2023 2nd Quarter Market Commentary

In our April Quarterly Commentary (please visit 2023 1st Quarter Market Commentary – Mission Management & Trust Co.), I analyzed Warren Buffett’s counsel that in the short run the stock market is a voting machine, while in the long run, it’s a weighing machine. In the recently concluded second quarter, voters clearly dominated. Excitement and enthusiasm for the “Magnificent Seven” – Apple, Amazon, Alphabet, Meta, Microsoft, Nvidia and Tesla – powered equity market indexes higher, reclaiming more of the ground lost in the bear market that began for various major indexes in the months around year-end 2021.

With interest rates continuing to rise in the second quarter, the Barclay’s Capital Aggregate Bond index again declined, albeit just fractionally. This extended the period of double digit losses for most domestic fixed income investors to two years or more. Having properly anticipated rising interest rates, our short Treasury ladder has provided Mission clients with positive returns for the fixed income portions of their portfolios in that same time period. Yields to maturity on current positions now exceed 5%.

While the major stock market indexes have surged since the October 2022 low, they have not yet fully recovered the losses they endured in their early 2022 declines. The fixed income picture is even bleaker. The total return for the broad Barclay’s Capital Aggregate bond index over the past 18 months is still a negative 11.2%. The frequently recommended 60/40 stock/bond portfolio is also down by 7.1% over that time period, with the S&P 500 representing the stock portion.

Curiously, the equity rally since October has lacked the typical earmarks of a bull market. Most bull markets begin from substantially oversold levels, advance on growing trading volume and in relatively early stages show broad-based demand, not selective strength. The current market advance has exhibited none of these characteristics. In fact, the narrowness of this advance has been one of the most extreme ever. The “Magnificent Seven” accounted for 73% of the S&P 500’s gains in the first half of this year, relatively little coming from the other 493 companies in the index.

A few weeks ago, The Wall Street Journal reported: “Buzz about AI has hit a fever pitch….By one measure, the current stock market rally has been its most narrow since the dot-com bubble in 2000 with a handful of tech stocks driving the returns, according to Goldman Sachs Group.” Clearly, much good has come from the emergence of dot-com technology, but back at the turn of the century, that prospective benefit failed to prevent the stock market from falling by 50% soon after and ultimately bottoming even lower nine years later. There is no question but that artificial intelligence will generate any number of potentially profitable applications. What we can’t know now is how widespread the benefits will be felt and which companies will be the ultimate prime beneficiaries. It’s instructive to remember that a huge number of companies that were the earliest rising stars in the dot-com era never became profitable. Many no longer exist.

It’s also important to recognize that AI is not new. When I worked in the investment management business in New York in the mid-1980s, our firm and others were exploring the potential benefits of AI. It’s fair to ask whether recent developments are going to prove profitable to many companies in the near future or whether there may continue to be a long lag before those benefits are meaningfully felt. It may also be difficult to identify at this stage which companies will ultimately utilize AI effectively.

The “Magnificent Seven” have all risen aggressively as analysts have celebrated recent advances in AI. While these companies may well eventually benefit, it is important to recognize their current elevated prices and valuations. As I write in mid-July, prices are stretched relative to their trailing 12-month earnings. These seven mega-cap companies have an average price/earnings ratio through this year’s first quarter earnings of 52.4 and a median ratio of 36.9. While a few companies may justify such valuations in the long run, most do not. In fact, in every era since at least the 1960s in which mega-cap tech stocks have led markets to historically overvalued levels, leading blue chip tech stocks have subsequently been beaten up very badly. For example, after their 1999-2000 peaks, these top-quality companies suffered the following losses: AMD: -86%, Cisco: -84%, Intel: -69%, Hewlett-Packard: -81%, IBM: -52% and Microsoft: -62%. Declines after severe overvaluation don’t just penalize the little guys, but take the giants as well.

The big question, of course, is not merely how market leaders will perform, but rather the entire market. On the encouraging side, so far in July, a broader base of stocks has risen, even as some of the mega-caps have rested. However, the overall market is substantially overvalued. As I write, the S&P 500 on a Generally Accepted Accounting Principles (GAAP) basis is trading at 25.8 times earnings, almost 70% above its long-term average of about 15. In addition, at the end of June, the ratio of the cumulative value of U.S. common stocks relative to the size of the U.S. economy, as measured by GDP, is higher than ever before in this country’s history except at the end of 2021, when the 2022 bear market began. As a weighing measure, this ratio also shows extreme overvaluation. Historically, markets have not fared well after measures of valuation even far less inflated than we are currently experiencing.

Theoretically, fundamental conditions could be about to improve sufficiently to justify today’s valuations. Typically, however, prices decline in order to meet fundamentals rather than fundamentals rising to meet prices. Let’s look at prospects for upcoming conditions in the following critical areas: geopolitics; economics, both domestic and foreign; Federal Reserve actions; interest rates; and corporate earnings.

Geopolitics: There is no precise way to evaluate risks in this area. Positive outcomes could involve Russia withdrawing from Ukraine, China accepting Taiwan’s independence and North Korea and Iran foregoing future nuclear development. None of those appears even remotely likely. The continuation or worsening of any current circumstances will be a negative rather than a positive for equity markets.

Economic conditions: No reputable, independent forecasters see this year’s U.S. GDP reaching even as high as a subpar 2%. The Congressional Budget Office recently forecasted no growth. For 2024, the Federal Reserve Bank of Philadelphia’s Survey of Professional Forecasters, the World Bank and the Organization of Economic Cooperation and Development see no U.S. GDP growth above 1%. Over the next few years, none of these organizations anticipates U.S. growth above a still subpar 2.4%. The World Bank, OECD and the International Monetary Fund all see 2023 and 2024 global GDP growth to be below average as well. In its June commentary, the World Bank said: “Global growth is projected to slow significantly amid high inflation, tight monetary policy, and more restrictive credit conditions. The possibility of more widespread bank turmoil and tighter monetary policy could result in even weaker global growth.” Economic help for the equity markets is not forecasted for the next few years either domestically or internationally.

Federal Reserve actions: Fed Chair Jay Powell has pledged to do whatever is necessary to bring inflation down to 2%. He and several Fed governors have declared their intent to raise interest rates higher for longer. Fixed income markets have exhibited some doubts about the Fed’s willingness to hold to that path if the economy weakens and a recession looks likely. The equity market would probably benefit, at least initially, should the Fed retreat from its current hawkish projections. At the same time, however, the benefit from a less aggressive Fed might be negated by a recession that would slow GDP growth and reduce corporate earnings. It looks unlikely that the Fed will begin to cut rates unless the economy weakens. At best, one positive would be offset by a negative.

Interest rates: The Fed raised short-term interest rates by a full 5% over the past five quarters. This led to serious double digit losses in most fixed income portfolios. That, in turn, led to the failure of three banks in the second quarter. Notwithstanding government rescue efforts to save other banks, higher for longer short-term interest rates could precipitate additional banking troubles. At the very least, even rates at current levels will lead banks to tighten lending standards. Restricted credit would reduce corporate profitability and slow economic growth. As indicated earlier, it’s unlikely that the Fed would soon promote corporate profitability with lower interest rates unless the economy were in danger of falling into recession. Again, such a positive would likely be offset by a negative.

Corporate earnings: Although it has received little publicity, the U.S. is already in the midst of an earnings recession. Corporate earnings declined in the fourth quarter of 2022 and the first quarter of 2023. Second quarter earnings announcements are just beginning, but earnings estimates have been steadily declining over the past few weeks. The most recent FactSet estimates for second quarter S&P 500 earnings show a year over year decline of 9%. Estimates for the third quarter are barely positive. Estimates for the fourth quarter and for 2024 are for much stronger earnings. If those stronger estimates are ultimately realized, valuations will start to come down from the stratosphere. It would take significantly more earnings growth even to approach historically normal levels, however, if stock prices should remain at current levels.

Analysts quite consistently overestimate earnings a year or two in the future, then reduce them gradually as the actual quarter approaches. The stronger earnings forecasts for the fourth quarter and beyond may be problematic in light of the earlier noted unanimity of economic forecasts for minimal GDP growth over those same periods of time. Far more often than not, earnings and economic growth parallel one another, so it is likely that either the economy will be stronger than forecasted or earnings will disappoint.

When faced with the question of how aggressively to invest, the investor is left to analyze whether voters or weighers are likely to prevail in the quarters immediately ahead. As described earlier, voters have clearly dominated since October. Sentiment readings, which are contrary indicators at extremes, have reached levels of bullishness last experienced at the market peak just before the 2022 bear market began. Nonetheless, there is no absolute limit to bullishness, and many talking heads on TV are extolling the virtues of AI and the prospect of better earnings in the quarters ahead. On the other hand, virtually all measures of valuation are at extremes, the Fed is still projecting higher interest rates for longer, and independent analysts anticipate subpar economic growth for the next few years. From a weighing perspective, a lower level of equity holdings seems appropriate. Voting and weighing are pointing in opposite directions. Each investor has to evaluate carefully his/her sensitivity to risk and how aggressive to be in an attempt to grow assets.

By Thomas J. Feeney, Chief Investment Officer