A.I. and the Magnificent Seven
As we pass the midway point of 2023, we would like to share our perspectives on what occurred in the markets in the first half of the year as well as share our outlook for the last half (and beyond). The prospect of lower interest rates and continued economic growth, thanks to continued robust consumer spending, provided support to the markets. Also contributing to the strength was government backing of the beleaguered banking system, injecting further liquidity into the economy and helping prop up markets during a tumultuous time. Equity markets rebounded strongly from the challenges experienced in 2022. The Nasdaq had the best first half of a year in its history, climbing 39%, while the S&P 500 gained 16%. Gains were primarily driven by a small handful of stocks (a.k.a. “The Magnificent Seven”) – Alphabet (Google), Amazon, Apple, Meta (Facebook), Microsoft, Nvidia, and Tesla. Much of the force behind the moves higher was based upon speculation on the prospects of Artificial Intelligence (“A.I.”). The strong outperformance of these seven stocks propelled indices higher since collectively they now comprise well over one-quarter of the S&P 500 Index. It was not until June that the other sectors of the market began to play catch-up and also participate in the gains. A stock portfolio not owning these particular names, especially in such large relative amounts, would have significantly underperformed the indices. This also led to many active strategies underperforming passive strategies. It is for this very reason this reverse could occur in the second half of the year; if these stocks underperform the broader market, actively managed strategies will outperform.
Many of this year’s best performers are now trading at high, but not necessarily absurd, valuations above historical averages. From a fundamental analysis perspective, it would be difficult to justify purchasing certain stocks at these levels since these valuations seem stretched even if the most optimistic projections do come to fruition. In some ways, the current environment is slightly reminiscent of the dot-com bubble of the late 1990s, in which former Fed Chairman Alan Greenspan referred to escalated asset values as being “irrational exuberance.” When it comes to investing, timing can be everything. Greenspan’s comments were eventually proven to be correct, however asset prices did not fall until more than three years later and in the meantime, gains in the stock market were plentiful. Today, momentum continues to drive markets, especially the aforementioned stocks, and momentum, either positive or negative, is difficult to stop or reverse.
Inflation and the Fed
Inflation has been slowly decelerating but remains persistent and above the Fed’s stated comfort zone. After a series of 11 consecutive interest rate hikes the Federal Reserve decided to pause in June and keep rates steady, however they have indicated they anticipate raising rates at least two more times this year. Even though they are signaling future hikes, the Fed does appear to be nearing the end of the current rate hike cycle. We could see a pattern of single quarter-point rate hikes followed by pauses to allow the Fed to assess monetary policy lag until they deem the job is finished and inflation is fully under control. When the Fed does decide to fully stop, it seems likely interest rates will be held “higher for longer” and will take some time before being lowered. One concern is that inflation, as measured by the government, could again accelerate, spurring further Fed action. Data shows that inflation peaked in June of last year with subsequent months showing continuously lower levels of year-over-year price changes. Now that the high readings of 2022 are more than a year in the past, future readings will be compared to 12 months prior when inflation was more subdued, increasing the probability of higher readings. Conversely, a worse than expected recession could spur the Fed to lower rates sooner than expected, but this is not an ideal scenario and would coincide with markets reacting unfavorably to economic data. If a recession is avoided in the short term and employment remains robust, which it has thus far, the Fed will see no reason to stop the current campaign. It should be noted that unemployment tends to trough, or reach its low point, at or near the beginning of a recession and then as the recession takes hold, jobs are cut, causing unemployment to spike. Unemployment continues to sit near multi-decade lows, so any inference that we are not in a recession because of the strength of the labor market is a faulty argument.
Soft Landing or Recession???
In addition to interest rates, corporate earnings are the other main factor driving the stock market over the long-term. Earnings are expected to drop compared to a year ago as inflation continues to pressure margins. We may already be in the midst of an earnings recession (not to be confused with an economic recession). According to FactSet, the S&P 500 is expected to show a year-over-year earnings decline of 6.8% for the second quarter of 2023. Interestingly, earnings per share estimates declined during the quarter while the S&P 500 Index rose. Increased probabilities of a soft landing coupled with the prospect of lower interest rates overcame lowered earnings expectations to push markets higher. This may not be the case going forward; lowered earnings coupled with higher interest rates could become a major headwind for the markets and derail the recovery.
Just about every Wall Street analyst has predicted a recession over the past year, but we have yet to see one. Are these analysts being too pessimistic or has the timing been off? One school of economic thought is that the supply of money is a clear cause of inflation. During the COVID pandemic we experienced the largest-ever expansion of the money supply through government stimulus programs and very loose monetary policy from the Fed. The stimulus payments have driven strong consumer spending, helping to prop up the economy over the past two years. When the stimulus money runs out, spending will return to normal levels and no longer provide as much support for economic growth. More recently, higher interest rates and tighter bank lending standards have shown signs of reducing the money supply and historically contractions in money supply lead to a recession. However, this seemingly has been the most anticipated and predicted recession of all-time so perhaps the bad news has already been priced into the stock market.
If you have been invested in the stock market you have most likely enjoyed rather robust gains this year, but you missed out if you are sitting on the sidelines. We would recommend not trying to chase the current trends as it may be too late, but instead look at investing in a well-diversified portfolio. We do not necessarily think a pullback is imminent, but rather see a slowdown with the “easy money” having already been made and gains being more difficult to achieve going forward. We expect returns to be more muted in the second half of the year. While we might sound pessimistic, we do not expect a major downturn but more of a levelling off in the market and do remain optimistic regarding certain sectors and strategies. With the prospect of more muted gains, dividends could play a larger role in overall returns. This is a good time to consider other investment alternatives and look beyond the traditional stock/bond portfolio. Given the outlook for more modest market returns and further market volatility, it may be wise to consider protection strategies. Many of these strategies provide potential for growth or income should the markets continue to rally but there is also downside protection should they fall. Risks certainly exist, as they always do, which have the potential to drive markets lower. It is also a good time to remind ourselves that markets do not always behave logically and rationally.
Despite what happens in the second half of the year and whether our outlook proves accurate or not, we would like to remind everyone that investing is a long-term proposition. You should only invest money you do not plan on spending in the short term so you can ride out market fluctuations over longer periods of time. Looking forward, we see challenges with returns possibly being less than we have experienced in recent memory while inflation remains persistent, chipping away at purchasing power.
While both optimistic and pessimistic investors are due to be right often enough to boost an ego, at least in the short-term, we feel a better approach may be to focus less on the funds invested for long-term wealth accumulation, and more on a comprehensive plan built around a spend in confidence, pay taxes consciously approach, we feel you will be rewarded with a comfortable retirement. We will continue to monitor the markets as we always do, making changes in portfolios when warranted, but we view our primary role for our clients being to ensure that the wealth accumulation from investment markets supports a well-designed retirement plan. To discuss your individual situation or learn more about some of the strategies we are currently implement do not hesitate to contact us. Our goal is to help guide you towards a Secured Retirement, regardless of what the next six months of 2023 provide in the financial markets.
We hope you are having a great summer!
Nathan Zeller, CFA, CFP®
Chief Investment Strategist
Please contact us if you would like to review your individual financial plan or learn how the TaxSmart™ Retirement Program can help you.
Office phone # 952-460-3260