Quarterly Market Perspective for 2Q23
Schwab Transition
In 2020, our custodian, TD Ameritrade, was acquired by the Charles Schwab Corporation. Over the past several years, the two companies have put tremendous thought and resources into planning and preparing for the transition of TD Ameritrade clients over to Schwab’s custody and technology platforms. The final transition is scheduled for the first weekend in September 2023 (Labor Day weekend), at which time all your accounts will be transitioned from TD Ameritrade to Schwab. At that time, you will receive new Schwab-based account numbers for the accounts we manage. We are happy to report that you will not need to sign any new paperwork.
The Schwab and TD Ameritrade teams have worked hard to make this transition as smooth as possible. In these coming months, you should expect to receive more communication from Schwab, TD Ameritrade, and Trademark regarding the transition. Please feel free to contact us at any time if you have questions.
Summary
The second quarter of 2023 was not that different from the first quarter. Stocks continued to surge despite forecasts of recession and a hawkish Federal Reserve because investors continued to believe that any economic downturn would be milder than predicted. First, April brought better than expected corporate earnings announcements. Then, May brought news that unemployment was holding steady in the 3.6%-3.7% range while the tide of inflation continued to recede. When the news is better than what is priced into stocks and there is a great deal of money parked in money market funds because of 2022’s volatility, this “recipe” produces higher prices as investors rush to get back in.
U.S. Stock Market Performance, 2Q23
If the story of the first quarter was the unveiling of ChatGPT and the artificial intelligence (AI) mania it unleashed, the story of the second quarter was semiconductor chip maker Nvidia’s profit announcement on May 24th, in which profit guidance tripled. For AI stocks, this added gasoline to the fire. The NASDAQ, where most of such companies reside, rose 13.07%[1] during the quarter. The S&P 500, increasingly a technology index, rose 8.74%. The average company rose only 3.87%, however[2] (most companies are not, strictly speaking, technology companies). The small stock-oriented Russell 2000 gained 5.21%. The Dow Jones Industrial Average rose 3.89%. The underperformance on the part of large tech stocks in 2022 was fully recovered by quarter end; both they and the slower growing, high dividend stocks of the Dow were roughly 12% below their year-end 2021 levels at quarter end[3].
International stocks did far less well in the second quarter than they did in the first. Foreign stocks prefer a weaker U.S. dollar and low inflation, and they got neither. Still, with recession largely avoided thus far and the hope for interest rates to come down later this year, foreign markets added 2.95%[4] last quarter. Japan led the way in developed markets with a 7.24% gain; the global move to technology and robotics plays into their strength. On the emerging market side, while the index itself gained only 0.90%, Latin America roared ahead 14.05%. Latin American central banks have been the first in the world to see inflation fall enough to begin cutting interest rates. Asia ex-Japan lost -1.26% on the disappointing (so far) recovery in China.
As a whole, bonds lost money during the second quarter. Their -0.84%[5] decline reflected the fact that the economy has not slowed as much as forecast and as a result, the Federal Reserve is still raising interest rates. Of course, the bond market is as diversified as the stock market is, so certain types of bonds gained in value last quarter. Both ex-U.S. developed market bonds and emerging market bonds rose last quarter, as did U.S. corporate high yield bonds and floating rate debt. The key was to take on credit risk but not interest rate risk. Default risk fell during the quarter, but interest rate risk did not. One could have avoided both types of risk and earned 1.22% in short term T-bills.
Activity
As the economic data came in during the quarter that continued to show that economy was not in fact on the cusp of recession, risk appetites grew, and we needed to nudge portfolios away from the defensive, dividend-oriented value funds that we started the year with. We increased exposure to cyclical and growth sectors with the proceeds from value fund sales and from cash, which had built up somewhat last year. We have also sold most positions that are “market neutral,” meaning they aim to provide single-digit returns no matter what the overall stock market is doing by using arbitrage, options, or some other hedge-type strategy. They were attractive in 2022, but by late-May it was becoming obvious that hedging was not going to be necessary.
Outlook
Three months ago I was tentatively optimistic that we could have a pretty good year despite the threat of recession looming, because investor sentiment was weaker than it objectively should have been[6]. Today, with stocks being roughly ten percentage points higher, I feel we have mostly played out the “sentiment reversal” trade, such that future gains are going to be harder to come by. I believe momentum and positive inflation news will carry us for maybe another month or so, but September is seasonally rough[7], and year-over-year inflation comparisons start getting tougher by autumn. The stock market has already digested the likelihood of a 0.25% interest rate hike on July 26, but it expects that bump to be the last one. If it begins to look like they will hike again in September, we could have some turbulence. The key for markets going forward is maintaining the current “not-too-hot, not-too-cold” environment where unemployment stays below 4% but prices and wage growth are closer to 3% than 4%. Again, I think we can do that in the short run.
Commentary – The S&P 500 is a Bad Benchmark
This Commentary is sub-titled, “How come the S&P 500 is up 15% and I’m only up 8%?” The answer to this question goes to the nature of the S&P 500 as a benchmark. A benchmark is designed to represent what percentage return an average investor in a particular asset category should have expected to receive. Therefore, it obviously follows, the benchmark should be broad enough to cover most of the asset category it is supposed to represent, and it should be investable – meaning the benchmark return was achievable through easily purchased securities. For these reasons, benchmark makers (Standard & Poors, Dow Jones, Bloomberg, etc.) make adjustments to a simple size-weighted model. Stocks that are hard to purchase because fewer shares trade are usually excluded from benchmarks, as are companies with dual share classes.[8]
Over the years, some benchmarks have proven to be less than ideal because of structural changes. For example, in 1990 Japanese stocks were the lion’s share of the international stock benchmark (MSCI). Before the Japanese asset bubble burst, this international index owned more Japanese stocks than all the other non-U.S. countries combined. Almost all active international managers under-performed the benchmarks from 1985 through 1989. After the Japanese bubble burst, international fund managers routinely outperformed the benchmark by underweighting Japan. This worked for about 25 years. U.S. investors experienced a similar situation during the dot.com bubble. The initial public offering of Netscape in 1995 (think AOL) sparked a mania that lasted until March of 2000. The S&P 500 was brutal to try to beat between 1995 and 1999, then surprisingly easy to beat from 2000 to 2008 as over-ownership of tech stocks was bled out of the market. The question you might be asking at this point is, how do prices get so out of line?
The S&P 500 is the most widely accepted benchmark because it covers more than 85% of the U.S. stock market capitalization, which is dramatically more than the Dow Jones Industrial Average does with just its 30 stocks. That said, from time to time a narrative arises that the future belongs to a handful of companies that are at the forefront of where the world is headed. As recently as June 30th, the top 5 U.S. stocks accounted for approximately 24% of the S&P 500’s value and the other 495 stocks accounted for the remaining 76%[9]. The last time a small group dominated this much was 1999 just prior to the dot.com bubble bursting See Item 1 below.
Item 1: Market Concentration
I was fortunate enough to have attended a lecture by NYU Business School professor Aswath Damodaran four years ago in which he discussed the sky-high valuations of Tesla and other market favorites. He argued that each company is valued both on what it is as a business and also on what it might become. Very little of the value of McDonalds or Waste Management is based on what they might become, but a considerable amount of Tesla’s value is tied up in what technologies Elon Musk may pioneer in the future. Nvidia’s current value places a very high premium on what artificial intelligence will ultimately achieve. All of this is fine, but there is a certain risk to valuing a company on what it might become. It might never fulfill its potential, either because of management missteps, the emergence of a superior competitor or technology, or because the opportunity itself was never that great. Even when you are right about the long term you can be very wrong in the short term – Microsoft stock fell over 72% between the end of 1999 and the end of February 2009; Tesla over 73% from November 4, 2021 to January 3, 2023. Stock with this kind of volatility should be components in a portfolio, but not the bulk of portfolios.
The S&P 500 equal weighted Index was up 3.83% last quarter and 6.71% year-to-date. I do not argue that you should have just as much Alaska Air or Ralph Lauren or Hasbro[10] in your portfolio as you do Apple or Amazon, but I know you cannot run an economy on technology alone.
A benchmark can be a useful guide to performance, but it should not push you into making unwise investment decisions. The Standard & Poors 500 Index reflects the weighted investment performance of 500 of the largest U.S. companies, but it does not tell you how you should personally be positioned. Increasingly it is the default investing option for those who don’t have the time or discernment to look into market fundamentals. A popularity contest if you will. Inevitably, some of today’s most favored stocks will become tomorrow’s beehive hairdos or parachute pants.
When we put together the core of an investment portfolio, we want future growth potential for sure, but we also want some stability and predictability as well. Mostly we want companies whose products and services are not going to be obsolete in five or ten years, and whose cash flow generation is more steady than episodic. That is why we diversify even when concentrating one’s assets in one area would have generated a greater return. One witticism about diversification, the idea that spreading out one’s assets into different, less-correlated baskets reduces risk, is that “Diversification means always having to say you’re sorry.”[11] It also means never having to say “Sorry about your retirement funds. You’ll have to go back to work.”[12]
[1] Per Morningstar workstation, as is the information on the Dow and S&P 500.
[2] According to the S&P 500 equal weighted index
[3] Per Goldman Sachs Asset Management
[4] All foreign performance information per MSCI via Morningstar Workstation
[5] All bond performance information per Bloomberg via Morningstar Workstation
[6] Though I did say that one shouldn’t get too aggressive.
[7] September has the worst average return of any month over the last ten and twenty years, according to tradethatswing.com
[8] All three found in the bottom dozen or so stocks in the S&P 500.
[9] Brian Portnoy, Forbes Magazine, March 9, 2015.
[10] Diversification does not guarantee investment returns and does not eliminate the risk of loss. Diversification among investment options and asset classes may help to reduce overall volatility.
[11] A dual share class structure gives a certain class stock greater voting rights than others.
[12] For more on this see Barron’s Magazine, July 10, 2023 “The S&P 500 is Now a Tech Fund” by Lauren Foster.
DISCLOSURE
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