Q2 2023 US Market Review & Outlook
Stocks winning streak continued, marking the third straight quarter of positive performance. The Federal Reserve (Fed) had two meetings in May and June. They increased rates by 0.25% in their first meeting, but elected not to raise rates in their second meeting. This was the Fed’s first meeting since March 2021 where they did not increase rates. So far, higher interest rates have taken inflation from 9% to 4%, while the broader economy and job market have proven far less sensitive than expected to higher interest rates. Economic growth continues to be solid and the unemployment rate is still near historic lows. The much discussed recession has yet to appear. These factors have helped lift the S&P 500 by 24.4% from the October 2022 bear market low and it is just 7% off the previous bull market highs.
This year’s rally has largely been led by the eight largest technology companies (Alphabet, Amazon, Apple, Meta, Microsoft, Netflix, NVIDIA, and Tesla). The average performance of these stocks is up a staggering 84% this year with Nvidia surging higher by 189.5% and Alphabet being the “laggard” of the group up a measly 35.6%. Seeing the “Great Eight” have outsized returns is positive but also presented some reasons to be concerned that most of this year’s gains have been concentrated in so few stocks. The market rally did start to broaden in June. The Equal Weighted S&P 500 started to outperform the S&P 500 in the final month of this quarter. The S&P 500 is based on companies’ size, so larger companies like Apple represent a greater weight in the index. A broader level of participation is a signal of a healthier and more robust market.
Investment Strategy
During this quarter, we updated your stock allocation. As we previously discussed, we had a checklist in place to guide us to remove our defensive strategy to position your portfolio to capitalize on a new bull market. After fulfilling our checklist, we made the following adjustments.
We increased exposure to small US companies and reduced our holdings in US low-volatility stocks. The low-volatility stock strategy performed admirably last year despite challenging market conditions.
We added to your large growth stocks to achieve a balanced mix of value and growth companies within your large-cap holdings.
We are overweight in smaller company stocks because of their historical outperformance during new bull markets. Small-cap stocks have consistently surpassed large-cap stocks because they are more sensitive to economic improvements in early economic cycles. They currently have an attractive relative valuation, trading at significant discounts based on price-to-earnings and price-to-book ratios. This is a tactical move and is not intended to be a long-term allocation. Small cap outperformance tends to see its most pronounced moves in the first six months.
Your portfolio remains invested in line with your strategic allocation of stocks, bonds, and cash. We acknowledge that short-term interest rates are appealing compared to the past decade. However, we urge you to remain focused on your long-term investment allocation and not consider short-term rates as a substitute for your long-term strategy.
Outlook
With the great start we've had this year, it's only natural to wonder what's in store for the second half. Let's take a look at some historical market comparisons, peer into 2024 to see what’s ahead, and discuss whether recession risks are in the rearview mirror.
History points to a positive second half of the year for stocks. Looking at the past 95 years of returns for the S&P 500, when stocks moved higher by 10% or more in the first six months, the median return for the rest of the year was a solid 9.7%. It saw positive returns 75% of the time. Now, let's dig a little deeper. When we focus on years that experienced a double-digit return in the first half following a negative return year, the results look even more encouraging. In these years, stocks rallied by 11.5% over the next six months, with a remarkable 80% success rate. This is a similar setup to what we have today.
Now that we're halfway through 2023, it's a good time to look at 2024 expectations. When making investment decisions, investors usually look ahead at least six months, if not longer. The projected earnings growth for next year is an impressive 11%, following two years of lackluster growth. It's likely that this year's rally is partly due to investors factoring in these positive expectations. These expectations have helped keep forward price-to-earnings ratios reasonable, despite higher interest rate levels. Stocks look attractive given forward estimates.
While our overall outlook remains optimistic, it is important to stay vigilant and continue monitoring key factors. Although recession risks have diminished in the past quarter, certain indicators are signaling caution. Financial stress within the banking sector has eased, but concerns persist regarding the potential impact of commercial real estate prices on banks.
The inverted yield curve and leading economic indicators still point to the possibility of a recession. Additionally, the Federal Reserve has indicated its intention to raise rates once or twice more to address inflation. While inflation has gradually decreased, it remains above the Fed's 2% target. Historically, the end of rate hikes by the Fed has been viewed positively for stocks. However, the expectation of higher rates for a longer period may dampen investor sentiment.
The rest of 2023 looks very good for stocks, bonds, and cash investments. Momentum in the stock market should continue to be positive based on future earnings expectations. Higher interest rates also make bonds and cash an attractive place to invest based on relative yields over the past decade.
Andrew Comstock, CFA