reinvesting into bonds. We want to be in a position to benefit when bonds start moving up back toward their par value, which they have yet to do. As a potentially mild economic recession looks more and more likely, we increased our exposure to higher quality, intermediate-term bonds, as they should be a beneficiary of a slowdown. Our confidence is high that patience will be rewarded over time.
We also made a minor tweak to our stock fund positions adding slightly to healthcare stocks to play some defense. We maintained our dedicated allocation to the technology sector to maintain some offense. These updates put clients in a better position to weather a potentially pending storm with quality holdings without losing the ability to capture the next move higher, however it occurs.
Thank you for your trust.Enjoy the fall weather!
Chris Proctor, CIMA®
Chief Investment Officer
1Kwanti for S&P 500 (VOO)and Bond Index (AGG); 2Saving on A Valuable Education (SAVE)Plan; 3Federal Reserve (FRED); 4JPMorgan, Yardeni Research; 5Fund Strat
Legacy Financial Strategies, LLC (“LFS”) is an SEC-registered investment adviser. Information included herein is provided for illustrative and informational purposes only and is subject to change. Some information included herein is derived from outside sources, and although those sources are believed to be reliable, no representation is made by LFS about the accuracy or completeness of such information. All investments involve risk, including loss of principal invested. Past performance does not guarantee future performance.