October 24, 2023
The first half of 2023 saw strong returns from a very small set of very large companies. The question market watchers asked leading into the 2nd half of the year was, “Can these stocks continue to carry market returns higher on their own?” Apple, as an example, is up about 36% year-to-date and now is worth more than the entire United Kingdom stock market! Microsoft is not far behind. And while the “Magnificent 7” of Apple/Microsoft/Tesla/Facebook/ Google/Nvidia/Amazon have continued to account for almost all of the S&P 500’s positive return for the year, in the third quarter the momentum of those stocks did slow down a bit. This is welcome at Cutler, as we look for positive contributions from other asset classes such as value stocks, international stocks, and fixed income for example. What took their place as market leaders? The Energy sector led all returns by a wide margin, very reminiscent of 2022 when that sector lapped the field while all others struggled.
Why this change in leadership? The biggest market influence continues to be the Federal Reserve, who indicated a bias of “higher for longer” rates. This makes investors risk-averse, and some of those lofty valuations from the Artificial Intelligence craze (i.e., NVIDIA) look a lot riskier as rates continue to push higher. Oil, specifically, has benefitted from a stable economy, OPEC cuts, and as of late, global instability. The escalation of war in the Middle East will continue to have investors thinking about how much risk they have in their portfolios.
As is often the case, investors do not lack reasons to sell stocks. Leading Economic Indicators (as measured by The Conference Board) have suggested for some time that a recession is on the way. Mortgage rates over 8% are likely to continue to depress the housing market, and commercial real estate remains largely vacant in a post-Covid world. The Fed feels that persistent inflation is sufficient for continued hawkishness. Geopolitics are once again front and center, and a US government shutdown still seems like a likely outcome. And yet, the resiliency of stocks is shown with the S&P 500 up 13.07% year-to-date. This demonstrates the futility of trying to “time the market.” Yes, there is plenty to worry about, but the stock market prices in future growth, and less so current negative news stories.
As we look ahead, what are the key questions we will be asking with regard to the markets? We’ve tackled a few of these below:
Growth stocks have been significant market leaders this year, up almost 25% year-to-date. Much of this has been a recovery from last year’s steep losses, while Growth stocks have also benefitted from the Artificial Intelligence boom. AI has great potential and will change the way we work and operate. It also isn’t a technology that is “far off”- with applications being rolled out in real time. That being said, the monetization of this technology is not yet realized, and investors are paying a steep price for this potential. With the risks highlighted above, we think investors will be best served by looking at cash flows and valuation. Chasing the latest market darlings has often proven to be a strategy that can have negative outcomes for investors. We would suggest maintaining current exposures to Growth, not adding more at these levels.
Cutler advocates an income-based philosophy, and higher rates can be a headwind for dividend stocks. Because much of the return from dividend stocks is from a “fixed payment”, they have attributes that correlate to bonds. With higher rates, investors may rotate into the higher coupons of bonds. Persistent inflation has recently led to a substantial rise in the 10-year treasury which recently crested over 5.0%. Stocks have sold off as investors rotate into these yields that are near multi-decade highs. Currently, the Fed Futures market is forecasting rates to remain at current levels until at least June 2024 and then to steadily decline from there. We view this scenario as unrealistic, however. The more likely scenario in our view is more of a crisis management Fed, with rates remaining high and then dropping more aggressively. We believe that when the Fed is motivated to cut rates, they will likely do so in response to market stress as has been the approach for the past few decades. This would benefit longer-term bond prices, and we are thus recommending extending duration at today’s prices.
The yield curve inverted, which is an often-cited indicator of a future recession, in July 2022. Other leading indicators also point to a negative picture. One well-regarded index provider stated, “With August’s decline, the US Leading Economic Index has now fallen for nearly a year and a half straight, indicating the economy is heading into a challenging growth period and possible recession of the next year.” (Justyna Zabinska-La Monica, Senior, Manager, Business Cycle Indicators, at The Conference Board.) Yet, despite this trend unemployment remains low and jobs growth has been strong. Because of this confluence of data, many hope that a recession will be mild, the often cited “soft landing.” This goldilocks scenario would allow inflation to continue to moderate, leading to a possible gradual interest rate decline. While Cutler views this as a possible outcome, we do believe investors should also prepare for a sharper contraction should the risks shift toward a stronger recession. Again, this scenario favors positioning toward value stocks, longer bonds, and diligent portfolio diversification.
Outside of the mega-cap trade, the markets have been fairly muted this year. Large Cap Value stocks are up 1.79% through the 3rd Quarter. Mid Cap stocks are also positive, up 4.27%. Small Cap stocks? As measured by the Russell 2000 index, they are up a modest 0.81% year-to-date. Perhaps not surprising as Small-Cap indexes hold a higher number of regional banks that have borne the brunt of today’s higher rate regime.
The performance of international has once again showed modest strength. The “equal weight” Developed Market index has outperformed its U.S. comparative thus far this year, demonstrating the outsized influence of the Magnificent 7. The MSCI EAFE (the broad developed market stock index) has returned a respectable 7.59% through the end of September. These markets continue to broadly trade at far lower valuations than our domestic US indexes and provide a higher dividend yield. They also have far less concentration risk than our very top-heavy S&P 500 index, which can help to smooth out returns if any specific industry shows weakness. The U.S. dollar has continued to be strong on the backs of the rising rates here at home, suggesting that any reversal of rates may also provide a tailwind for client’s non-U.S. positions.
Fixed Income was broadly negative for the quarter, with investors pulling in on duration and looking to reduce their risk exposure. We are in the midst of an unprecedented third straight year of negative returns for the Aggregate index. And one of these years, 2022, bonds were down over 13%! Our continued advocacy of short-term bonds has been beneficial, as longer-term bonds have sold off the most. But today’s rates are enticing, and while we do not see a need to push far out on the yield curve, we do believe there is upside in reducing short-term bonds (or money market funds) and extending into positioning more closely mirroring the Aggregate Index.
Commodities were again a mixed bag for the quarter. Oil futures saw a large spike in price, driven by stable demand and reductions in planned output from specific OPEC providers. Meanwhile, gold was down over 4% for the period and is barely above flat for the year to date. The reputation as an inflation hedge continues to be a dubious one, at least in this current inflationary period. Bitcoin saw more selling pressure after weakness in Q2, and price continues to be driven as much by regulatory/taxation, as it is by investor interest and relative price. Rumors of a domestic Bitcoin ETF have been closely watched by crypto investors. While these types of holdings can add value in particular time periods, the high volatility measures make them difficult to recommend as unique holdings within a diversified client portfolio.
These blogs are provided for informational purposes only and represent Cutler Investment Group’s (“Cutler”) views as of the date of posting. Such views are subject to change at any point without notice. The information in the blogs should not be considered investment advice or a recommendation to buy or sell any types of securities. Some of the information provided has been obtained from third party sources believed to be reliable but such information is not guaranteed. Cutler has not taken into account the investment objectives, financial situation or particular needs of any individual investor. There is a risk of loss from an investment in securities, including the risk of loss of principal. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will be profitable or suitable for a particular investor's financial situation or risk tolerance. Any forward looking statements or forecasts are based on assumptions and actual results are expected to vary. No reliance should be placed on, and no guarantee should be assumed from, any such statements or forecasts when making any investment decision.
