In our January letter, we wrote that there were reasons to believe happier times could be in store for investors in 2023. So far, that has been the case with the S&P 500 Index and Barclays Aggregate Bond Index up 17% and 2%, respectively, through the first half of the year.[1] This follows a painful 2022 when both indices were down double digits.
The S&P 500 confirmed a new bull market on June 8, 2023 using the standard definition of a 20%+ rally that was preceded by a decline of 20%+ on a closing basis.[2] What’s more impressive is that the stock market shook off plenty of bad news such as bank failures, US recession fears, lackluster China reopening, Debt Ceiling negotiations and rising rates. Needless to say, this has been a complicated first half of the year. So, how did we get here despite plenty of negative headlines?
As we’ve written previously, inflation and the Federal Reserve’s response have been the primary driver of markets. 2022 was a year when the Fed was late to attack inflation and both stock and bond markets were playing a game of catchup in adjusting to the aggressive response. In our opinion, Federal Reserve policy remains the biggest driver of where markets will go. However, things are different this year.
If you listen to Fed officials, certain news outlets or politicians, inflation remains a major problem. Even with a meaningful easing of inflation pressures, the risks of an upside rebound are cited as a reason to be skeptical. Looking at the data, it’s hard to be skeptical. Virtually every survey of inflation expectations for businesses and consumers shows pricing pressures easing. Regional Fed surveys of both the Manufacturing and Services sectors show that both the Prices Paid and Prices Received components have been falling rapidly. This comes in tandem with the year over year price of crude oil and gasoline down 40% and 23% as of May 31.[3] The difference between last year and this year lies in the data and the data gives plenty of evidence that the Fed is nearly done with this tightening cycle.
Stocks and bonds have reacted accordingly with positive returns in the first half of the year, but there’s a caveat. This year’s stock market rally has been reminiscent of previous rallies where index
returns have been driven primarily by the largest constituents. Big Tech has been the clear leader this year, likely attributed to 1) anticipation of the Fed being close to done, 2) a flight to safety during the regional bank crisis and 3) the buzz around artificial intelligence.
A market in which a handful of stocks are driving performance is often called a “narrow market” and greeted with a healthy degree of skepticism. This is something we highlighted as a caution flag in last quarter’s letter. Without getting into the nuance of whether narrow markets mean unhealthy markets, we would say that broad market participation would give us more conviction in this recent rally. As seen in the chart here, seven companies contributed to the bulk of the S&P 500’s returns in the first half.
We would agree with skeptics in saying that it would be hard for the market rally to remain sustainable if only a handful of the largest stocks were doing all the work. However, in June we saw signs of the stock rally broadening beyond just Large-Cap Growth companies. For example, Large-Cap Growth stocks surged 20.8% in the first five months of the year, while Large-Cap Value (-1.4%) and Small Cap (-0.1%) were negative. Reassuringly, June saw Large-Cap Value (+6.6%) and Small-Cap (+8.1%) rally.[1] We believe that markets that resemble June, with broad participation, are necessary for the sustainability of the new bull market we’re in. Let’s also not forget that the US isn’t the only Bull Market. Japan is in the third longest Bull Market in its history, while India, one of the fastest growing countries in the world, is in another bull market.[2] We continue to believe that there are global opportunities for stocks.
What could go wrong? There’s always a lag between interest rate increases and the slowing of the economy. Has the Fed done enough to solve our inflation problems? Or have they done too much? The yield curve remains massively inverted, continuing to signal recession.[1] Tighter lending standards resulting from the regional banking crisis are a legitimate concern as access to credit is the lifeblood for small and medium-sized businesses. Finally, let’s not forget that stocks, for the first time in years, have legitimate competition from a 2 Year US Treasury bond yielding 5%.[2]
While our crystal ball can be foggy, we continue to rely on our process and believe that price often leads fundamentals. This is especially pertinent when the economic signals are mixed. Markets will be focused on economic growth and how it has measured up to past and current expectations. Markets tend to respond positively to outcomes better than expectations and vice versa. If the economy continues to see a resilient jobs market, falling inflation and steady consumer spending, we expect the stock market rally to continue. So, while we’re not waving the “all clear” flag, we’re optimists who tend to focus on what is going right rather than what could possibly go wrong.
As always, please don’t hesitate to reach out to us with any questions or concerns. We’re grateful for your continued trust in us and we hope you have a wonderful summer.
Jack Piper
Founding Partner & Portfolio Manager
[1] Thomson One 7/1/2023
[2] Bespoke Report 6/23/2023
[3] Bespoke Report 6/23/2023
[4] Dynasty Financial Partners Market Outlook – Morningstar & Bloomberg 7/7/2023
[5] Dynasty Financial Partners Market Outlook 7/7/2023
[6] St. Louis Fed 7/7/2023
[7] Charles Schwab 7/7/2023
Disclosures
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This information should not be considered investment advice. Opinions expressed reflect the judgment of the authors and are current opinions as of the date appearing in this material only. While every effort has been made to verify the information contained herein, we make no representation as to its accuracy and it should be regarded as a complete analysis of the subjects discussed. All investing involves risk, including the loss of some or all of your investment.
Past performance does not predict future results.
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