Q2 2023 Compass Review
The second quarter can be summed up in one word: Resilient. A resilient economy, despite higher interest rates. A resilient stock market, despite narrow leadership by the tech giants. A resilient banking system, despite last quarter’s banking failures. A resilient Ukraine. And a resilient America, despite a slate of controversial US supreme court cases.
It’s been 15 months since the Federal Reserve began tightening monetary policy to combat inflation. Since then, interest rates rose from 0 to 5%. Historically, a rapid tightening of policy brought a slowing economy and a recession of varying severity.
This time, at least so far, the economy keeps chugging along. Housing prices are still elevated in the face of 7% mortgage rates. Airplanes and hotels are full. Tight labor markets persist, and the unemployment rate sits near a multidecade low of just 3.6%. Meanwhile, the stock market is right back where it started.
So, what gives? Is the economy still feeling the lingering effects of fiscal stimulus from the Covid years? Or is it the future fiscal stimulus promises of President Biden’s Chip Act and Inflation Reduction (Infrastructure) Act? Are consumers revenge spending on borrowed time (aka credit cards)? What about the promises of Artificial Intelligence driving improved productivity? Could the Fed actually stick the soft-landing scenario by bringing down inflation without a recession?
As historian A.J.P. Taylor said, “The future is a land of which there are no maps.” What we do know is that inflation declined quicker than anticipated with the CPI peaking at 9% in the US; now down to just under 4%. It may take another hike or two, and a little more time to get back to the Fed’s 2% target, but we aren’t far off. Wages are the last thorn in the Fed’s side, but we can think of worse things than people getting paid more while prices go up less.
We also know that the Treasury yield curve remains inverted with long-term rates lower than short-term rates. In normal times, a healthy economy has a positively sloped yield curve with markets anticipating stronger growth in the future. Despite the resiliency, this bond market says the opposite, looking for interest rate cuts at some point next year, and a return to a low interest rate environment in the future. This inversion won’t hold for much longer and we’ll soon find out if the economy is strong enough to support itself at higher rates or if indeed, despite the near-term resiliency, the Fed is forced to cut rates on economic weakness down the road.
Right now, the markets seem happy with either outcome. Through the first half of 2023, the S&P 500 charged 15.9% higher. To beat a dead horse, most of the increase came from the magnificent 7 (Tesla, Nvidia, Amazon, Apple. Meta, Microsoft and Google). Those stocks returned 90% on average. Without them, the index rose just 5%, while the equal weight S&P 500 gained 6%.
At present, just 7 companies constitute 28% of the S&P 500, with a total market capitalization of around $10 trillion dollars. Much has been written about the health of such a heavily concentrated market. History would suggest that it typically doesn’t end well, but maybe there’s a different explanation.
For starters, it’s hard to argue with the deservedly high valuations of these tech behemoths. Let’s look at the two largest. Apple is the dominant consumer products company, with a near monopoly on high-end mobile phones; a position that won’t disappear anytime soon. It’s currently worth $3 trillion, has sales of nearly $400 billion, and operating margins of 30%. It also happens to trade for ~30 times next year’s expected earnings. A valuation multiple not seen in at least 15 years, when the company was worth $100 billion and had merely $40 billion in sales.
The story is similar for Microsoft, also selling for 30 times earnings. Microsoft is the preeminent platform for the enterprise with Office, Azure Cloud and Windows. Yet its growth has slowed substantially. It’s possible this is just a post Covid lull and that investments in AI will reaccelerate growth, but it’s also likely that competition will be fierce in AI and high-end cloud applications. Both companies are more expensive than they were last year despite slower growth and higher interest rates. What gives?
There’s a lot of possible explanations for what’s going on, but we boiled it down to 4:
1) These large companies are so strategically entrenched with competitive moats, only strengthened by Artificial Intelligence and Cloud, that their domination will only grow, and therefore a significant market premium is justified.
2) We have reached the lazy stage of the investing cycle, where the safest bet is last decades’ winners.
3) This is the last hurrah before the market accepts the reality of tighter monetary policy and higher interest rates for the foreseeable future.
4) The market is right about a soft landing, and the best long-term returns will come from the laggards; where the market’s low expectations provide a margin of safety alongside high potential returns.
In truth, it’s likely the next year will include some combination of all 4 statements, but the skeptic in us shade our optimism towards the latter statements.
At the end of Q2, small cap stocks were up a measly 5%, followed by mid-caps only slightly better at 8%. They sell for 14x earnings, a large discount to large caps. Meanwhile, the S&P 500 minus the magnificent 7 sells for about 18x forward earnings, a modest premium to historical levels, but if growth continues to accelerate, it’s not unreasonable. This gives us hope.
We’ve already seen the narrative begin to change in July. The stock market is finally beginning to broaden beyond the magnificent 7. Sure, some are concerned about commercial real estate and the uptick in credit card delinquencies, but the idea of mass bank panic has receded. Yes, long-term electric vehicles will drastically reduce the amount of gasoline needed for cars, but in the meantime oil demand continues to increase. Indeed, it’s hard to imagine a global economy working well with China stuck in a major debt trap, but the resiliency of the rest of the world has more than made up for it.
Quite frankly, the challenge now is that optimism is becoming more popular. Which means we may not get the real bargains we have been hoping for. Instead, we’ll have to settle for reasonable returns on reasonably priced stocks, while we earn a positive real return on our rainy-day reserves (for the first time in a decade)! Resilient, with a hint of realism.
Compass Wealth Management LLC is a SEC registered investment advisor, clearing transactions primarily through Pershing Advisor Solutions and Pershing LLC subsidiaries of Bank of New York Mellon Corp. This letter is written by Compass for the benefit of its clients and does not necessarily represent the opinions of its affiliated organizations. It is based on information believed to be reliable, but which is not guaranteed to be correct. Nothing herein shall be construed to be a solicitation to buy or sell securities, indicate that past performance is predictive of future returns, or recommend individual investments.