Third Quarter 2023 – The Magnificent SevenSubmitted by Alsworth Capital Management, LLC on October 26th, 2023
The S&P 500 reached a 2023 high at the end of July before selling off 7.5% through August and September to finish the quarter down 3.3%. Year-to-date the index remains up a solid 13%. Smaller-cap stocks (Russell 2000) also had momentum early in the quarter, but changed course and ended the quarter down 5.1%, though are still positive 2.5% year-to-date. Within foreign markets, developed international stocks (MSCI EAFE) declined 4.1% in the quarter, yet remain up just over 7% year-to-date. Emerging market stocks (MSCI EM) fell 2.9% bringing down their year-to-date return to just under 2%. The U.S. dollar (DXY Index) climbed over 3% during the quarter, resulting in a headwind for foreign stocks as well as Gold, which was down 3.7% in the quarter and holds on to a positive 1.2% gain year to date. In bond markets, the 10-year Treasury yield rose to 4.59%, which represents the highest yield since before the financial crisis in 2008. As a result, core bonds (Bloomberg U.S. Aggregate Bond Index) fell sharply, declining 3.2% over the quarter. The 1-year Treasury yield is currently at 5.4% as we continue to see a strange phenomenon known as an “inverted yield curve,” with short term rates exceeding long term rates. This is often a precursor to recession as investors seek to lock in longer term rates prior to a slowdown in the economy.
The Wild West of Narrow Markets
With virtually all segments of the stock market posting gains this year through September, one might think that we’re in the midst of a broad-based rally. However, stock gains have remained unusually narrow, with the largest stocks in the index leading the way. Despite stalling in the latter half of the quarter, the year-to-date performance of the “Magnificent Seven” stocks (Amazon, Tesla, Apple, Microsoft, Nvidia, Google, and Facebook) continues to explain most of the U.S. stock market’s returns. These seven stocks have collectively increased more than 80% this year, while the remaining 493 stocks in the S&P 500 index are basically flat. Like the classic western movie by the same name, these seven gunslingers are capturing all the glory, but history suggests that none are invincible.
As a result of their massive outperformance, the “Magnificent Seven” have a combined $10.7 trillion market cap and constitute more than 30% of the S&P 500 index. This level of concentration at the top of the U.S. market exceeds what was witnessed in 2021 and the tech bubble of the late 1990’s / early 2000’s. We have to look all the way back to the early 1970’s (remember the “Nifty Fifty”?) to see a market as concentrated as it is today. These growth stocks are trading at extremely high valuations, and we have taken positions in the portfolio intended to reduce our relative exposure to these stocks, as we expect them to be the most vulnerable to a potential pullback in investor sentiment.
Litman Gregory and iMGP
For many years, we have worked with a firm called Litman-Gregory to provide much of our research, portfolio strategy and scenario modeling. They have substantial resources, with over $10 billion in assets under management and they were recently acquired by a firm called IM Global Partner (iMGP), with over $38 billion in assets under management. Under the iMGP umbrella are a host of investment management firms, a hedge fund replication firm and an asset allocation firm managed by famed strategist, Richard Bernstein. We have been leaning heavily on these resources in recent months, as economic uncertainty has risen, and valuations have remained detached from fundamentals. I wanted to introduce iMGP, as they will continue to be referenced in our materials along with Litman-Gregory.
Investment Outlook and Portfolio Positioning
From a macroeconomic perspective, the big question remains whether the U.S. economy can avoid recession or not, and the timing if it does occur. It goes without saying that the answer will likely lead to meaningfully different market outcomes. If the Fed can manage to slow the economy while avoiding recession, we would expect to see the market’s gains broaden out beyond the large-cap technology- related sectors. Conversely, if the Fed’s monetary tightening cycle leads to recession, it would likely lead to broader-based declines.
Our base-case is for a mild recession looking out to 2024. We have seen one of the quickest and sharpest tightening cycles in history, and bank lending standards have tightened considerably. Both factors create recessionary conditions. However, on the positive side, if the economy falls into recession, we believe it will be relatively mild. The pandemic related stimulus programs are still working their way through the system, consumer spending is still strong and the job market remains supportive. A mild recession is a common expectation, and many corporations are starting to preemptively slow spending and hiring, which could ease the impact versus a sudden drop off in economic activity.
Inflation has come down from its June 2022 high of 9.1%. Recent inflation data show it has declined to 3.7%, suggesting the Fed’s policy has been working and that the current interest rate hiking regime may be coming to an end. The rise in interest rates has taken a bite out of bond returns, which have suffered steep losses over the past couple of years. The silver lining is that looking forward, interest rates ended the third quarter at levels not seen in nearly 20 years (the Bloomberg Aggregate Bond Index ended the quarter yielding 5.4%). Higher starting yields, all else equal, should lead to higher expected returns. We remain positive on core bonds given their combination of healthy fundamentals, attractive current yields, and the downside protection they provide portfolios in the event of a recession.
Overall, we remain underweight the U.S. market in favor of foreign stocks. While it is true foreign stocks will likely decline as much as U.S. stocks in a recessionary scenario, foreign stocks are far less expensive than the U.S., setting them up for attractive medium-to-longer term expected returns. As U.S. debt levels have exploded, combined with higher interest payments due on that debt, we remain cautious on the value of the U.S. dollar. We continue to hold Gold as a hedge against potential declines in the U.S. dollar and increasing global geopolitical uncertainty.
As we look ahead, a mild recession is still our base-case looking out to 2024. However, we can’t rule out the possibility that the Fed threads the economic needle and successfully guides us to the rare soft landing of lower inﬂation and slower economic growth without recession. Nobody can time markets perfectly or predict the future with consistent accuracy. As such, we maintain a diversiﬁed portfolio to have exposure to multiple scenarios, while shifting our allocation on a probability weighted basis. We will continue to be humble in our approach and rely on data over emotions. As always, we appreciate your trust and welcome any questions or feedback you might have.
Shane M. Alsworth, MBA, CFP®, CLU®, CIMA®
The views and opinions presented in this article are those of Shane Alsworth only
Sources: Morningstar/Ibbotson data, Ned Davis Research, BCA Research, Litman-Gregory, iMGP
*US large stocks (S&P 500 Index), US large cap growth (Russell 1000 Growth Index), US large cap value (Russell 1000 Value Index), US small stocks (Russell 2000 Index), (Developed international stocks (MSCI EAFE Index), Emerging Market stocks (MSCI EAFE EM Index), Core investment-grade bonds (Bloomberg U.S. Aggregate Bond Index), Floating Rate Loans (S&P/LSTA Performing Loan Index), US Dollar (DXY Index), Gold (Aberdeen Physical Gold ETF), Commodities (Bloomberg Commodity Index)
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