June 30, 2023
The S&P 500 finished the second quarter up over 16% year-to-date. The resiliency of markets has been fully on display this year, as this positive return has happened despite a regional banking crisis, persistent (yet dropping) inflation, and a recession continuously predicted by an inverted yield curve. Once again, this shows that “timing the market” is not something investors should be comfortable trying to achieve with any consistency. But let’s look under the hood of the 16% return to see how healthy the market actually is. At closer look, the gains have been based on the returns of a few specific stocks: Apple (now over $3 trillion market capitalization), Microsoft, Google, Tesla, Amazon, NVIDIA, and Facebook. A few of these stocks have yet to achieve their previous highs prior to last year’s sell-off (such as Tesla or Facebook aka “Meta”), while others have rallied on speculation for an Artificial Intelligence boom. The banner-carrier for the AI boom has been NVIDIA, with the company’s blockbuster earnings report catapulting this company into the $1 trillion + club. Don’t look now, but the company’s valuation is currently near 40x sales, just modestly above the S&P 500 average price to sales of 1.7x.
Another, frequently overlooked, reason for the tech stock rally could be the rise in the use of ultrashort-expiration options, commonly known as 0DTE (zero days to expiration). These options began trading in 2022, and they now comprise almost 50% of daily share volume. Options have existed for decades, but this style of option motivates traders to focus less on valuations and instead on momentum. Popular stocks (such as many of those mentioned above) are trading at Price-to-Earnings (PE) ratios well over the broad index averages, and 0DTE options may be at least part of the explanation. While the stock-market in the short-term has been influenced by these mechanical influences, ultimately profits and thereby the economy will determine the direction for stocks. And while the economy has remained resilient, posting consistently strong wage and employment data, there remain reasons for diligence. The inverted yield curve remains in place; a scenario where the bond market forecast future rates below today’s rates. This scenario has typically pre-dated recession onsets by 12 to 24 months, and we just crossed through month 11 since the inversion began last July. We also have Leading Economic Indicators (LEIs) trending negative, tighter lending standards, some increase in unemployment rates, etc. On the other hand, consumer activity has remained strong and unemployment- while modestly higher- is still quite low by historic standards with wage growth continuing to show strong. We have also seen liquidity increase yet again, with bank lending programs setting new weekly records and the M2 money supply seeing recent increases following months of reduction. A mild recession remains a likely base case, but that does not necessarily mean a sizable drop in stock values. The market is best thought of as a forecast of future economic growth, not today’s economy. As such, we believe stocks can begin to look past the mild recession to an economic environment of lower inflation and lower interest rates. The outcome should help the sectors beyond technology to participate in the market growth.
With so much scrutiny on big domestic stocks, it can be tempting to ignore other asset classes and markets. Small cap stocks, REITS, international, mid-caps, value-stocks, and bonds all play a role in diversified portfolios. Notably, foreign stocks were positive for the period, though their gains moderated after a strong Q1. Developed markets are facing issues related to inflation, as those markets tended to not raise lending rates as aggressively as we did. Some key markets, such as Germany, either already reached recession signals or likely will soon. As noted above, markets are forward looking, and the recessionary news from Europe hasn’t led to dramatic stock drops. These markets also consistently trade at much lower valuations than our major indexes. Emerging Markets were also modestly positive, even with China facing modest GDP growth numbers.The broad bond index had a rather bland quarter, moving between slight gains and losses to finish the quarter down about 1%. This obscures some of the frantic action in the short end of the yield curve, as the inversion between the 2-year and 10-year Treasury reached levels not seen since the early 1980s. As mentioned above, this is a frequently watched recessionary signal. It is clear that bonds have priced in a recession due to the cumulative drag higher interest rates may ultimately have on the economy.
Looking ahead, our attention will remain heavily focused on the Fed. Futures are pricing in a likely rate increase in July, with an outside probably of another rate increase in September. We believe September will not see an additional hike, as inflation has moderated. But, we also believe the Fed may be slow to cut due to inflation remaining above the Fed’s 2% goal. Cutler’s “higher for longer” positioning has correctly been and is still our target bond allocation positioning, but as we get closer to 2% Core inflation, we anticipate transitioning toward a more neutral bond allocation. We agree with the direction of the bond market, but not necessarily the timing. The severity of a recession (and its impact on underlying inflation) may determine the returns from the long-end of the yield curve, but for now the short-end continues to be attractive. After all, money market funds and short-term bonds continue to pay roughly 5%, a yield we are very comfortable with at the moment.
In 2022 our bias toward Value-style stocks with consistent dividends helped to buffer against sizable losses. The first half of 2023 has seen a sharp reversal in that trend, with massive concentration in Growth names for returns. The Nasdaq 100 was up roughly 15% for the 2nd quarter, bringing its 2023 gain to almost 39%, the best first half performance since 1983! But as noted above the valuations for many key constituents have gotten quite speculative. The 2nd quarter saw stronger gains in some less Tech-heavy sectors, like Industrials and Financials, but despite the Fed’s strong stance on keeping rates restrictive Growth continues to retain much of the market’s momentum. We are focused on ensuring our growth allocation is meeting relevant benchmarks, but do not believe investors are best served by “chasing performance” at this time. Where do we see opportunities? We don’t believe the S&P 500 is expensive outside of technology, and small-cap and mid-cap stocks have been left behind in this rally. Should we enter a dropping interest rate environment, we believe these asset classes would be well-positioned.
Fixed Income benchmarks were broadly negative this quarter, but sizable yields have kept bonds positive for the year to date. Our portfolio recommendations are biased shorter in duration than the benchmarks, as this is where the higher yielding positions currently reside. However, the bond market anticipates lower rates going forward, and we will look to transition into longer-term holdings at the appropriate time.
We continue to recommend international diversification and recent dollar weakness (as the market anticipates lower rates) has supported that positioning. Foreign developed stocks were positive for the period, but not nearly as strong as during the first quarter. The Emerging Markets class also saw modest gains in the period. While we believe these are important asset classes for portfolio diversification, the exposure remains modest relative to the weights of our domestic recommendations.
The alternatives asset class has provided strong relative gains and continues to be a strong “3rd leg of the stool”. Our standard “alts” position, the Goldman Sachs Absolute Return Tracker fund, gained just over 3% for the quarter and is up over 6% this year. It has also done so with reasonable volatility relative to both stocks and bonds. This class continues to be a value-add for client portfolios.
Commodities again saw very mixed results for the quarter. Oil futures began the quarter with increases, but oil has not participated alongside the stock market’s growth. We see this as an important indicator to watch, as either oil should rally or the economy should slow to meet today’s lower oil price. What about positions thought of as inflation hedges? Both gold and Bitcoin haven’t responded to rising inflation in the past few years. Gold reached $2,000/oz near the end of March, but then softened throughout the Spring to end the quarter closer to $1,900. Bitcoin saw some selling pressure after a huge rally in Q1, but ended with some strength on speculation that it will become more broadly available via ETFs and major provider purchase access. While these types of holdings can add value over very specific pockets of time, we do not recommend them in portfolios as the volatility is quite high.
These blogs are provided for informational purposes only and represent Cutler Investment Group’s (“Cutler”) views as of the date of posting. Such views are subject to change at any point without notice. The information in the blogs should not be considered investment advice or a recommendation to buy or sell any types of securities. Some of the information provided has been obtained from third party sources believed to be reliable but such information is not guaranteed. Cutler has not taken into account the investment objectives, financial situation or particular needs of any individual investor. There is a risk of loss from an investment in securities, including the risk of loss of principal. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will be profitable or suitable for a particular investor's financial situation or risk tolerance. Any forward looking statements or forecasts are based on assumptions and actual results are expected to vary. No reliance should be placed on, and no guarantee should be assumed from, any such statements or forecasts when making any investment decision.