Market Review: The broad equity indices continued their ascent in the second quarter with the Standard and Poor’s 500 Index gaining 8.7%, the Russell 2000 Small Cap Index increasing 5.2% and the MSCI All World ex-US International Index rising 2.6%. The Bloomberg Aggregate Bond Index fell 0.8% and Gold fell 2.7%. Returns for the first half of the year were: S&P 500 16.9%, Russell 2000 8.1%, MSCI All World ex-US 9.9%, Bloomberg Bond 2.1%, and Gold 5.1%. The S&P 500 is now slightly above its level of March 2022 when the Federal Reserve initiated their rate hike program.
Climbing the Wall of Worry? At the start of 2023, the Bloomberg survey of 25 Wall Street strategists reflected a negative S&P 500 target for the first time since the survey was started in 1999. So far, the consensus is wrong as the post pandemic economy continues to outperform gloomy expectations. The Federal Reserve has not provided the boost as it has continued its tightening program with three rate hikes this year to a range of 5.0% to 5.25%. In fact, the futures market has pushed out previously anticipated rate cuts from the latter half of 2023 into 2024. The leading economic indicators have declined for fourteen consecutive months and are at levels associated with recession, and the yield curve is as deeply inverted (short-term bonds having a higher yield than longer term bonds) as it has been since the 1980’s, traditionally a harbinger of recession. These indicators await their efficacy as the economic data surprises to the upside. First quarter GDP was recently revised upward to a real growth rate of 2% and the Atlanta Fed’s GDP Now gauge points to a similar level of activity in the second quarter. Labor demand remains strong and travel, hospitality, and durable goods’ orders such as autos are all strong. While the odds of a “soft landing” are increasing, based on history, that would be truly threading the needle. Regardless, the market will have to adapt to rates being higher for longer.
The Mega Caps: It is impossible to review market performance without understanding the outsized impact of a handful of mega-cap growth stocks on the indices. The “Magnificent Seven” of Apple, Microsoft, Nvidia, Amazon, Alphabet (Google), Tesla and Meta (Facebook) generated 80% of the S&P 500’s return in the first half of 2023 by collectively increasing in market capitalization by $4 trillion. These seven stocks now comprise 27% of the S&P 500 Index (which is capitalization-weighted) with Apple and Microsoft making up almost 15%, a record for two companies. Apple’s capitalization is now larger than all the companies in the Russell 2000. Notably, the S&P Equal Weight 500 Index, where each of the 500 companies’ returns have the same influence, has a year-to-date return of only 7.0%, with all of the return occurring in the month of June as market participation broadened.
Portfolio Strategy: Our team has experienced many market cycles and this one is difficult to interpret, nonetheless we are comfortable positing that large cap growth valuations reflect very optimistic assumptions. The “Magnificent Seven” rallied despite the majority of them seeing negative earnings revisions for 2023, though the generative artificial intelligence hype train clearly gave a huge boost to these companies starting early in the second quarter. The economic and cultural impact of AI, let alone the companies that will most benefit, is likely a long way from being known. We will continue to look for opportunities to incrementally re-allocate from large cap growth to other investments if we believe it makes sense on an after-tax basis in seasoned portfolios. Currently, value stocks in the aggregate are historically cheap relative to growth stocks. Hedge fund and quant shop AQR Capital Management claims emerging market equities show their most attractive relative values in 25 years. With the higher interest rate environment and stabilizing inflation backdrop, money market funds and short to intermediate government bonds finally offer solid real returns (bond yields > inflation rate). There are more attractive categories to tactically allocate to than there have been in some time as we follow the economic trends and the resulting impact on corporate profitability.
We thank you for your continued support and welcome the opportunity to discuss the specifics of your investment strategy.