Q3 2023 Commentary
After a roaring start to the year, markets took a break in the third quarter.
The S&P fell 3.6%. The Nasdaq, which had just put together its strongest first half in forty years, fell more than 4%. In the context of the returns these indices produced in the first half, the pullback appeared rather mild. A broader look at the markets, however, shows more widespread weakness.
While the S&P 500 index closed the quarter up more than 10% for the year, the average S&P 500 stock had only advanced by 0.3%. More than 90% of the index’s gains have been delivered by the seven largest companies (despite those stocks composing less than 30% of the index’s market cap).
The performance of these stocks may look magnificent, but if we zoom out, it has not been enough to truly buoy markets. The benchmark index is still down over the last two years and sits more than 10% below its all-time high. The Nasdaq is more than 17% below its own 2021 high.
Many market participants have seemed surprised by the rough performance for stocks over the last two years, but that path was well telegraphed and has been fully justified.
In 2021, markets reached a price/peak earnings multiple of 25. Valuations that high had not been seen since the tech bubble, and have never been sustainable. All of market history was telling us that stock prices should fall. Even if things were truly different this time, stock returns were highly likely to be far below average. It turns out that things were not all that different this time, and the S&P 500 plunged 20%. The bulls of two years ago may blame inflation for ruining the party. In a sense they are correct, but the same forces that fueled inflation are the same ones that fueled excessive stock prices to begin with.
The bulls of 2021 were correct in another regard: stocks fared surprisingly well during the correction. A 20% down year is not what most analysts had anticipated (in fact, the annual Barron’s survey had an average prediction of +9%), but considering the historically rapid rise in inflation and interest rates, it could have been worse (particularly when considering the starting valuations).
Historically, the average market low has occurred with a price/peak earnings ratio below 14. A correction to those levels would have allowed for a 40% decline from the market peak. Instead, last October’s lows occurred with a price/peak earnings ratio just above 18. That correction was just large enough to return equity valuations back to “sustainable” territory. Still historically expensive, but sustainable.
The rebound from those lows through the first half of this year was largely driven by a widespread belief that the economy would undergo a soft landing (falling inflation without substantial economic fallout), which would allow corporate profits to continue growing while the Federal Reserve cut interest rates.
Again, the optimists were largely correct. Disinflation in the United States has been the biggest economic story of the year. Core inflation peaked at a year-over-year rate of 5.6%, which included several multi-month stretches of price increases in excess of a 6% rate. The latest core PCE reading came in below a 2% rate for the first time since 2020. This is not a one-month aberration, as the three-month rate is also its lowest since 2020, and the year-over-year rate came in below 4% for the first time since H1 of 2021.
Additionally, economic data has been resilient, led by a strong labor market. We did see jobless claims slowly rise for part of the year, but that increase has subsided, with the 4-week moving average of initial claims back at its lowest level since February. The latest employment report showed strong job gains, and the unemployment rate remains under 4%.
This run of positive economic data has given the Federal Reserve cover to continue to pursue their goal of fully quelling inflation. The Fed has been telling us that rates will be “higher for longer” until they are convinced they have achieved their goals, and markets have finally come to accept that reality. This realization has dashed market dreams of falling rates, resulting in a rapid rise in longer-term yields, with the ten-year treasury yield surpassing 4.75% for the first time since 2007.
That interest rate rise has been, justifiably, accompanied by falling equity prices.
Again, bulls might not be getting what they want from stock prices, but they are getting precisely what they hoped for on a fundamental basis. Inflation is falling and the economy remains resilient. It is the definition of a soft landing. Stronger growth allows the Fed to pursue more aggressive monetary policy, but we will take solid growth alongside falling inflation any day.
Though we find reasons to be optimistic about the macroeconomic backdrop, it is quite possible markets continue to drift lower, and it all circles back to valuations. By the end of this year, S&P 500 earnings are expected to break above their previous record high, yet stocks are trading at more than 21 times those levels. That is still very expensive, particularly if we are in a higher-for-longer interest rate environment.
There is a silver lining to valuations. Just as the market gains this year have been concentrated among the largest companies, so are the highest valuations. The P/E ratios of the top seven companies in the S&P 500 range from ~29 to over 100. All trade at an enormous premium to the market, combining to a cap-weighted P/E ratio of over 50. If you look outside of the largest names, the rest of the large-cap universe is far more reasonably priced. If you look further down the market-cap ladder, small and midcap stocks even look cheap.
Unfortunately, that is not a discrepancy that is likely to resolve itself without some pain. Were the top names to revert to a mere 50% market premium, that would necessitate a 35% decline in their stock prices. All else equal, such a price move among these seven names alone would result in a nearly 10% decline in the S&P 500. Of course, we know that not all else would be equal in such a scenario.
Despite the potential risks ahead, we have been taking advantage of the recent volatility. Traditional Time Overlay accounts entered the third quarter nearly 70% exposed to equities. That exposure had decreased closer to 40% by the beginning of September. We increased our allocation to quality names throughout September, and most traditional Time Overlay accounts ended the third quarter approximately 60% allocated to equities. We began the fourth quarter with more incremental buying.
The drivers behind our recent buying should be familiar to our clients: falling prices among quality names, accompanied by uneasy retail sentiment, amidst a solid economic backdrop. This approach has served us well throughout the last several years of high valuations.
As they have all year, our global accounts remain more conservative, awaiting broader weakness before committing more capital.
-Robert Drach