Second Quarter 2023 Market Update
July 26, 2023
“We expect macroeconomic uncertainty to remain high in the near term. Since the pandemic and the invasion of Ukraine, it seems even more difficult for the market to accurately forecast energy prices, inflation, and interest rates. Forecasting the interlinked impact of these factors is even more complex.” – Activist Hedge Fund Manager
Second Quarter 2023 Market Update
Markets were mostly positive in the second quarter of 2023, closing out an impressive first half of the year. After raising rates by 25 basis points (0.25%) in May, the U.S. Federal Reserve (the “Fed”) held interest rates stable at its June meeting, marking the first pause in rate hikes since beginning its tightening campaign almost 15 months ago, in what economists dubbed a “hawkish pause” in their rate hiking cycle. Fed Chair Powell noted that he expects to raise policy rates two more times in 2023, totaling incremental increases of another 50 basis points (0.50%). Although inflation has started to cool, and recent data suggests that the Fed’s fight against it appears to be working, key inflation metrics remain well above their stated 2% target levels. Nonetheless, market participants applauded the pause in rate hikes, moderating expectations for terminal rates, and signs that the economy remains resilient despite the Fed’s policy actions. Previous pessimism around the possibility of a moderate or severe recession in the near-term seems to be waning, as the U.S. economy has shown its resiliency and that it can withstand the Fed’s interest rate hikes without experiencing significant near-term economic damage.
Domestic equity markets, as measured by the S&P 500 Index, were positive for the second quarter, returning +8.7% (+16.9% YTD). The NASDAQ Composite Index finished the quarter up +13.1% (+32.3% YTD), as large cap technology stocks proved to be the best performing area of the market during the period (as discussed further later). From a sector perspective, technology (+17.2%, +42.8% YTD), consumer discretionary (+14.6%, +33.1% YTD) and communication services (+13.1%, +36.2% YTD) all continued to exhibit strong positive performance. All sectors were positive over the period except for utilities (-2.5%, -5.7% YTD) and energy (-0.9%, -5.5% YTD). Value stocks meaningfully underperformed growth stocks over the quarter, weighed down by exposure to sectors including financials, where bank failures earlier in the year continued to weigh on the banking industry. Growth stocks have also been deemed to be a more significant beneficiary of the progress being made in artificial intelligence (“AI”), which drove significant market movement over the period. Large cap stocks outperformed mid- and small-cap stocks again this period, highlighting significant dispersion among pockets of the equity markets. Developed international equities, as measured by the MSCI EAFE Index, were up +3.0% for the period (+11.7% YTD) measured in U.S. Dollar (“USD”) terms. Since the USD valuation peak in the fall of 2022, international developed equity markets have outperformed domestic markets by more than 500 basis points. Emerging market equities were up +0.9% (+4.9% YTD), as measured by the MSCI EAFE Emerging Markets Index (in USD terms). A weaker USD and positive economic data points were supportive of returns broadly outside the U.S.
Fixed income markets continued to stabilize, and markets saw a significant drop in volatility as immediate recession fears moderated; however, performance was mixed over the course of the quarter. The Bloomberg U.S. Aggregate Bond Index finished the quarter down -0.8% but remained in positive territory for the year (+2.1% YTD). Investment grade corporate bonds were slightly negative for the quarter, and high yield corporate bonds were slightly positive. On a YTD basis, investment grade and high yield corporate bonds have both produced positive returns, up +3.2% and +5.4%, respectively. Municipal bond returns have been positive over the course of the year, up +2.7%. U.S. Treasury returns have also been positive, with longer-dated maturities performing better than short-dated. The 30-Year Treasury gained +3.5% YTD as compared to the 2-Year which returned +0.6% YTD. A sizable portion of the total return across all fixed income sectors in 2023 has predominantly come from yield as opposed to price appreciation. The U.S. Treasury yield curve continues to be inverted, a traditional signal that precedes recessions, with short-term rates increasing as the Fed has continued to raise benchmark interest rates, whereas long-term rates have remained relatively flat. As of quarter-end, the 6-month Treasury yield was 5.5% as compared to 10-year Treasury yield of 3.8%.
Index Concentrations and Narrow Markets
“Narrow markets are fragile markets, and the top-heavy nature of the S&P 500 creates an environment prone to volatility and risk reversals.” – Domestic Equity Manager
While the headline returns of the S&P 500 Index this year have been impressive (+16.9% YTD), marking three straight quarters of positive returns, its performance has been predominantly driven by a very small group of mega-cap technology stocks, most of which have been seen as beneficiaries of the quickly escalating artificial intelligence theme. The S&P 500 Index is capitalization weighted, meaning companies’ representation within the index are based on their market capitalization (calculated by multiplying its share price by the number of shares outstanding). As such, stocks with larger market caps and higher weightings have an outsized effect on performance. The (more often quoted) market capitalization weighted S&P 500 Index has outperformed the equal-weighted S&P 500 Index by over 10% this year, its fourth widest spread in history, and highlights how narrow market breadth has been.
This year, the top ten companies in the S&P 500 Index have accounted for over 95% of the index performance, with the top seven companies alone (now being dubbed by some pundits as “The Magnificent Seven”), contributing 74% of its performance. These seven stocks have posted remarkable returns and include Alphabet (+36% YTD), Amazon (+55% YTD), Apple (+50% YTD), Meta (+138% YTD), Microsoft (+43% YTD), Nvidia (+190% YTD), and Tesla (+113% YTD). One of our investment managers recently pointed out the percentage of stocks within the S&P 500 that outperformed the overall index touched a record low in June, eclipsing the prior low set in March 2000. While not uncommon for a small number of stocks to significantly impact a capitalization weighted index, it does however, highlight elevated concentration risk that bears watching.
In addition to the S&P 500 Index being dominated by a handful of companies, a closer analysis of equity markets this year reveals a wide dispersion of returns across styles (growth vs. value), market capitalizations (large cap vs. small cap) and sectors (technology/consumer discretionary/communication services vs. all other sectors). As an extreme example, as measured by their respective Russell-based indices, large cap growth stocks were up +12.8% for the quarter and small cap value stocks were up +3.1%. On a YTD basis, their variance was even more prominent with large cap growth stocks up +28.9% versus +2.5% for small cap value. In markets like the ones that we find ourselves in today, with high levels of performance concentration, the importance of diversification cannot be understated. To the extent that markets continue their upward trajectory, laggards for the year (e.g., value stocks, smaller capitalization stocks, etc.) could see a “catch up” to large cap growth stocks. Whether the Magnificent Seven catches down or the rest of the market catches up, we believe that diversified exposure across styles, market capitalizations and sector exposures could prove valuable in the back half of 2023 and beyond.
Artificial Intelligence and Valuations
“AI is in its early innings, and we have a long way to go to understand its implications and uses.” – Global Long/Short Hedge Fund Manager
Since OpenAI’s release of its artificial intelligence (“AI”) tool ChatGPT in the fall of 2022, investor enthusiasm around AI has skyrocketed. In an example of just how much attention this topic is attracting, the four large technology companies (Meta, Alphabet, Microsoft, and Amazon) mentioned “AI” a record 168 times in their first quarter earnings calls. While these companies and many others continue to be enthusiastic about the potential long-term benefits, productivity gains, and efficiencies that could be realized from advancements, it has also been abundantly clear that market participants have been rewarding companies that have been discussing the topic and making investments in the area. It is hard to argue with the possibility that AI and its related technological advancements have the potential to significantly save time and labor costs, leading to increased productivity, and ultimately increased economic growth. However, while the potential impacts are large, they remain highly uncertain.
The AI-related boom in markets has been one of the primary drivers pushing valuations back to elevated levels. At the end of the quarter, the forward price-to-earnings (“P/E”) ratio of the S&P 500 was 19.1x, as compared to its long-term 20-year average of 15.5x. The top 10 stocks in the S&P 500 (many of which are beneficiaries of the enthusiasm around AI) are trading at an average P/E ratio of 29.3x. Many other S&P 500 valuation metrics tell a similar tale – price-to-book, cyclically adjusted price-to-earnings, price-to-cashflow, etc. And while today’s P/E ratio is below the peak of the Dot Com and COVID bubble peaks, it still ranks in the 84th percentile versus history. Across the capitalization and style spectrum, the only component of equity markets trading meaningfully below their long-term (i.e., 20-year) average P/E ratios are small cap value stocks. In short, there is not much that appears cheap in today’s equity markets, based on historical metrics. Companies will have to deliver on the market’s earnings expectations to justify their current valuations.
Investment returns in the first half of the year have pleasantly surprised to the upside and have been a welcomed step forward in moving past the difficult returns of 2022. Markets have shaken off additional rate hikes by the Fed, a persistently inverted yield curve, looming recession risks, concerns over the U.S. debt ceiling limit, multiple bank failures, continued elevated inflation, etc., and continued their march higher. While we have been surprised by the market’s performance to start to the year, we continue to remain cautious, and think that the second half of the year could exhibit higher volatility and look quite different than the first half. Valuations are now elevated versus historical averages, markets have already priced in an upcoming Fed policy pivot, enthusiasm around AI has led to significant (but narrow) market participation, and global growth is slowing. In short, markets in many ways seem to be pricing in perfection and investors will continue to watch closely to see if economic stability and corporate earnings will follow.
As is the case in any environment, but particularly in today’s, we believe that balancing risk with reward is paramount. We rely on a steady approach to investing, being mindful of appropriate diversification in portfolios, and always strive to fully understand and balance both risk and returns. While there are certainly risks to be mindful of, we are also seeing exciting opportunities to put capital to work today across many asset classes in investments that we believe will offer attractive risk-adjusted returns.
As always, we welcome the opportunity to discuss your portfolio in detail and appreciate the trust and confidence that you have placed in Prairie Capital.
Past performance is not an indication of future results. This publication does not constitute, and should not be construed to constitute, an offer to sell, or a solicitation of any offer to buy, any particular security, strategy, or investment product. This publication does not consider your particular investment objectives, financial situation or needs, should not be construed as legal, tax, financial or other advice, and is not to be relied upon in making an investment or other decision.
Certain information contained herein has been obtained or derived from unaffiliated third-party sources and, while Prairie Capital Management Group, LLC (“Prairie Capital”) believes this information to be reliable, makes no representation or warranty, express or implied, as to the accuracy, timeliness, sequence, adequacy, or completeness of the information. The information contained herein, and the opinions expressed herein, are those of Prairie Capital as of the date of writing, are subject to change due to market conditions and without notice and have not been approved or verified by the United States Securities and Exchange Commission (the “SEC”), the Financial Industry Regulatory Authority (“FINRA”), or by any state securities authority. This publication is not intended for redistribution or public use without Prairie Capital’s express written consent.