Market Commentary - July 2023
“Be a goldfish.”
—Coach Ted Lasso
For those seeking a remedy for challenging news headlines and dystopian movies, look no further than Ted Lasso, streaming on AppleTV+ (from Apple, a core WCF holding). Jason Sudeikis wrote, produced, and stars as an inexperienced English soccer club coach from Kansas. What Ted lacks in technical expertise (pretty much everything), he compensates for with a keen understanding of people. After a tough loss, Coach Lasso, sensing that his players are down, suggests they “act like goldfish.” When asked why, Lasso informs the players that goldfish have 10-second memories. They do not dwell on the past.
Has the stock market embraced that advice?
Stock prices are the product of both expected company earnings and a multiple applied to those earnings. This multiple is mostly a function of interest rates, which are affected by government monetary policy. All else equal, the higher the interest rate, the lower the multiple. In turn, corporate earnings are impacted by government fiscal policy: regulation, spending, and taxation. Let’s consider the recent direction of these influences.
Unemployment was expected to be up to 4.5% by the end of 2023 by the Federal Reserve Board. (1) Though up modestly from the 3.4% low reached in April, the current unemployment rate of 3.7% falls far short of the Fed’s expectations. (2) Wage pressure remains one of the most stubborn sources of inflation.
Inflation targets from the Fed were down 3.6% by the end of 2023. (3) The latest print points to 4.05%, suggesting more work for the Fed, given their frequently stated goal of bringing inflation down to 2%. (4) The Fed has no microsurgical instruments available and depends instead, on the crude tool of raising interest rates.
Interest rates have increased ten times in this cycle–taking the Federal Funds Rate to 5.07% from 1.58% one year ago. (5) Impacts include higher mortgage expenses, an increase in the cost of capital for business, more competition for stocks, and a higher discount rate applied to future streams of cash flow (mathematically reducing the value of assets—especially longer dated). Yes, the Fed did “pause” in June, but the financial markets expect increases to resume next month. (6) Three major banks failed this year, indirectly tied to the spike in interest rates. (7)
The economy continues to slog forward but has experienced two consecutive quarters of slowing growth. (8)
The inverted yield curve demonstrated in the chart below has historically served as a warning signal of a pending recession (the gray bars). (9)
Earnings on the S&P 500 were originally projected to reach $228 for the calendar year 2023. (10) The current estimate of $219 represents both a disappointment and uninspiring growth of less than 1% growth from 2022. (11)
To summarize, the economy is slowing, short-term interest rates are rising, and earnings are disappointing. So, we would not have been surprised if the stock market had faltered in 2023, except the S&P 500 instead is up more than 15% for the past six months.
Why? We can identify three specific reasons.
First, the index is misleading. The graph below depicts two widely divergent experiences, yet both consist exclusively of the five hundred companies that make up the S&P 500. (12)
The purple line tracks the performance of owning each of the five hundred constituents in equal portions. The yellow line depicts the actual function of the S&P 500 Index, where the larger the market capitalization (size) of the company, the greater the weight in the index. The market cap weighted index is up almost three-fold compared to the performance of the equal weighted index. To put this into perspective, Apple, the largest company, represents 7.6% of the entire index. That means Apple influences the index more than the cumulative movement of companies 20-30. Names in this group include Merck, Costco, Coca-Cola, and Walmart. The bottom one hundred companies have little influence on the index performance despite including companies such as Coors, MGM Entertainment, Juniper Networks, and Campbell Soup, for example.
The weighting issue is not in isolation. The biggest catalyst for the stock market in 2023 has been the fervor surrounding A1—artificial intelligence. Consider the following:
- The top 25 companies in the U.S. based on size, were up 25.3% YTD.
- 5 of the top 7 companies have direct ties to AI, including NVDIA, that has doubled this year.
- Elimination of the top 7 biggest, leaving the other 18, would reduce the YTD return to exactly 0% instead of 25.3%.
We want to be explicit here. Seven of the five hundred companies in the S&P 500 have driven the index returns this year.
Finally, Ted Lasso’s goldfish story applies to the stock market. The stock market not only forgets the recent past, but it really never cares much about it either (except as a source of lessons learned). The market is about the windshield, rather than the rear-view mirror.
The economy, despite the friction created by the Fed, bank failures, and the inverted yield curve, still demonstrates resilience. The Fed’s own model estimates real GDP growth (seasonally adjusted annual rate) in Q2 of 2023 at almost 2.0%. (13) Consumer confidence, as measured by the University of Michigan survey, jumped up 8% in June. (14)
Moreover, the massive fiscal stimulus bills that have passed since the pandemic will soon lead to spending on new semiconductor facilities and clean energy projects.
In other positive news, the U.S. recently managed to avoid a debt ceiling crisis. Although the inflation news on June 30 was better than anticipated, as discussed earlier, financial markets expect the resumption of interest rate hikes. The Fed operates primarily through short-term maturities and has much less influence on interest rates for longer dated securities. (15); (16) In fact, the 10-Year Treasury which peaked in the current cycle at 4.25% last October, is now hovering closer to 3.8% at the halfway point of the year. (17) The interest rates on many loans in the economy are directly tied to the 10-Year Treasury, implying mortgage rates may have peaked. Earnings on the S&P 500 are projected to reach $245.73 next year, representing 12% growth if achieved. (18)
There are lots of moving parts and lots of uncertainty but, for now, it appears a better investing environment may be seen through the windshield than through the rear-view mirror.
FOMC vs FOMO
FOMO, or the fear of missing out, can accelerate an upward moving stock market, creating MOMO, or momentum. Any enthusiasm for jumping in might be tempered by the fact that the FOMC (Federal Open Market Committee), according to the financial markets, is likely to resume hiking short-term interest rates. Investors can earn 5.4% today in a completely safe one-year U.S. Treasury Note. Rolling over one-year Treasuries may not represent a viable long-term investment strategy for most people, but it does represent a safe harbor. What happens if those short rates continue to rise? Would that dynamic serve to siphon money out of the stock market?
In addition, the $245 in projected earnings for next year values the S&P 500 at 18 times—well above the historical average of 15.7 times. This math suggests one of two outcomes: either actual earnings will exceed the current forecast or future market returns could disappoint.
Going forward, WCF will take advantage of attractively priced short-term Treasury Notes. We will continue to allocate some of your equity capital to both small cap U.S. stocks and foreign equities. Within the S&P 500, we will not cave in on our price discipline and pay 100 times earnings for NVDIA, even at the cost of missing out. NVDIA, according to a recent report, has a similar valuation to some of the 2000s largest Dot Com Boom beneficiaries, many of which cratered. (19)
Or, as Ted Lasso once said, “A palace made out of crystal seems mighty fragile to me.”
- “Fed projects jobless rate to reach 4.5% by end of 2023.” The Hill; March 22, 2023
- “News Release;” Bureau of Labor Statistics; June 2, 2023
- “FOMC Projections.” Board of Governors of the Federal Reserve System; March 22, 2023
- “Consumer Price Index Summary.” U.S. Bureau of Labor Statistics; June 13, 2023
- “Effective Federal Funds Rate.” Newyorkfed.org; June 26, 2023
- CME FedWatch; June 27, 2023. Currently assigning a 76.9% probability that rates will rise again in July.
- “Bank Failures in Brief – 2023”. June 27, 2023. Failures include First Republic, Signature Bank and Silicon Valley Bank.
- GDPNow; Federal Reserve Bank of Atlanta; June 27, 2023
- YCharts.com; West Coast Financial
- “The History Lesson.” Morgan Stanley; January 10, 2023
- Yardeni Research; June 26, 2023; 2022 actual earnings on the S&P 500 were $218.19.
- YCharts.com; West Coast Financial
- GDPNow; Federal Reserve Bank of Atlanta; June 29, 2023
- “US Consumer Confidence Improved Substantially in June.” The Conference Board.org; June 27, 2023
- “Fed’s Preferred Gauge Shows Lowest Annual Inflation Since April 2021. Wall Street Still Expects Rate Hike.” Barron’s; June 30, 2023
- CME FedWatch; June 27, 2023. Currently assigning a 76.9% probability that rates will increase again in July.
- Bloomberg.com; June 29, 2023. The yield is 3.83% today.
- Yardeni Research; June 29, 2023
- “The Dot Com Boom highlights the risk from high investor expectations.” Goldman Sachs; June 10, 2023