Quarterly Newsletter

On June 8th, the stock market hit an official mark which must have surprised many investors: a definitional bull market. The S&P 500® Index was up 20% from its market low in October. The normal spirit behind a bull market was in distinct contrast to the overall economic mood, with persistent inflation, a Federal Reserve committed to keeping interest rates high, household debt rising, and the entire month of May mired in the debt ceiling crisis. Signs that the overall economy was beginning to stutter included a slowdown in bank lending, a continuing contraction of the money supply, and recent reports that manufacturing orders were down. Looking beneath the Index returns helps illuminate this disparity.

From our perspective, the most important aspect of the stock market this quarter and for the year has been the narrowness of the advances. A handful of large technology firms have been the main drivers of the gains, most recently behind the frenzy over AI (Artificial Intelligence). Just five stocks were responsible for 85% of the Index’s 9.6% gain through May . Early June activity, buoyed by the compromise in Washington, sent the Index into double digits. But it’s important to always keep in mind that the S&P 500 is a capitalization-weighted index with the largest stocks having an oversized impact on index returns. The ten largest firms constitute one-third of the entire index.

When each of the returns of all 500 stocks in the index is given equal weighting, the 9.6% year-to-date index return through the end of May is reduced to -0.6%. By early June, the trailing three-month period saw just 20% of the S&P 500’s stocks beating the overall index. If anything close to this low level prevails for the year, it will be a new 50-year record. By mid-year, the market gains were the narrowest since the Nifty Fifty era in the early 1970s and were reminiscent of the more recent tech boom of the late 1990s into 2000. Both cases signaled high risk and potential trouble for investors overly concentrated in the market’s darlings when they sport oversized valuations. This may prove to be a largely overlooked risk for popular capitalization-weighted index securities as well. One positive sign for a potential rotation to a broader rally was the strength in early June for economically-sensitive cyclical and small cap stocks.

While focus may have bounced from the tribulations over the debt ceiling to the excitement over advancements in AI, the underlying issues for stock and bond investors continued to be interest rates and the Federal Reserve. Elevated Fed fund rates are intended to act like a wet blanket laid on top of an overheated economy. The impetus currently driving investors is not just over the effect of that action but, more controversially, how long elevated rates will remain. Many believe the Fed will begin lifting that weight later this year. Others believe the Fed’s refrain to expect elevated rates for “some time.” The principal target of the Fed’s sharpest rate increases in history has been inflation. The latest readings show a continued downward trajectory, but rates remain well above double the targeted 2% level. Overall economic growth has slowed but remains positive, with GDP growth in the first quarter at 1.1%. Projections suggest slower growth ahead, even with persistent strength in the job market. Parsing through recent Federal Reserve Board statements shows a frustration with stubborn inflation. As such, the possibility of yet more rate increases remains. However, the statements also include hints that the current rates may be restrictive enough to dampen it with patience. The jury is still out if that patience includes a period of negative growth — in other words, a recession.

As we prepare for the remainder of 2023, we will be focused on economic indicators, especially the employment metrics, since job loss is often the last shoe to drop in a slowdown. Over the past year, earnings estimates for all the S&P companies have dipped by 10%, a trend many believe is not yet over. We believe investors should be braced for the typical lagging impact of higher rates and the possibility that the Fed will keep rates high at least through 2023. In the meantime we are seeing historically attractive yields from bonds and a nice reversal from 2022 in terms of bond returns. The sustained narrowness of the stock market should make security selection paramount and could pressure returns, particularly for speculative companies which have been the main drivers of the market advance so far this year.