What Lies Beneath
After a topsy-turvy first quarter, stocks raced ahead during the second quarter as banking crisis fears subsided and the Federal Reserve paused their aggressive interest rate hiking campaign. In mid-March, the S&P 500 was nearly flat for the year after dropping 8% from its early February high. Since that point, stocks have surged and the popular broad stock market gauge is now up 17% for the year – its best first half finish since 2019. The tech-heavy Nasdaq experienced an even greater rally and closed out its strongest first six months since 1983.
The recent rally has seemingly caught many investors off guard. Coming into 2023, the average Wall Street strategist tracked by Bloomberg predicted a down market this year. That type of negative sentiment had not been seen in decades.
Not only that, but 2023 has already produced plenty of potential negative catalysts that could have or should have added to the sour sentiment. The Fed has hiked rates three times this year, with more increases likely on the way. Inflation remains sticky. The yield curve is more deeply inverted than at any point over the past 40+ years, a classic recession indicator. There was the aforementioned regional banking crisis, which included several of the largest bank failures the country has ever experienced. There was another testy debt ceiling showdown in Congress. A year-and-half following Russia’s invasion, the war in Ukraine is still escalating. Yet, none of this has seemed to matter to stocks.
However, a look beneath the surface tells a somewhat different story. The vast majority of this year’s S&P 500 gains have been driven by a handful of megacap growth stocks – primarily tech companies. According to research firm Strategas, the top ten names in the S&P 500 are responsible for 77% of the index’s gains this year. That is the second highest contribution by the top 10 stocks in a positive performance year ever (the top 10 stocks represented 79% of 2007’s 3.5% gain). Eye-popping returns from Apple (up 50%), Microsoft (up 43%), Amazon (up 55%), Nvidia (up 190%), Tesla (up 113%), Alphabet (up 36%), and Meta (up 139%) have masked the dearth of other stocks participating in the rally. According to Bank of America, only 25% of stocks outperformed the S&P 500 in the first six months of 2023, marking the narrowest first-half breadth ever.
The rally in many of these top names was inspired by the recent “artificial intelligence” mania. Artificial intelligence chatbot ChatGPT burst onto the scene late last year and quickly reached 100 million users in January, the fastest-growing consumer application in history. That drove significant investor interest in companies either developing or leveraging AI. For example, Microsoft is backing OpenAI – which created ChatGPT. Nvidia is a leader in providing computer chips and services that underpin much of what is transpiring in AI. Tesla is relying on AI in their pursuit of fully autonomous driving. You get the idea.
Despite the AI-driven mania, it should be noted that many of these top companies don’t necessarily look like bubble stocks of the past. They have real earnings, strong balance sheets, and realistic growth prospects. As a matter of fact, several of these stocks have become viewed as “safety plays” given the companies essentially print money and are sitting on billions of dollars in cash. That said, while these megacap firms are clearly healthy, they are not exactly cheap. The top 10 stocks in the S&P 500 currently sport a forward price-to-earnings ratio of 29.3 versus an historical average of 20.1. The S&P 500 overall currently has a forward p/e of 19.1 versus an historical average of 16.5.
All of this is to say that this year’s stock rally might not be everything that it seems.
So, What Does This Mean for Stocks Moving Forward?
We noted last quarter that our focus remains squarely on corporate earnings:
If the Fed is overly aggressive and the economy enters a recession, that will negatively impact earnings and likely stock prices. If the Fed is able to thread the needle, corporate earnings could show some resiliency and stocks should remain buoyant.
If stocks (and not just megacap stocks) are to continue ascending, earnings will be critical. According to FactSet, the S&P 500 is expected to see a second quarter earnings decline of -7.2%. If that actually occurs, it would mark the largest drop since the pandemic shutdown resulted in a nearly 32% earnings decline in the second quarter of 2020.
Companies continue to grapple with inflation and some have struggled in passing along higher costs to customers, who are fatigued after a parade of price increases over the past two years. Higher input costs and a weary consumer are not a recipe for earnings success.
While the rate of inflation has continued to come down, prices are still significantly elevated from where they were two years ago. Remember, even if the current year-over-year inflation rate is 4%, that does not mean prices are coming down. It simply means prices are going up at a slower rate! Inflation remains sticky.
As usual, any discussion on inflation brings us back to the Federal Reserve. The Fed paused their aggressive rate hiking campaign during the quarter. After hiking rates seven times last year and three times this year through May, the Fed refrained from an increase in June. With inflation coming down and lingering concerns over the health of the banking sector, the Fed decided to take a “wait and see” approach.
The Fed is attempting to orchestrate what is referred to as a “soft landing”. They want to kill inflation without causing a recession. While the market is currently pricing-in two additional rate increases the remainder of the year, it is clear the Fed is nearing the end of its rate-hiking cycle. Inflation is obviously heading in the right direction, but the focus now is on the health of the economy and whether a recession can be avoided. Dodging a recession will be critical to corporate earnings.
Chicago Federal Reserve President Austan Goolsbee recently told CNBC that he’s confident they can thread the needle:
“What the Fed’s overriding goal right now is to get inflation down. We’re going to succeed at it and to do that without a recession would be a triumph. That’s the golden path, and I feel like we’re on that golden path. So, I hope we keep putting off the recession to forever. Let’s never have a recession again.”
If the Fed can stay on that golden path, a soft landing should be supportive of corporate earnings and, therefore, stocks. That will be the focus of our attention the remainder of 2023.
Interestingly, those same Wall Street strategists mentioned earlier are more bearish than ever on the second half of the year – but we know how that worked out in the first half of the year. We will continue monitoring the Fed, inflation, corporate earnings, and any economic data pointing towards a recession.
A Brief Note on Bonds
With the recent Fed rate hikes, short-term U.S. Treasuries are now yielding over 5.5%. Investment grade corporate bonds are sporting even higher yields. We want to reemphasize that there is now “income” in fixed income. That can be a portfolio game-changer after years of paltry yields. Regardless of what may happen with stocks in the near future, the bond portion of a portfolio is now meaningfully contributing to returns. That should offer some confidence to investors moving forward, particularly retirees. Also, if you have money parked in a bank account yielding next to nothing, now is the time to consider additional options. There is no reason to leave 5%+ on the table.
As always, we remain long-term optimistic on the markets, but we will continue monitoring short-term risks – particularly on the stock side of the equation. Our team of advisors remains attentive and ready to answer any questions you may have on your portfolio or the financial markets.