Quarterly Newsletter

In the parable of the blind men and the elephant, each of the men describe the elephant based on a singular part. One touching the tail believes the elephant to be like a snake, one feeling a leg says tree and so on. In the original, not only do they form these disparate impressions but descend into discord arguing their positions. In the world of investing, we often see something analogous as thousands of practiced eyes fixate on the same financial markets, often coming to a similarly bewildering range of conclusions. Even more puzzling are the times when a consensus appears to be widespread, only to be proved wrong as markets move to the contrary.

We note this not because this past quarter was one of particularly wide assessments or one of those vexing inflection points, but rather because markets were largely on the course to which we’ve become accustomed. Such periods can produce an unearned complacency and what behavioral economics have identified as “recency bias.” Recency bias is a well-documented human tendency to demonstrate the kind of confidence the parable participants showed regarding the elephant, but in this case on the future using the recent past rather than history. One common example is the strong pull when investing new capital to add to the assets which have the best short-term results. The stock market today seems to us to have particularly strong temptations.

Rising markets not only produce happy investors, but tend to create snowballing enthusiasm and risk complacency. A deeper look into the market shows that close to half of the S&P 500’s return through the end of May has been concentrated in only four mega-cap technology firms. This sort of concentration should be accompanied by at least a modicum of concern, but the more common reaction is a compulsion to join the trend powered by a fear of missing out.

Much of the excitement which has taken the stock market to new highs and powered individual stock runs has centered on the rapid deployment of artificial intelligence. However, history should remind us that there is a difference between identifying an undeniable trend and picking the companies that will end up as the long-term beneficiaries. For instance, in the 1980s it was apparent that desktop computing was going to be a huge innovation, but the early leaders in the industry are now obscure names like Kaypro and Commodore while later winners like Gateway failed to flourish. The trend can be clear while the investment implications remain uncertain.

By the end of a strong May the S&P 500® Index had returned 11.3% year-to-date, with an additional advancement of 3% through mid-June. Rising interest rates suppressed bond returns so far this year, with the Bloomberg Aggregate Bond Index showing a year-to-date -1.6% loss through May. In addition to the mega-cap leaders, broader returns were fueled by a resilient, if slowing economy, solid employment numbers and enough suggestions of moderating inflation to maintain expectations of incipient Federal Reserve rate cuts.

How singular has the market concentration become? At the peak of the dot.com boom of the late 1990s and into 2000 the S&P 500 became 29% tech weighted. Looking past the recent reclassifications (from Technology Sector to Communication Services for instance) today’s S&P 500 can be characterized as up to 40% technology. While some of this is secular (virtually every company depending on technology and technological advancement), it’s vital to be clear eyed about the increased risk of performance concentration. We believe the disparity in stock price advancement opens the possibility for solid returns from the most attractive companies that retain reasonable valuations.

Lagging bond performance this year has only added to the appetite for stocks with a natural inclination for the leading companies. Fundamental investment principles emphasize rebalancing — trimming the winning assets and buying the lagging. We see this very behavior from our most experienced and steadfast institutional accounts, even though it requires overcoming the emotional instincts of performance chasing. Short term bonds continue to produce attractive returns, while investors looking for income over time have numerous choices in longer bonds.

As has been the case since March 2022 when the Federal Reserve (Fed) began to ramp short-term rates in the most aggressive manner in history, eyes remained focused on any signs from Chairman Powell and the Board that rate cuts are imminent. At their recent June meeting, the Fed decided to keep rates unchanged and suggested there might only be a single rate cut for the remainder of the year. This met our standing expectation for higher rates for longer based on sticky inflation and fiscal realities.

Over the past months and years our primary stock strategy has rested on the ability to participate in a rising stock market while still emphasizing valuation and risk assessment. For individual investors, part of this discipline means keeping or even increasing fixed income allocations, as appropriate, at a time when the immediate rewards may be lacking. We can celebrate new highs in the stock market while simultaneously noting that the prices of many stocks are increasing faster than earnings, making them more expensive as measured by the standard price to earnings ratio. We believe today’s market only increases the imperative for thoughtful asset allocation and careful stock selection.