Market Commentary July 2023
Stock Market Throws a Party in the Second Quarter—98% of Companies Don’t Show Up
The S&P 500 hit its most recent low point on October 12, 2022, when the index touched 3,577. On June 30, 2023, the index closed at 4,450, marking a 24.4% increase. Investors in broadly diversified stock funds saw strong returns, but not all investors fared the same.
For the year, the S&P 500 stock index is up +17%, exceeding the expectations of nearly every market strategist at large and respected investment firms. As we noted in January’s commentary, it is rare for stocks to experience two consecutive years of negative performance. Other historical indicators suggested that early 2023 market activity would be consistent with a positive year in the stock market.
Stock market performance has certainly been positive year-to-date, but the surge in prices has come with very little “breadth”. As opposed to a broad-based rally where nearly all companies rise together, this particular surge in prices has a select few large technology companies to thank. These names have skyrocketed thanks to a general sense of “FOMO” (fear of missing out, as the kids say) on the artificial intelligence boom.
Since the S&P 500 is a capitalization-weighted index, meaning that larger companies have more impact, huge price moves in just a handful of mega-cap tech companies have had a disproportionate effect on overall market returns this year. As you can see below, the “magnificent seven,” as they are being called, picked up the slack for the other 493 stocks in the index.
This trend may be changing. While technology-related stocks have driven much of the index return for the year, we started to see more broad-based participation from stocks in other sectors. In fact, technology performed in line with the S&P 500 and only in the middle of the pack relative to other sectors in June. Continued participation from stocks outside of technology would help maintain year-to-date gains or even add to them during the second half of the year.
Everyone Says a Recession is Coming, but They’ve Been Saying That for a While Now
It’s hard to remember another time when everyone agreed that something ominous was coming — not that it might come, but that it was definitely coming, and it was just a matter of when. In 2022, many strategists predicted that the increase in interest rates and declining stock prices was a sure sign that a recession was coming by the end of the year or by the first quarter of 2023.
As we enter the second half of 2023, many strategists have pushed the timeline out to 2024, while some have predicted a “soft landing” with no recession at all. Others have called for a new kind of recession. Perhaps to save face or perhaps to get eyeballs on their Twitter feed, they’re calling it a “rolling recession.”
In this scenario, instead of a traditional recession where unemployment rises rapidly, housing prices fall, and corporate profits plummet, we would instead experience each of these elements in isolation. Downturns in commercial real estate, corporate earnings, jobs, and manufacturing may all occur, but in a rolling recession, they may not occur in a coordinated or synchronized fashion.
The result would be an unofficial recession that occurs over a period of many months. While a real estate agent would swear we were in the depths of a major recession, a factory manager might totally disagree until the following year. In other words, the truth may lie in the eye of the beholder.
“Recession is when a neighbor loses his job. Depression is when you lose yours.” -Ronald Reagan
Economists could be forgiven for getting this one wrong because these last few years have certainly been unprecedented. The amount of liquidity that was dumped on the economy by the central banks and legislators of the world brought unimaginable stimulus in the form of forgivable loans, low interest rates, and tax credits. Without precedent, it would be nearly impossible to know what the impacts of those decisions might look like.
The traditional models of economic expansion and contraction have not provided great guidance in a post-COVID world. Therefore, most predictions have fallen woefully short of reality: i, ii
In our view, it would take a significant event to thrust the U.S. into a deep recession. That might be an escalation of hostilities by or against Vladimir Putin, further tension in China/U.S. relations, or, more likely, something completely out of left field that isn’t currently on the global chessboard.
This fall, economic headwinds may loom. Resumption of student loan payments, a potential UPS worker strike, and decreased government spending could all provide potential blows to either supply or demand, but they’re unlikely to derail the economy. If the economy does falter, the Fed is finally in a position to cut interest rates, an option that was unavailable when rates were at zero.
Based on the fed funds futures, a popular predictor of future interest rate movements, there is a 40% chance of a rate cut in November and a 50% chance of a rate cut in December. While economic headwinds may try to hinder stock market growth later this year, it would also be tough to bet against stocks in a declining interest rate environment.
Inflation Continues to Cool
The all-important inflation picture has continued to improve, but it’s also a source of great confusion for most consumers. Below, I’ll try to shed some light on the topic.
When we talk about inflation, we generally think of prices going up. Without a doubt, the price of most goods and services has been rising. However, the rate at which it has been increasing has declined.
With the Fed looking back 12 months to assess the severity of inflation, each new month of data subtracts an old month of data (13 months ago). As you can see in the bar chart, June of 2022 will soon be eliminated in the year-over-year calculation. This could very well lead to an annual inflation number very close to 3%; much closer to the Fed target of 2% and lower than the end of the inflation battle in 1982.
It’s also notable that shelter/rents comprise roughly one third of the Consumer Price Index and has remained stubbornly high. For over 20 years, Penn State has generated an Alternative Inflation Index including a “market based” measure for shelter/rents. Their year-over-year Rent inflation for the month of May was -6.4% versus +8.0% for the Bureau of Labor Statistics (BLS), a dramatic difference. Penn State’s estimates indicate that the CPI and Core CPI are negative 1% year-over-year versus +4.0% and +5.3% respectively from the BLS. If the market-based measures more accurately reflect real time costs, the government’s inflation number is overstated and the war on inflation should be over sooner than many believe.iii
If you’ve heard friends and co-workers complaining that the government numbers can’t be accurate, you’re not alone. Some of the Fed’s methods are arcane and haven’t changed since the 1970s. To figure out how rent prices have changed, they randomly call households and ask homeowners how much they think they would be willing to rent their residence for. Seriously.
Clearly, there may be better gauges than the Fed itself. At best, their numbers are always one month old. Interestingly, some high-tech, data-driven organizations have attempted to find the true rate of inflation in real time using publicly available transaction information. One such organization, Truflation, claims that inflation peaked at about 12% last year and is currently close to 2.5% (see chart below).iv This may suggest that the Fed has raised rates too far. Time will tell.
Where Do Rates Go from Here?
At the Fed’s June meeting, they decided, unsurprisingly, to leave rates alone for the first time since March of last year. After considering the impacts of several bank failures in the first quarter and uncertainty about passing a debt ceiling deal in Congress, they’ve taken a wait-and-see approach, which most experts agree is prudent.
The current inflation battle is constantly compared to the early 1980’s. In October 1982, Fed Chairman Paul Volcker announced that he was ending the war with inflation when readings were similar to what we see in 2023. Headline inflation was 3.7% then versus 4.0% today. Core inflation, which removes volatile food and energy prices was 4.5% then versus 5.3% today.
Indeed, the lag effect of interest rate hikes makes it difficult for central bankers to know when to stop the “tightening.” The time delay between the Fed’s actions and the economic response creates a “guessing game” of sorts. The Fed will likely sit on the sidelines and buy a bit of time this summer.
What We’re Doing
Current conditions have led to fewer transactions in our portfolio management than has been typical over the last few years. So far, it’s proven effective.
On the stock side of portfolios we’ve maintained a small position in healthcare, not yet convinced the all-clear sign is visible. Healthcare tends to perform well in weakening economies, so in our view, a small percentage is still warranted for most clients. We are still broadly exposed, however, to both growth and value stocks with a preference for U.S. domiciled companies.
Our technology allocation remains slightly overweight because we’re convinced that the A.I. (artificial intelligence) boom will create both disruption and opportunity in the coming years. Groundbreaking innovations rarely lead to straight-line gains, but periods of change in the technology space often provide the potential for substantial gains over time.
Due to bond market volatility, we’ve continued to keep an overweight allocation to shorter-term bonds for the time being.
We’ll be paying very close attention to the gross domestic product and corporate earnings as they are released early in the third quarter. We’re looking for validation that a significant recession is not likely this year.
As always, we never manage money as if we know what will happen in the short-term. On the contrary, we allocate as if we don’t know. In the long-term, we’re much more confident!
As always, we appreciate your trust and partnership.
Chris Proctor, CIMA®
Chief Investment Officer
Sources: i72% of economists expect a recession by the middle of the next year|CNN Business; iiWhy a global recession is inevitable in 2023 (economist.com); iiihttps://sites.psu.edu/inflation/; iiiiIndependent, economic & financial data in real time on-chain (truflation.com);
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.