“Most people get interested when everyone else is. The time to get interested is when no one else is. You can’t buy what is popular and do well.”
Warren Buffett, 1930 – Present, Chairman & CEO Berkshire Hathaway
RECESSION OBSESSION AND WILD MARKETS
Imagine trying to write out a math equation in words. For lower level computation problems, this would be difficult enough, but for longer algebra and calculus problems, writing out an equation in words could take multiple pages. Although numerical notation systems (using symbols to express relationships between different mathematical objects) did exist as much as three thousand years ago, modern algebraic symbols to write mathematical notations weren’t introduced until later in the sixteenth century.
Equivalence in mathematics, for example, is defined as a relationship between two expressions holding the same value. Until the sixteenth century, the most common way to write ‘equal to’ was to use the Latin ‘aequales’ or ‘aeq’, making the time to accomplish long division truly long. It wasn’t until 1557, when Welsh physician and mathematician Robert Recorde first introduced the now familiar equals sign (=), which would forever change mathematics. In his book “The Whetstone of Witte” (the title was a pun about sharpening one’s mathematical wits), he states his reasoning for adopting two parallel lines: “And to avoid the tedious repetition of these words - ‘is equal to’ - I will set as I do often in work use, a pair of parallels or Gemowe (meaning twin) lines of one length, thus: =, because no two things can be more equal.”
While it was nearly a century before the two parallel lines were generally accepted and recognized to denote equivalence, Recorde’s invention was an important step in the development of algebra and helped introduce mathematical education to an English audience at a time when printing in the vernacular was relatively new and literacy was limited.
In a similar vein, a relationship between two numbers or values that are not equal to each other is called inequality. It is denoted by two parallel horizontal lines cut by a slanted line as ‘≠’, and was popularized by Leonhard Euler, an 18th-century Swiss mathematician who developed many concepts that are integral to modern mathematics. For example, 6 ≠ 3 states that 6 is not equal to 3.
We are confronted with mathematical equations in everyday situations and often use them without even noticing it because they are so familiar. Inequalities are arguably more common in daily life than equalities. In fact, they are widely used in the business world, among other things, to produce pricing models, control inventory, and assist in managerial decision-making.
The popular notion among economists and investors that ‘the stock market is not (≠) the economy’ claims that the day-to-day performance of Wall Street often bears a scant reflection of what’s happening on Main Street. In fact, they often exist in two different realities, as the rally in risk assets in the first half of this year demonstrated, when stocks climbed the proverbial ‘wall of worry’ into bull market territory, while having to contend with interest rate hikes, a banking crisis, tightening credit conditions, sticky inflation, contentious debt ceiling negotiations in Washington D.C., declining corporate earnings, an inverted yield curve, and the possibility of a recession.
Whether deep or shallow, long or short, the idea that the economy is heading for a recession is pretty much the consensus view among economists. The American public is also concerned about the probability of a recession, with around 68% of U.S. adults expecting one within the next six months, according to a survey from Nationwide. Like Vladimir and Estragon in Samuel Beckett’s masterpiece ‘Waiting for Godot’, so many people are anxiously awaiting an economic downturn, which now seems to be ambling into next year - if it arrives at all.
The U.S. labor market continues to show resilience and has so far defied expectations of a slowdown, with employers adding an average of 310,000 people every month to payrolls, according to the Labor Department. After more than a year of aggressive interest rate increases by the Fed, many industries, from construction to restaurants to health care, are still adding jobs to keep up with consumer demand. The nation’s unemployment rate is at historically low levels and wages have grown at the fastest rate in more than 20 years.
The strong labor market is in part fueling stubbornly high inflation, as millions of workers are seeing the largest pay gains in years. Wages rose 5.2% in May from the previous year, much higher than the pre-pandemic average of 3%. The job market’s continued strength confronts the Fed with a conundrum: can they meet their objective of full employment while bringing down inflation? The central bank decided to hold the federal funds rate at 5 to 5 ¼% last month to assess the effects of prior increases on the economy and to avoid overdoing it after 10 straight hikes in 15 months. Yet they also left the door open for further hikes as, in the words of Fed Chair Powell, “the process of getting inflation back down to 2% has a long way to go.” Policymakers expect to end the year at a rate of 5.6%, implying two additional hikes.
More hiring translates into more Americans earning paychecks, a trend that suggests that consumer spending - the main driver of U.S. economic growth - should continue to stimulate the economy, despite the challenges created by the emergence of higher inflation and rising interest rates. In the 1st quarter of 2023, personal consumption expenditures represented more than 68% of the nation’s Gross Domestic Product (GDP), according to data from the Bureau of Economic Analysis (BEA). Given the critical role consumer spending plays in the broader economy, any slowdown in spending activity could raise recession risks.
Data on household assets and checking account balances support the view that for now, households across the income distribution generally have considerable excess savings - BCA Research estimates there’s still $1.3 trillion in surplus cash - that should support consumer spending at least into the fourth quarter of this year. In addition, Federal fiscal largesse continues to provide hundreds of billions of dollars to boost infrastructure spending, renewable energy production, and semiconductor manufacturing, thus injecting significant stimulus into the economy.
As a result, U.S. economic growth appears to have ticked up a notch in the second quarter even as recession worries persist. After increasing at an annualized rate of 2% in the first quarter, the Atlanta Fed’s GDPNow model currently pegs second quarter real GDP growth at an annualized rate of 2.2% as the U.S. economy has shown surprising resilience in the face of the Fed’s aggressive rate hikes (see graph above).
So, why are Wall Street and Main Street sounding a recession alarm? Because when it comes to economic forecasts, the U.S. Treasury ‘yield curve’ is the go-to gauge for many seasoned investors. The yield curve is a graphical representation of the interest rates on debt for a range of maturities. It’s a way to measure bond investors’ feelings about risk and can be used to help gauge the direction of the economy.
The ‘yield curve indicator’, pioneered by Duke University professor Campbell Harvey, has accurately foreshadowed all 10 recessions since 1955, and right now it is flashing red after it inverted to levels not seen in decades. A so-called yield curve inversion is an unusual state in which longer-term bonds have lower yields than short-term debt instruments, signaling that investors are collectively looking for safe havens to wait out economic uncertainty (see graph below).
At the end of the second quarter, 10-year Treasurys yielded 3.81%, with three-month Treasury yields at 5.43%, a sign that investors expect higher interest rates or economic risk in the near term and demand more compensation. In ordinary times, investors tend to require higher interest to lend for longer periods because there is more inflation and interest rate uncertainty over the long term than in the short term. Such a ‘normal yield curve’ is generally linked with positive economic growth without significant changes in the rate of inflation or major interruptions in available credit. (A normal yield curve differs [≠] from an inverted one).
At its core, the inverted yield curve was the root cause of the recent troubles in the U.S. banking sector, which began with the collapse of Silicon Valley Bank (SVB) in March. Banks’ traditional business models are based on borrowing cheaply via customer deposits and lending longer-term at higher rates – which is pretty much the opposite of what is currently offered by the market.
Historically, a recession tends to follow a year after the curve inverts, though the variance can range from as little as seven months to as much as two years. An inverted yield curve doesn’t say anything about the severity of a coming recession, however.
While employment remains strong, other key economic indicators paint a different picture:
- The ISM Manufacturing PMI contracted in June for the eighth consecutive month and fell to its lowest level since May 2020. Although the Non-Manufacturing PMI remains in expansion territory, it is inching closer to levels that signal contraction;
- the Conference Board Leading Economic Index (LEI) for May declined for the 14th consecutive month in May – the third-longest streak of consecutive monthly declines since 1959 – putting the predictive index well beyond the level where a U.S. recession would be expected.
- M2 money supply, a benchmark measure of how much cash and cash-like assets are circulating in the U.S. economy, is declining at the fastest rate since 1933. Such declines are typically associated with a higher probability of an economic slowdown.
- the New York Fed’s recession probability indicator suggests there is a 70.85% chance of a U.S. recession sometime in the next 12 months, the highest reading in more than four decades.
Unfortunately, Wall Street is unlikely to receive the clarity it seeks anytime soon. Until there is a signal that the Fed is shifting to easier policy, the yield curve will likely remain inverted. In the meantime, the probability of the U.S. experiencing an economic decline over the next year remains elevated as the consequences of the Fed’s aggressive rate increases work their way through the economy.
Nonetheless, someone forgot to tell the stock market that the domestic economy is headed for an imminent recession. While bonds have reflected persistent uncertainty since November, the benchmark S&P 500 has rebounded into bull market territory after rallying more than 20% off its recent low reached in October 2022 - meeting the common definition of a bull market - as many of last year’s big losers bounced back on hope that the Fed is at the end of its most aggressive interest rate hiking cycle in decades.
Despite plenty of bad news in the first half of 2023 that could have derailed markets, the S&P 500 has returned 16% so far this year as investors appear to be closer to pricing in a ‘soft landing’ scenario more than anything else. The resolution of the debt ceiling and further passage of time without additional regional bank failures reduced the level of concern on display in the market, including a drop in the equity market “fear index” (VIX) to pre-pandemic levels.
Those gains aren’t what they seem however as the performance of the S&P 500 index is now the most concentrated since the 1970s. Almost all of the benchmark index’s gains so far this year have been fueled by outsized gains of a narrow group of so-called Big Tech stocks, which Bank of America dubbed ‘The Magnificent Seven’, masking a pretty mediocre performance from the remaining 493 companies. The stocks leading the charge are Alphabet (GOOGL), Amazon (AMZN), Apple (AAPL), Meta Platforms (META), Microsoft (MSFT), Nvidia (NVDA), and Tesla (TSLA). For most of them, the key driver of this year’s rally has been investor excitement over these firm’s investments in generative artificial intelligence (AI) technologies.
Just five of those seven stocks represent nearly a quarter of the market capitalization of the entire index, and at $3.0 trillion, Apple’s market capitalization exceeds the entire Russell 2000 index of smaller U.S. companies. It’s also bigger than the entire market capitalization of the Toronto Stock Exchange. Together, that small group of AI-charged tech stocks contributed almost 14% of the total gain to the S&P 500 this year. Excluding them, the index would be up around 3% year-to-date, making it a truly average year (see graph below).
With about 75% of the total market capitalization now coming from the largest 10 stocks, the U.S market has never been so concentrated in the last 100 years. So, while the tech centric Nasdaq Composite had its best six-month start to a year since 1983, up a whopping 32% since the end of 2022, an equal weight measure of the S&P 500 was up a much more moderate 6% in the first half of the year.
The main reason for the surge is the promise of AI. Since the launch in November of ChatGPT, an AI-powered chatbot, investors have grown ever more excited about a new wave of technology that can perform activities that usually require human reasoning, intelligence, learning, or decision-making. Firms that can make the best use of the technology, the thinking goes, will be able to gain market share and expand profit margins.
Those gains, however, have driven equities to more expensive levels and made them more vulnerable to declines. The S&P 500 now trades at 19 times its expected 12-months earnings, well above its historic average of 15.6 times, according to Refinitiv data. Valuations are even more stretched for the Nasdaq 100, which trades at nearly 27 times forward earnings estimates, compared to its historical average of 19.3 times. The 10 largest tech stocks have an even higher average P/E ratio of 39 times, compared to the non-tech average of about 16.
One of the trickiest elements for investors is that this concentration can resolve in one of two ways: either the rest of the market catches up with the leaders, or the high-fliers fall back down to earth. Indeed, there are signs that the rally is finally starting to broaden as buying expanded beyond just the handful of Big Tech stocks to other sectors and categories in June, which could mean that more gains for the major indexes lie ahead.
Yet according to Richard Bernstein Advisors, this would be the first bull market since at least 1990 to begin with the market cap-weighted S&P 500 index outperforming the equal-weighted S&P 500 index. An equal-weighted index gives each constituent the same weight in the index, versus a market-cap weighted index, where bigger companies hold a larger share of the index (equal weighted ≠ cap weighted).
At Telos, our client portfolios (with the exception of the Sherman Core portfolios) are generally equal-weighted, and, depending on the chosen investment strategy, own several of the Magnificent Seven in weights lower than the S&P 500. For the reasons explained in this newsletter, it should not be surprising when those diversified portfolios outperform or underperform a market-cap weighted index in any given quarter or year. However, ignoring the noise of such short-term market movements, staying focused on your longer-term goals, and sticking with your plan through the inevitable ups and downs of the markets are among the keys to long-term investment success (short-term returns ≠ long-term investment plan)!
As a fiduciary, Telos has a legal, moral, an ethical obligation to properly diversify our clients’ investment portfolios to avoid the unreasonable risk of ‘putting all your eggs in one basket’. But in a world where the best- and worst-performing investments tend to dominate the headlines, it’s easy to lose sight of the fact that a diversified investment portfolio is generally the most reliable approach for meeting long term investment objectives. Historically, the result is a less volatile portfolio that tends to produce more consistent returns over time.
The current rally may indeed be the early stages of a bull market, but based on history, this would truly be unprecedented. Only in hindsight will we know for sure whether this current rally is truly the end of the bear market. Regardless, longer-term investors should look beyond the debate about whether the current environment is a bull market or not and focus on what really matters in the long run for accumulating and preserving wealth.
In our view, there is an elevated risk that economic conditions could remain challenging over the next few quarters, depending on the direction of a host of variables that currently remain very uncertain. Having an active approach and thoroughly evaluating companies and all the impacts those variables have on their valuation is essential in the current environment of richly-valued stocks. In this environment, we expect increased volatility and favor overall defensive positioning combined with select risk-taking. Peak inflation and the end of policy tightening will ultimately usher in a conducive backdrop for risk-taking, as periods of downside volatility often present excellent entry points for long-term investors looking to buy stocks of quality companies.
As aptly stated by Benjamin Graham, “in the short-run, the market is a voting machine; in the long-run, a weighing machine.” Ultimately, the market evaluates and measures the true worth of investments based on their underlying fundamentals.