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Q2 2023 Market Commentary

July 28, 2023

Priced for Federal Reserve Perfection

“If you can walk away from a landing, it’s a good landing. If you use the airplane the next day, it’s an outstanding landing.” – Chuck Yeager

As of this writing, the Federal Reserve raised the federal funds rate at its July confab to the range of 5.25 to 5.50%. Much of the rhetoric emanating from the financial press seems centered around the idea of a soft landing for the U.S. economy, whereby inflation has been brought under control without inflicting serious economic damage in the form of higher unemployment and falling consumer demand.

Meanwhile, the tremors coming from the banking sector in the wake of the spring SVB and First Republic Bank failures seem to have all but disappeared. And speculative fervor in the stock market seems alive and well. Artificial Intelligence is the all the rage. However, ignored in this year’s run up in the S&P 500 index have been major warning flags – pointing to a recession – that have deteriorated even further as calendar year 2023 has unfolded. The Leading Economic Index (LEI) has been down 15 consecutive months, as reported by The Conference Board, and has posted the longest streak of contraction since the time leading up to the 2007-2008 Great Recession. The yield curve remains deeply inverted, with shorter-term interest rates garnering higher returns than longer-term bonds, a classic recessionary signal. Furthermore, The Redbook Index’s gauge of same store U.S. retail sales has gone negative on a year-over-year basis, indicating the strong consumer may have run out of steam.

The long and variable lags of monetary policy are just that. And waiting for the arrival of a recession has been like “Waiting for Godot.” We are left asking ourselves whether this time is different. Have we entered some sort of new era? Is the traditional business cycle dead? We’re not so sure.

It’s Getting Crowded at the Top … Again

“The stock market is a device for transferring money from the impatient to the patient.” – Warren Buffett

Focusing on the less popular and lower than market valuation stocks amid the 2022 market decline proved to be a much more pleasant investing experience than owning the S&P 500 index and its technology-heavy representation within its top 10 holdings. However, 2023 has been a “Back to the Future” moment, with mega-cap technology leading the index higher off the back of their price to earnings multiples expanding, slim earnings growth outlook, and a Federal Reserve that continues to tighten monetary policy. [See the chart below from JP Morgan Asset Management.]

Concentrated stock leadership in a stock index can lead to some unfavorable future investing results. As we mentioned in our Q2 2022 Market Commentary featuring famed investment strategist Bob Farrell’s “Ten Market Rules to Remember,” we are again presented with a situation where Rule No. 7 might bear revisiting: Markets are strongest when they are broad and weakest when they narrow to a handful of blue-chip names. But what’s the real danger here? The handful of blue-chip names in this case are considered assets that are sensitive to changes in interest rates, otherwise known as long-duration assets. July may be one of the last interest rate increases we might see in this cycle; however, the Federal Reserve may keep rates higher for a while longer, having communicated that this may be a possibility. Higher interest rates and high multiple stocks are like oil and water: they don’t mix.


In Conclusion

The tone of the financial media and Wall Street is that a soft landing for the U.S. economy has been achieved despite some key economic indicators that warn that a recession is looming. We are of the mind that the business cycle is not dead. Technology and retail sales can experience cyclicality during a bona fide economic slowdown. And we may once again find comfort in owning and investing in companies that have lower valuations than the broader market, with offsets such as a stable yet growing dividend.