Own It All Because You Just Don’t Know
In the spirit of the holiday shortened week, I’m going to truncate this missive with my thoughts strictly focused on the markets. The basic theme of my view, at the moment, is that no one has a clear view on where we go from here. Therefore, a portfolio exposed across a broad array of asset classes with a generous dash of humility seems right. The market this year has made fools of both bulls and bears at some point in the opening six months of this year. Such a claim seems inconsistent to say about the bulls with the S&P 500 up 15%, the Nasdaq Composite up 31%, and the Russell 2000 Small Cap index up 7% in the first half. But I am unaware of anyone expecting such a run coming into this year or throughout most of the opening six months of 2023.
The Dow has been this year’s laggard (possible second half catch up opportunity) up just under 4% ytd, but even foreign markets are off to a lucrative start with the All Country World Ex-U.S. index up 8% and Emerging Markets up nearly 7%. Even gold put in a 5% gain in the face of interest rates marching back up near their late-October highs.
Once the S&P 500 broke out of the topside of its trading range (4,200) in early June you could make the argument that the technicals were aligned to push equities higher, but don’t mistake it as a fundamentally driven move. Nevertheless, we are where we are and while I’d rather have equities moving up than down, I still find our work suggesting that little has been decided in regard to whether the economy experiences a ‘soft landing’ or ‘hard landing’. Many trusted leading indicators on the economy suggest economic activity will continue to deteriorate (LEI’s, jobless claims, temporary employment, aggregate hours worked, money supply, global trade, bankruptcy filings…), but the global economy to this point just has not cooperated with these signals and proven to be much more resilient than forecasted. Coming into this year even the Fed’s own research staff was forecasting a recession commencing sometime in 2023. But any worthwhile analyst objectively looking at the data must admit at this moment they were wrong. It’s that simple.
It's important to recognize that being wrong is an important part of this profession because even the best of us are right only 51 – 55% of the time. What’s more important is how one is positioned to make or not lose money based upon their research. While we’ve maintained a negative fundamental bias throughout the entirety of the year other factors (overly bearish positioning and sentiment coming into the year – the negative fundamental view was far from unique) kept us from being positioned for a negative outcome. Moreover, we’ve been positioned defensively, which is a key distinction and has allowed portfolios to participate in the broad appreciation across asset classes while also acting as a drag in keeping pace with the S&P 500.
But for the skeptics like me, all we can do is admit our error (as I embarrassingly raise my hand), reevaluate our analysis, and/or kick the forecast out another quarter or two. For me it’s a combination of all three. It’s worth pointing out that looking back over the past three years the pandemic really threw a lot of noise and externalities into the data. Not only did policymakers shutdown and restart the global economy (an event never attempted before), but they also injected a record level of stimulus and policy one-offs – all of which I don’t think can be fully comprehended yet. It’s still wreaking havoc with many data series, and it will take years and even decades in some cases for things to normalize. This has created challenges and false dawns for even the most sophisticated models.
As for markets, here’s my synopsis of various asset classes:
U.S. Equities: stocks have outpaced their fundamentals to the upside and valuations are rich with the S&P 500 trading near 21x forward 12-month EPS. However, valuations have been getting more expensive over the past two decades and that hasn’t prevented stocks from rising. Take Apple for example, it’s up nearly 50% ytd with earnings growth falling for three consecutive quarters, sales growth in the low single digits, and it trades at over 32x earnings. It now commands a whopping $3 trillion market cap, oh, did I mention that Apple’s weighting in the S&P 500 is 7.6% - larger than five sectors in the S&P 500 (Materials, Real Estate, Consumer Staples, Utilities, and Energy) just below Industrials (8%) and Communication Services (8.75%).
What has become more obvious over the past two decades is that capital flows and passive indexing are driving equity market performance. Fundamentals still matter, but they have taken a backseat to flows. Flows are dominated by stock buybacks and 401k contributions. Buybacks are driven by profits and 401k contributions are driven by employment.
In my estimation passive investing has created a monster where 27% of the S&P 500 is now comprised of just seven companies. This monster will continue to grow and consume itself as has been the case over the last decade; intermittently disrupted by downturns in the labor market which reverse (for a time) 401k flows and then when the employment cycle turns back up the flows will too. It’s this dynamic that has made the S&P 500 a less relevant benchmark for investors. Only in an index fund can someone justify that a 7% weighting in one security is prudent. Most active managers are constrained from owning any more than 5% of a portfolio in any one holding, but the likes of Vanguard and Blackrock have a stronghold on the regulators in the financial services industry and all is fine when viewed under the veil of low cost broad market diversification for the common folk. Yes, you are correctly picking up an annoyed tone in my voice.
Bottomline, I’m not convinced that stocks crater even if we have a recession. This business cycle and the global investment setup is different than past cycles with inflation and sovereign debt profiles extremely unique relative to history. There is the possibility that the best companies in the world could be viewed as the world’s safe asset and therefore take on the role of a savings account. I know, it sounds as crazy typing it as it likely does to you reading it but think through it as there is some depth to the thesis.
On a shorter-term/tactical basis I think stocks are due for some consolidation if not an outright correction and I still lean in the direction that a recession awaits. Both will provide an opportunity to get incrementally less defensive and add to existing and new positions. However, with sentiment moving decisively to the bullish side and positioning leaning in the same direction I’m inclined to be patient while holding existing exposures and not put much fresh capital at risk.Fixed Income/Cash: This asset class is a little simpler for me to evaluate at the moment. I think the Fed is at the end of its tightening cycle with futures markets already priced for another two hikes over the course of the next three months. I do think the more than 500 basis points of hikes will have their intended impact on moderating growth in the back half of the year. Moreover, inflation has come down considerably and will continue too in a ‘two steps forward one step back’ fashion. So, with growth and inflation no longer a risk to the upside it should cap any further rise in interest rates. Something we are already seeing on the long end of the Treasury curve. The 2-year T-bill yield closed at 4.94% and is more than 20 basis points above where it was last November when most yields peaked. However, the 10-year Treasury yields 3.86% and is 40 basis points lower than last fall’s peak (30-year yields are 50 basis points lower).
Bottomline, for the first time in a decade-and-a-half investors can collect mid-single digit returns on risk-free short-term Treasuries and in parts of the corporate credit market high-single digit/equity, like returns are available. That goes for money market funds as well where if an investor wanted to take no risk today you can get almost a 5% yield in cash. It’s been a long time since conservative investors have had it so good.Gold: Gold closed today around $1,929/oz and is little changed over the past twelve months. It has held up surprisingly well considering the +500 basis point rise in short-term rates over the past year and real rates moving up to cycle highs. Given the sovereign debt profile around the globe and my view that eventually the cost of servicing all this outstanding debt at these higher interest rates will force the Fed’s hand back into cutting rates and QE, I think gold is a must own investment going forward. It may not work every day, every week, every month, or every quarter, but over time it should serve a portfolio well.
Think about this, the U.S. has run a budget deficit of $2.1 trillion over the past twelve months (8% of GDP) and this is with an economy operating at full employment. Prior to the pandemic you would only ever see these level of deficits as a percentage of GDP during an economic recession when tax receipts dried up. The proposed budget for 2024 is $6.9 trillion (larger than the GDP of all countries in the world except the U.S. and China) which makes the case that we are transitioning from an era of monetary dominance to one of fiscal dominance. Such a shift is structurally more inflationary, which is good for real assets and not good for fixed income.
Financial repression has taken a sabbatical over the past 18 months with this transitory spike in inflation, but I suspect it will return and eventually the Federal Reserve will have to revert to some form of Yield Curve Control (holding interest rates below the level of inflation) which is very constructive for precious metals.
In closing, I think investors should spread their wings and feel comfortable with a diversified portfolio in the current backdrop. That includes cash, precious metals (gold and platinum are two we like), fixed income (both short and long-duration), and equities. I also think this approach is a prudent way to participate in a future with very little visibility. I didn’t hit on it above, but foreign equities (India, Japan, Mexico, and EM ex-China) look as attractive if not more so than U.S. equities and should garner some exposure in a portfolio.
That’s all for this week and if you’re celebrating the Fourth of July, have fun and stay safe.
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