2023 1st Quarter Market Commentary

The bear markets that began for all major US stock indexes between November 2021 and April 2022 got a reprieve in this year’s first quarter. The bear markets for domestic investment quality fixed income indexes began even earlier, from early to mid-2020, but likewise saw returns improve in this year’s first quarter. The worst returns for most investors have come over the most recent five quarters. Over that 15-month period, the S&P 500 has declined by 12.0%, and Barclay’s Aggregate Bond Index has lost 10.4%. The commonly recommended 60/40 stock/bond mix would have declined by 11.4%.

Because of the S&P 500’s 7.5% first quarter 2023 return and Barclay’s Aggregate’s 3.0% gain, the market’s negative results for the past year have been reduced to 7.7% for stocks and 4.8% for bonds. In such a difficult environment, we are very pleased that virtually all our clients have experienced positive returns over the trailing 12 months. The only portfolios not sporting a plus sign, and those few only minimally negative, are portfolios with legacy securities that we cannot sell for capital gain reasons.

Voting Versus Weighing

There is a very instructive quote about stocks that Warren Buffett attributes to his former mentor Benjamin Graham: “In the short run, the market is a voting machine, but in the long run, it is a weighing machine.” How investors are voting is seen in market behavior, whereas weighing involves measuring current economic and corporate conditions and comparing them to long-term measures of similar conditions.

Voting is an expression of current levels of enthusiasm or dismay about the prospect for stock ownership in the near-term future. How do investors feel? Weighing is a less visceral process that relies much more on the concept of value. How is the economy doing, and what are its foreseeable prospects? How are publicly traded corporations faring in terms of current corporate profits and their outlooks for growth in the years ahead? How do the data align with long-term standards of over-or undervaluation?

As seen in the performance statistics above, the bear markets in both stocks and bonds that began from 2020 to 2022 have been relieved by recent encouraging rallies. It is still an open question whether these rallies mark the beginnings of new bull markets or whether they are temporary rallies in ongoing bear markets, with prices fated to descend to or below prior lows.

All major domestic equity indexes gained in this year’s first quarter. The most powerful gains were registered by the NASDAQ indexes which are heavily weighted by a small number of giant companies, mostly in the high-tech category. In fact, at the end of the quarter, just seven companies – Microsoft, Apple, Amazon, Alphabet (Google), Tesla, Nvidia and Meta (Facebook) – comprise over 51% of the NASDAQ 100 index. Despite its powerful first quarter rally, this index is still down more since the beginning of its bear market than any other major domestic equity index. Such an aberration could indicate that, despite the huge declines of most of these corporate giants in the bear market, their former success and ongoing popularity quickly attract more investor votes whenever prices begin to climb.

Further highlighting the narrowness of the current advance, Bianco Research pointed out at the end of the quarter that: “The S&P 500’s gains this year are thanks to just eight stocks.” (The seven stocks mentioned earlier plus Netflix) Collectively, “the other 492 stocks in the S&P 500 are down on the year.” Additionally, on April 14, Elliott Wave International pointed out that the NASDAQ 100’s powerful first quarter rally hid the weak underbelly of the index’s components. The number of net new 52-week lows on the NASDAQ was greater than net new 52-week highs for 27 consecutive trading days.

Also on April 14, Lowry Research, which has done excellent technical research since the 1930s, commented: “The major price indexes are approaching the tops of the year-long trading ranges with internal gauges of market health lagging far behind. As a result, the risk/reward for stocks appears negatively skewed.”

All that said, there is no sure way to forecast how investors will vote in the short run. Many different factors may trigger bullish or bearish responses. At best, this is a probability business. As a result, it is important to know what the markets have done when major variables have resembled current conditions, even though conditions are never identical. When we turn to the weighing process, there are a great many factors to consider. Let me outline a few that I consider most important.

Market prices can and do move opposite to or in different degrees from the movement of the economy, especially over the short run. Over the longer run, corporate profits and stock prices tend to move roughly parallel to economic growth. However, stock prices have historically been severely impacted when the country goes into recession. That potential impact presents a point of some concern in light of recent economic forecasts. While there is no unanimity about a recession forecast in the next few quarters, that is the majority expectation. The International Monetary Fund in early April issued its weakest global growth expectation in more than 30 years. The IMF expects global growth of a meagre 2.8% this year and 3% in 2024 and the next five years to be the weakest since 1990. Their GDP growth forecast for the United States is just 1.6% this year, for the Eurozone 0.8% and for the UK -0.3%. They expect China and India to grow at more than 5% each, which would compensate somewhat for the weakness in the developed economies. One important caveat is that these forecasts are based on the assumption that recent financial sector stresses will be contained. They admitted that: “A hard landing has become a much larger risk.”

The IMF is hardly alone. Virtually every respected economic forecasting organization expects well below average economic growth over the next several years.

The massive amounts of money introduced into the economy by the Federal Reserve and US Treasury since 2008 not surprisingly resulted in rampant inflation. The Fed is trying to reduce inflation to its 2% target with sharply raised interest rates and quantitative tightening. These are the exact opposite of the interest rate reductions and quantitative easing the Fed used to support stock and bond prices for more than a dozen years whenever there appeared a danger of any significant decline. Now the Fed has indicated its intention to slow the economy, even at the risk of recession, to bring inflation back down to its target. Very few, if any, analysts expect that goal to be realized in just the next few years.

The almost 5% rate rise over less than a year and a half has contributed mightily to the failure of a few banks. Certainly, bank managements failed in their responsibility to control risk, but that fault would likely not have resulted in bank failure if interest rates had not been raised so high and so fast. The Fed was forced to raise rates with historic speed in large measure because of many years of their own excessive monetary expansion. Jaime Dimon, CEO of banking giant J.P Morgan Chase, and Warren Buffett have each recently warned that the problem for banks has by no means been solved by the government’s hasty steps to guarantee all deposits at the failed banks. Many other banks are also hurting from the effects on their balance sheets from declining values of their long maturity bonds. These declines will incentivize banks to tighten credit standards, just at the time that a great many commercial real estate loans will be coming due. This credit tightening will affect most stringently clients of small and mid-sized banks that hold about 70% of such CRE loans. If there is any good to come of this, it’s that credit contraction is a deflationary event, which will aid the Fed’s anti-inflation efforts.

Corporate Earnings

What will all these factors do to corporate earnings? It is widely expected in the analyst community that year-over-year S&P 500 earnings will decline by 5 to 7% in the just completed first quarter. Most analysts expect earnings to decline again in the second quarter but by a lesser amount. As a group, analysts hate to have to forecast declining earnings. They hate to offend current or prospective corporate clients. They tend to be overly optimistic about earnings, especially for more distant quarters. Today, most analysts predict slightly growing S&P 500 earnings in this year’s third quarter, then far stronger earnings in the year-end quarter. Curiously, these predictions run counter to many of the macro strategists’ forecasts for a recession in the back half of the year, which would almost certainly damage corporate earnings reports.

On a Generally Accepted Accounting Principles (GAAP) basis, the S&P 500 saw year-over-year earnings decline by 12.7% in 2022. Even if normally optimistic forecasts in the outer quarters prove accurate, year-over-year earnings for 2023 are merely expected to be slightly above flat. And even if a recession can somehow be avoided, nobody is forecasting more than minimal GDP growth in the years beyond 2023. It would be very difficult to make the case for strong earnings growth in a relatively stagnant GDP growth environment.

Valuation

In my view, the single most important weighing measure is valuation. The most commonly used valuation measure is price-to-earnings (PE), although there are many against which current conditions can be compared. As I write this in mid-April, the PE for the S&P 500 on a GAAP basis is 24.1 times earnings, just about 60% higher than the long-term average GAAP PE ratio of about 15. The other commonly employed valuation measures are similarly extended.

The valuation excesses demonstrate clearly that voting and weighing can lead to dramatically different conclusions about what represent attractive securities prices. Inasmuch as securities prices have always ultimately reverted to their historic valuation means – unless it’s different from ever before – we can expect that equity prices will eventually revert to historic valuation averages. With forecasts for both economic and corporate earnings growth well below average levels for an extended period of time, the path of least resistance is for stock prices to meet valuation at lower rather than higher levels. There is, of course, no way to know how long voters will continue to push prices up, especially in the absence of attractive fundamental valuations. While every investor has a unique set of objectives and risk tolerance, it is an appropriate caution not to get too carried away with the voters’ path when it deviates significantly from the weight of economic and corporate conditions.

Portfolio Construction

In an environment of far above normal equity valuations, declining corporate earnings, still rising interest rates, tepid economic growth forecasts, concerns about bank stability and credit contraction, and the specter of the political parties possibly unable to agree on approving an increase in the debt ceiling, we are focusing our investment firepower on protecting assets and guaranteeing as much risk-free income as possible. As clients have seen in their portfolios, to the extent that cash has been available, we have constructed two US Treasury ladders – the longer centered around the 2-year maturity and the shorter around the 3-month treasury bill. With no certainty about the path of interest rates, the Fed’s ultimate terminal rate or the duration of its restrictive policy, we put the longer purchases out far enough to guarantee at least two years of attractive risk-free income. At the same time, we obtained excellent short-term yields on a series of T-bills that will provide intermittent maturities offering the opportunity to add to the longer ladder as long as those rates remain attractive. Current yields-to-maturity on the fixed income portions of portfolios average about 4.5%, an attractive yield in a highly uncertain environment.

We simultaneously continue to review economic and corporate data in the ongoing search for attractively valued and positioned equity securities that offer an appropriate prospect of safety, income and growth potential. They have been in short supply in the last couple of years.

By Thomas J. Feeney, Chief Investment Officer