What Did We See?
- U.S. Large Cap stocks, or the S&P 500 index, were up about 8.7% in Q2.
- The developed market of Japan was up about 14%.
- Europe and the U.K. were up about 3% and down about 1% respectively.
- Emerging Markets and Asia (Ex-Japan) were down about 1% each.
- Global fixed income returns ended the quarter up from about 1.5% to down about 2%
Where Do We Stand?
- The very strong Bear Market rally continued in Q2.
- Valuations are elevated (extremely in some cases) versus historic averages while earnings remain at risk.
- The markets will likely remain choppy from here as rallies validate bulls and pullbacks validate bears.
- We remain in a position to weather the volatility with positions in Gold and Cash while taking advantage of opportunities when they present themselves.
U.S. Large Cap stocks posted another quarter of very strong gains attributed to the outsized performance of only a handful of stocks. While the majority of Global markets (and much of the U.S. Markets) experienced muted returns, the largest growth stocks (i.e.: mega cap tech) performed so well that overall equity indexes here in the U.S. looked much better than others.
The outperformance has been supported by the fact that the rise in unemployment that many believed would manifest itself in the first half of 2023 has yet to materialize. Furthermore, optimism around inflation taming and a more dovish Federal Reserve afforded market participants the green light to flood into a select group of securities. With valuations on some risk assets at multi-year highs the overriding question now is whether or not the current markets have missed the “forest for the trees”. Certainly, the Fixed Income markets are acting as if they have.
Recession Countdown
We are now heading into the most anticipated recession in all of history. As we came into 2023, the consensus prediction for “early 2023” was that the US would be in a recession and markets would be lower. As the first half of 2023 came to a close, that prediction officially become a bust. The recession has not materialized and the stock market is actually up almost 17%. On the surface it looks like we have dodged the bullet of recession and everything is going back to normal. However, the devil is always in the details.
Historically, expansions end and recessions begin by following a somewhat typical pattern. First, housing peaks and begins a confirmed decline. Then, orders for goods start to dry up. Coincidentally, the yield curve inverts and finally, employment, income and spending fall in succession. When all that happens, corporate profits decline and the market follows or anticipates this decline.
This time around we have realized most of the ingredients for the recession recipe. Existing home sales peaked in late 2020 and have fallen by a third since then. New orders for goods peaked last June. Coincidentally, the yield curve inverted at about the same time (July 2022) and is now one of the most inverted we have seen in our lifetimes.
Employment, Income and Spending
These last three ingredients for a recession have either begun to be realized, or likely will be soon. Employment, while seemingly holding up (if you follow the headlines) has begun to start showing some cracks. Initial unemployment claims have been slowly ratcheting up over the last few months. Credit card balances have grown at the fastest pace in at least 20 years while the cost of that debt is now at multi-decade highs. This is likely due to higher inflation not being surpassed by higher incomes and families being forced to use debt to support the same level of goods and services. Or it could be that people without work are beginning to rely on credit until they become employed. Coincidentally, consumer credit card delinquencies are rising.
Looking forward, we see no silver linings for income and spending. Student loan repayments are set to begin again in September. The deferment of student loan payments has accounted for about 2/3 of the real growth in personal spending over the past year. That spending will be replaced with loan repayments to some degree over the coming months. Loan repayments do not drive the consumer economy!
Furthermore, the Treasury has been withdrawing liquidity due to the most recent debt ceiling showdown and will continue to do so throughout the year. Much like a sinkhole, these next things happen slowly then at an every increasing pace as the sinkhole feeds on itself.
The Spending Sinkhole
Those ingredients of employment, income and spending have a way of feeding on themselves both to the upside and the downside. As employment comes down, incomes contract leading to lower aggregate levels of spending. This reduced demand causes companies to reduce their own capital spending, including reducing headcount. We have already seen companies boost temporary employment in anticipation of this because it is easier to reduce temporary workers if demand wanes. All of this further erodes employment, income and spending and the cycle repeats. Until it finds a balance between demand and spending, or the Fed steps in with rate cuts to slow it. However, with inflation still a problem we don’t see the Fed cutting rates for some time.
Liquidity Sinkholes
With interest rates at 40 year highs, inflation still well above the Federal Reserve’s target and the government issuing $1Trillion (with a T!) in bonds over the remainder of 2023, liquidity is poised to disappear. This is important because it is liquidity that drives stock prices. It is liquidity that drives lending. It is liquidity that drives corporate spending patterns. Without ample liquidity all these things begin to dry up.
Further eroding liquidity is interest rates sitting at 40 year highs (meaning less people/companies borrowing) and the potential for bank capital requirements to go up. With the recent failures of several large banks this is a strong possibility.
Profit Sinkholes
All of this leads down to what matters in investing. How are the companies you own doing and how will they fare going forward? With reduced spending (see above) we are likely to see some real volatility around earnings in the near term.
Earnings have not been as front of mind for the market as they should have been be for the last few years. With the massive liquidity inductions into the economy from our collective Covid experience, many companies have looked artificially great. With no concerns over corporate profits the last few quarters, the markets could focus on the Fed and try to anticipate when the rate hiking cycle would end.
We are getting very close to that time when markets stop looking solely at every gesture the fed makes. When the Fed becomes less of a factor, participants will need to start looking somewhere else for information to react to. If earnings matter more again the markets could be in for a rude awakening. It will be the companies with strong balance sheets and earnings prospects that survive.
Super Concentrated Sinkholes
No we’re not talking about Orange Juice here although it could be a metaphor for the markets. The returns we have experienced this year are some of the most concentrated returns we have ever seen. Meaning, the drivers of the great first half of 2023 have been limited to only a handful of names. That does not speak to a healthy market. So, even though the indexes that the average investor looks at may show a second quarter return in the 6% to 8% or more range, the average investor likely did not experience that.
In fact, more than 95% of this years gains in the large cap index came from merely 10 stocks. This is a very dangerous behavioral sinkhole for investors. It may cause people to begin to chase returns by buying only those stocks. With some of these companies trading at extremely ridiculous valuations, I would advise against this. It usually doesn’t end well when you buy a company trading at 200 times trailing earnings.
The Waiting Game
As I have said numerous times over the past few quarters, our portfolios have a lower than targeted level of equities. We have replaced some of this equity allocation with short term treasuries (now paying a nice yield) and a small position in Gold. This has limited our portfolio returns in the short term in favor of being prepared for any major downturns. We are interested more in protecting and growing wealth than buying or holding companies at extreme valuations.
Should the time come when the recession is upon us, earnings have declined, the Federal Reserve has sufficiently contained inflation and we can buy great companies at great prices again we will do so. That day is not here yet. Expectations remain disconnected from reality and this will take some time to correct itself.
If you have any questions or have experienced any changes in your financial situation please do not hesitate to Contact Me.
We appreciate you being a part of the Shorepine Wealth Management family!
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