“Nothing is ever as good or as bad as it seems” – Scott Galloway
Welcome to fall! While most of us in Maine are sad to say goodbye to summer, stock investors are happy to flip the calendar from September to October. True to form, September lived up to its reputation as a bad month for stocks with the S&P 500 falling 4.7%.1 A weak September in the stock market is historically textbook but the surge in Treasury bond yields has made it yet another treacherous year for bond investors.
Anecdotally, this is one of the most data-dependent markets we’ve seen in recent memory. With investors extrapolating each datapoint, attempting to forecast what the world will look like years from now, we’ve seen wild swings in prices. The most obvious example is the bond market all but abandoning its recession call with the yield on the 10-year US Treasury surging from 3.9% to 4.6% in the third quarter.2 The sharp increase has brought back the painful stock/bond correlation we saw in 2022 (Treasury yields up, stocks down). This was especially acute in the third quarter, as seen in the chart below showing year to date levels of the S&P 500 (purple) and US 10-year Treasury yield (orange).
Generally speaking, interest rates tend to move higher for one or both of the following reasons: 1) Inflation and/or inflation expectations are going up and 2) The economy is growing. At this point, we will rule out the inflation factor. By almost all measures, inflation has been falling steadily since June 2022.3
In our view, the Treasury market is pricing in a more resilient economy and, therefore, a Federal Reserve that keeps interest rates higher for longer. However, there are signs that the economy isn’t as good as it seems. Yes, unemployment remains below 4%4 but recession indicators such as high oil prices (crude oil rallied 25% in the third quarter)5, an inverted yield curve, risk of financial and geopolitical shocks, and a weakening consumer6 are signaling caution. With inflation cooling and some vulnerabilities in the economy, our thinking is that the recent surge in 10-year Treasury yields is likely an overshoot. While impossible to time the market, we could see the tide turning for bond investors after a brutal couple of years, with the Federal Reserve possibly cutting rates at some point in 2024.
As of this writing, we’ve passed the one-year anniversary of the bear market low from last year. Though the S&P 500 remains below its 2023 high in late July, we’re still up over 20% from the low on October 12, 2022.7 In that same time, the equally-weighed S&P 5008 returned only 11.8%.9 Good but not great. What this tells us is that we’re still in a “narrow market,” something we discussed in our last letter. As seen in the chart to the right, the S&P 500 is up just over 13% through the third quarter. However, most of those returns have come from only a few constituents.10
Clearly investors see few reasons to own the broader stock market, which seems fixated on what the Fed does next. We’ve said this previously and stand by it, broad participation on a stock and sector level will give us more confidence that this bull market is more sustainable. A narrow market eventually becomes a vulnerable market.
What are we paying attention to in the final quarter of the year that we haven’t mentioned yet? We’ve written quite a bit about the historical relationship between a weak US Dollar and stock returns in international markets. As the dollar substantially weakened in the 4th quarter of 2022, we saw international markets begin to handily outperform the S&P 500. As the US Dollar strengthened over the summer, international stocks started to give away much of that outperformance.11 The direction of the US Dollar will be a big driver of performance in international markets.
We’re also keeping an eye on geopolitics and Washington, DC. Markets typically view events in DC as mostly theatre rather than substance. However, the dysfunction in the House of Representatives has our attention. A House without a speaker has no immediate policy consequence but it puts the US in uncharted territory, as there is no historical analog. With the House in disarray and lawmaking at a standstill, the market could grow frustrated if this becomes a prolonged issue.
Finally, the events in the Middle East have been both shocking and tragic. Recognizing the elevated uncertainty of what will happen next, we expect the market, and particularly oil, to be sensitive to news coming out of the region. However, from a strictly market and historical perspective, geopolitical conflict is relatively unimportant to markets. The biggest risk to markets would be a broadening conflict into a regional war.
We ended last quarter’s letter by saying that “we continue to rely on our process and believe that price often leads fundamentals. This is especially pertinent when the economic signals are mixed.” This has not changed. Staying disciplined during times of uncertainty is what we pride ourselves on. There will always be good and bad news, but we don’t overreact, as nothing is ever as good or bad as it seems.
Please don’t hesitate to reach out with any questions or concerns. We’re grateful for your continued trust in us.
Founding Partner & Portfolio Manager
 Bespoke Report 9/29/2023
 Y-Charts 10/12/2023
 Bureau of Labor Statistics 10/16/2023
 Bureau of Labor Statistics 10/6/2023
 Dorsey Wright 10/6/2023
 The Conference Board 9/26/2023
 Bespoke 10/12/2023
 Invesco 9/30/2023 The S&P 500 Equal Weight Index, which consists of the same companies within the market cap-weighted S&P 500 Index but equally weights them (each company has the same weight of 0.20%), reducing concentration risk.
 Y-Charts 10/12/2023
 Bloomberg 9/30/2023
 Y-Charts 10/16/2023
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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.
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