Q2 2023 Commentary

One year ago, we were lamenting the worst first half for domestic equity markets in over 50 years.  The S&P 500 had lost more than 20% of its value over six months, contributing to the weakest start for a 60/40 stock/bond portfolio since 1932. By the end of the year, conditions had improved slightly, but domestic stocks still delivered the fourth worst year in the last eight decades. 

Tuning into financial media today, you would have no idea that we are coming off of one of the most tumultuous years in history.  Coverage is instead dominated by the new bull market, led by the Nasdaq, which just posted its strongest first half in forty years.  Any reference to the Nasdaq seems to omit that this historic rally has left the index lower than it was two years ago and 15% below its 2021 peak.  Similarly, the S&P 500 has only managed to gain 3.6% over the last two years and remains nearly 8% below its own 2021 high. 

Though it has been a rough two years for equity markets, you cannot blame investors for reveling in some relief. The economy just endured skyrocketing inflation and the most restrictive monetary policy in forty years. In that context, sitting within 10% of all-time highs is quite the accomplishment.

The rally of the second quarter built on the same fundamentals as the gains during the first: solid economic data and a Federal Reserve that seemed like it might actually engineer a soft landing. 

In last quarter’s commentary, I made the case that the three major bank failures were impactful enough to disqualify any resolution to the current cycle from being labelled “soft,” but so far, the rest of the data is fitting the bill.  GDP, ISM and PMI numbers continue show broad economic growth, and the labor market remains robust. 

Beyond the steady growth, markets have seen many “green flags” allowing optimism to supplant doubt.  The most encouraging progress has come from inflation data.  Year-over-year headline inflation peaked in June of 2022 at 8.9%.  The latest reading saw inflation slow to 4.1%, and the upcoming release (to be released between my drafting and your receiving these comments) is expected to show headline inflation falling to 3.1%.  As we have made clear in these comments before, markets can handle high inflation, but it is generally rising inflation that causes the most damage.  Stabilization alone was a positive for stocks, significant disinflation is a bonus.

The moderating inflation data (along with a smattering of weakening economic data) has allowed the Fed to “pause” rate hikes for the first time since beginning the inflation fight in 2022 – another major green flag for equity markets.  Though the Fed may have more work ahead of them, the historic rate hikes of last year (including four consecutive 75 basis point hikes) are behind us. The stabilization in rates provides a level of certainty not seen in 18 months. 

Perhaps the most tangible evidence of stabilization has occurred in the housing market. The housing sector had slowed significantly in the face of rising interest rates, but recent numbers show a sizable uptick in sales and a rebound in prices – implying that the housing market may have bottomed in January. The ability of the housing market to rebound in the current environment is an extremely encouraging sign for the broader economy.

Looking at the blend of stable/improving data, one might find the move in equities to be fully justified.  Better than expected data and a less uncertain economy should equate to higher stock prices, all else equal.

It is difficult to argue with the direction of stocks since their October lows.  It is easier to debate the magnitude of the move.

The rebound in the first half brought the Price/Peak Earnings ratio back above 22.  Price multiples that high have only been sustainable twice in history: in 2017 ahead of the most corporate-friendly tax cuts in history, and again in 2020, amidst the most aggressively stimulative monetary and fiscal policy in the history of our country. 

Today, the economy may still be benefitting from fiscal policy, but we are dealing with higher interest rates and hawkish monetary policy, and there are no further corporate tax cuts on the table. Our valuation concerns are backed by a recent report from the Federal Reserve, which notes that between 1989 and 2019, falling interest rates could account for all of the increase in P/E multiples, while lower rates and tax cuts have likely accounted for nearly half of real corporate profit growth.

Without recent or longer-term tailwinds, it becomes very difficult to justify today’s price multiples. 

Whether or not you are concerned with valuations, it is worth exploring cracks in the popular narrative.  Beyond the headwinds noted above, there are also signs that the balance between interest rates and the labor market has not yet reached equilibrium.  Though headline inflation is trending downward, core inflation has stalled in the 4-5% range – too high for the Fed’s comfort.  While employment data has been rather resilient, jobless claims have been drifting higher and June was the weakest month for job gains since December 2020 (amidst the first COVID winter).

Cracks in the narrative and headwinds are not necessarily enough to dissuade us from investing in this market.  The histories of strong rallies and bull markets are clear reminders that momentum is a powerful factor.  The magnitude of the rebound from last year’s lows has drawn may parallels that imply the next six months have a high probability of providing strong positive returns (and additional selling opportunities).  After more than a year of depressed sentiment and cash fleeing equity funds, there is plenty of capital to be lured back in by higher prices.

We do not typically defer to momentum in this way.  We entered the quarter anticipating significant risk reduction in the face of continued market strength.  Instead, across strategies, we ended the quarter with equity allocation targets only slightly lower than where we began.

For traditional, domestic accounts, most of our data sets have been encouraging us to raise additional cash, but the orderly nature of the move higher in Q2 has prevented stocks from becoming meaningfully overbought – a requisite technical signal before we reduce exposure.  Overbought conditions can develop rapidly, and if they do, we will almost certainly be reducing equity allocations.  If we do not see a selling opportunity arise, however, we remain confident holding a portfolio of high-quality stocks in this environment.

Without the ability to be as selective with quality names, our global ETF-based strategy has been more cautious.  These accounts have maintained a large cash allocation, while opting to hold a small basket of higher-beta funds. It would likely take a large pullback for ETF strategies to become more aggressive in the third quarter.

Finally, some clients who subscribe to the Drach Market Research weekly report have asked us about our approach to financial stocks. The latest banking crisis prompted a reevaluation of risk management across our strategies, and, after over 45 years of publication, the weekly report has chosen to exclude the financial services sector altogether.  We are not adopting the same draconian restrictions in client accounts, which have always taken a more sophisticated risk management approach, but we are making changes that will reduce future investments in banks, capital markets and select insurers.  That same risk reevaluation also increased our confidence in other sectors, which may see us taking on slightly more equity exposure for longer going forward.

Robert B. Drach

Drach Advisors LLC