December Investment Comments
Since late October, the stock market has rallied off multi-month lows and is now back near its 2023 highs, giving something extra for investors to cheer about as we head into this holiday season. Third quarter earnings are largely in the books, with Q3 2023 marking the first quarter of year-over-year earnings growth since Q3 2022 according to Earnings Insight by FactSet’s John Butters. The recent rally has returned S&P 500 valuations to approximately their five-year average of 18. That feels a little rich considering what has happened to interest rates over the last five years.
The recent rally has been sparked by encouraging inflation data and the Federal Reserve’s accompanying pause in interest rate hikes. Core consumer price inflation, which excludes volatile items such as food and energy, edged down to 0.2% sequentially in October. Core prices have risen 4.0% over the past twelve months. While that is still faster than the Fed’s ostensible 2% target, the falling rate of change is important to consider as well. The data has recently followed a disinflationary pattern, stoking hopes that interest rates have gone high enough to accomplish the job of bottling up consumer prices.
In a series of 11 rate hikes that constituted the most aggressive policy tightening since the early 1980s, the Federal Reserve took its benchmark rate from zero to a target range of 5.25%-5.5%. The rate hikes may now be coming to an end. According to the CME Group, futures pricing indicates less than a 1% probability that the Fed will approve a final rate hike at its Dec. 12-13 meeting.
Both stock and bond investors are eager to look ahead to an eventual new regime of declining interest rates. Long-term bonds, as measured by the 20+ year Treasury exchange-traded fund TLT, have lost more than 10% year to date after being down 31% in 2022. Bond bulls have been beaten up more severely, and more consistently, than stock market bulls and are likely feeling more desperate for a return to the good times of falling rates that predominated for most of three decades prior to long-duration bonds peaking in early 2020.
Lower rates would help companies raise cheap capital and also bolster stock market valuations, as future earnings are discounted at lower interest rates. It is little wonder that a recent bounce for TLT coincided with an approximately 10% jump for the Nasdaq, along with slightly more modest increases for the less volatile S&P 500 and Dow Jones Industrial averages.
But perhaps the bulls are a little too eager to call the next bond market upswing. Declining interest rates are not a sure thing. The Fed has indicated that it will hike rates further should inflation reaccelerate. The bulls seem to perceive this as an empty threat. No matter the Fed Governors personal beliefs, desires or inclinations, ultimately the Fed will have to respond to the facts on the ground. The economy continues to do well. In the third quarter of 2023, GDP expanded by 4.9%, and consumer spending rose by 4%. The U.S. dollar recently stopped advancing against a basket of foreign currencies, breaking—or at least pausing—an uptrend that has prevailed since late July. A weaker dollar would be inflationary on the margin. Energy prices tend to become more volatile in the northern hemisphere’s winter; and we are lapping a historically warm winter.
With economic and political risks seemingly on the rise, investors are huddling together for protection. Much of their seeming exuberance has been narrowly confined to a few leading mega-cap stocks. While the S&P 500 has turned in a strong performance of more than 16% year to date, the equal-weighted version of the index is up only 3.5%. Meanwhile, the top 10 companies of the index are collectively up over 50% year to date. The S&P MidCap 400 index is up 1.7% year to date while the S&P SmallCap 600 index is down 2.3%.
The same story applies to many other asset classes. Very few are outperforming the S&P 500 year to date, with the exception of the even more top-heavy Nasdaq 100. The Dow Jones U.S. Real Estate index is down 4%, and international companies represented by the MSCI All Cap World ex-US index are up just 5.4% year to date. Harry Markowitz famously called diversification “the only free lunch in investing.” More or less universally, investors who diversify their portfolios across industries and asset classes in accordance with that wisdom are being punished with underperformance relative to the stock index values being quoted on CNBC. We all have mega cap envy. It is probably not wise to be as concentrated personally as the indices have become, but in a bull market, greed rules and “wise” comes to mean “doing whatever is working.”
The relative underperformance of other indices vs. the S&P 500 should create opportunities. While large-cap companies represented by the S&P 500 are currently priced at a price-to-forward earnings multiple of 18, the S&P 400 is trading at 13, and the S&P 600 is at 11. These lower valuations should provide ample opportunities to find attractive investments for investors and managers willing to do their homework. The alternative of crowding further into the largest, best-performing companies in the market does not sound very smart, but again, there is what common sense seems to support and then there is what has worked. We doubt whether common sense will ever be the death of us, although it has been the death of relative performance recently. Solid companies at fair valuations remain the best way to make money reliably over time.
Eric Wathen, CFA