By Jonathan Bergman, CFP®, President
TAG has been skeptical of the 2023 equity market rally for some time, and despite the recent flow of good economic news, we have conviction that the market is not supported by fundamentals. That includes both economic challenges that are being overlooked, as well as equity markets that have underlying concerns.
Economists at the Federal Reserve and some of the nation’s largest and most influential banks are backing off their earlier projections of a recession. Many are now anticipating a soft economic landing. Even the more hawkish economists among them are revising their view of a moderate to serious recession and now predicting a mild one.
Labor, housing and fading inflation look like economic strengths at the moment. Those are positive signs, but also lagging indicators of growth. Low unemployment is the result of strong economic growth, but not always a cause of it. The housing market has not yet absorbed the full effect of interest rate hikes yet. Though home prices remain strong, mortgage applications, a leading indicator, are down more than 25% over the last 12 months through August 31. We see real potential economic and market weakness ahead in the following areas:
Interest Rates. Amidst a slow growing economy such as the one we’re in now, stocks should be revalued lower when interest rates rise because future earnings are worth less in present dollars. Just the opposite has taken place. Rates are rising, and may not yet have peaked. Higher interest rates mean companies, homeowners and consumers with floating rate loans will have increased monthly costs. On the asset side, higher yielding Treasuries present a more attractive substitute for riskier investments, i.e., stocks. Either the full effect of the Fed’s rate hikes have not yet been baked into the market, or for some reason investors and borrowers are ignoring them for the time being. Either way, it is a red flag.
Treasury Yield Curve (June 30, 2023 compared to June 30, 2022)
High Yield Debt. These bonds may look appealing at 9%, but there’s not a lot of upside based on very tight spreads. It’s abnormal for spreads to be this tight at this stage of the economic cycle. Normally, high yield securities decline when economic growth suffers as downgrades and defaults begin, which should be on the radar of investors.
Leveraged Loan Yields. This $1.4 trillion market carries floating rates (short-term base interest rates plus the spread) that have risen quickly over the past year. This could have a dramatic effect on borrowers, causing interest payments to double or even triple what they were previously. This will likely have the effect of reducing corporate net income, potentially leading to higher defaults and possibly bankruptcies for these borrowers.
Consumer Credit. Credit card balances reached an all-time high of $1 trillion in the second quarter. This means the consumer is taking on more credit at the same time as credit gets more expensive due to higher borrowing costs. Balances have now increased year-over-year for seven quarters in a row. In a very unusual development, first quarter 2023 credit card balances exceeded the fourth quarter’s balance. It’s common for consumers to increase borrowing during the holiday season, but for the first time in 20 years, balances did not decline in this year’s first quarter. Additionally, Macy’s and Nordstrom both reported rising credit card delinquencies for their store credit cards. More delinquencies indicate consumers are struggling to stay afloat and will have to curb future spending.
Earnings. Consensus full year estimates for S&P 500 companies for 2023 and 2024 have declined since the beginning of the year. Eroding earnings while a market rallies is perplexing.
An Unequal Market Rally. Not all components of the index are created equal, and the S&P 500 performance is not truly indicative of a broad rally. The rally is led by a few mega-cap companies (Apple, Meta, Alphabet, Amazon, etc.) that have been responsible for the great majority of the index’s performance this year. Though the S&P 500 was up almost 16% through June 30, 2023, if you weigh the index components equally, it was only up about 6% in the first half. Small and mid-cap stocks did not participate in the rally anywhere near the extent of much larger companies.
First Half 2023 total returns of S&P 500 Market-Weighted Vs. Equal-Weighted
Unsustainable Multiples. As of June 2023, Amazon was trading at 137 times earnings, Microsoft was at 35 times earnings, and Apple at 32. NVIDIA, viewed as the leading AI company, was up nearly 200% in the first half of 2023, trading at 204 times earnings and with a trillion-dollar market cap. The overall S&P 500 was at 21 times earnings, compared to the past 20-years, when it averaged 18 times earnings.
We see enough concerns that we believe repositioning portfolios to prepare for an expected turn in the market is prudent and warranted. There are five areas that we are looking at to help prepare for it.
- Take Profits. There’s too much risk in equities right now. Stock exposure should be reduced, the fundamentals simply do not support the rally. Certainly, stocks can continue to rally, but it likely won’t be for a good reason. It will be much harder to stomach watching paper profits vanish than it will be to miss out on a little more of what we view as an unsustainable rally in stocks.
- Hedge Equity Exposure. We believe in positioning portfolios to retain some upside exposure while limiting downside risk using hedging tools. Those can include selling out of the money calls or buying out of the money puts. Other hedging structures we believe can be effective include zero cost collars on indices and individual positions.
- Rotate Equity Exposure. As we mentioned, large cap growth stocks have completely carried the rally. On the other hand, small company value stocks haven’t participated. Any reversion to the mean should close the gap between large stocks and all other equities, particularly small company value stocks (as represented by the S&P 600 Value) whose PE ratio was under 11 at mid-year. At the margin, we suggest rotating out of large cap growth stocks and into small cap value stocks.
- Treasuries. Yields are at or above 5%, an unusual development and a worthwhile investment right now. Two-year maturity yields have hovered near 5%. If stocks take a turn, longer duration Treasuries may appreciate if there’s a typical flight to quality and that would make for a solid investment.
- Absolute Return. Absolute Return strategies can exploit increasing volatility whenever it returns, which we expect it will if there’s a market shift. Absolute Return targets minimal correlation between stock and bond markets. They can include arbitrage and relative value strategies. We leaned on these strategies for positive returns in much of 2022 amidst extreme volatility and a rare period where stocks and bonds declined more than 10%.