Market Outlook: Q3 2023

by John M. Fidler

Cormac McCarthy, acknowledged by many as America’s greatest living novelist, passed away last month at the age of 89. McCarthy served as a Trustee of the Sante Fe Institute, a New Mexico think-tank dedicated to the inter-disciplinary study of complexity science, along with investment luminaries Bill Miller, Bill Gurley, Michael Maouboussin, Jim Pallotta, and Doyne Farmer. However, it was another aspect of McCarthy’s relevance to the world of economics and markets that came to mind as we watched the markets in the first half of 2023. This is the idea of scarcity: the simple notion we learn in Economics 101 that prices are driven by supply and demand. In 2006, when McCarthy published his haunting, post-apocalyptic, Pulitzer Prize-winning novel The Road, he signed 250 copies of the first edition of his book and put them in a locked safe for his son to inherit. He never signed another copy of the book. McCarthy understood that scarcity drives value. If something is rare, people will pay a high price for it, potentially an irrationally high price.

2023 has been a great year for the broad markets thus far, with the S&P 500 Index and Nasdaq gaining 16% and 32%, respectively. Bond markets have also begun to recover from their disastrous 2022, with the Bloomberg Aggregate Bond Index returning 2.1% through June 30. Developed International and Emerging Market equities are also positive on the year, with only Small Cap stocks (especially Small Cap Value) lower year-to-date. Asset returns this high and broad are typically associated with early-stage cyclical recoveries, when economic growth is above trend and monetary policy is loose. Today, we have exactly the opposite economic conditions, with slowing growth and restrictive policy.

So, how to explain the resilience of the market? If we look under the hood, index returns do not tell the whole story. Just 7 stocks (Apple, Amazon, Alphabet, Meta, Microsoft, Nvidia, and Tesla) drove virtually all of the gains in the S&P 500 Index. The other 493 stocks in the index, in aggregate, are only 5% higher on the year. Much of the 60%+ average price gain in these 7 stocks is related to the promise of artificial intelligence (AI), and its potentially life-altering ramifications. In an era of increasingly concentrated economic power, the perceived future cash flows from this “AI revolution” mainly accrete to a few massive companies: the tech “hyperscalers” (Apple, Amazon, Alphabet, Meta, and Microsoft) and a few semiconductor companies that produce the cutting-edge semiconductors necessary for the massive computing power AI requires (primarily Nvidia, along with a few others).

There seems to be little doubt that AI will prove to be a durable secular trend. Some have speculated that it could be as important a technological innovation as the internet, and we certainly believe that is possible. Nvidia, the company perhaps most directly levered to AI and now the closest thing to an AI “pure play,” is already reaping the benefits of demand for their high-powered microchips. 2024 earnings estimates for Nvidia have roughly doubled this year (while the stock price has nearly tripled). As investors have rushed to gain exposure to the secular trend of AI, they have limited avenues to do so. There is a scarcity of direct AI beneficiaries, just as there’s a scarcity of signed first editions of The Road. But as a result, valuations of these companies have become “priced for perfection” in our view. Nvidia now trades at around 30x its expected 2027 earnings, almost double the earnings multiple for the next 12 months of the S&P 500 as a whole. We believe AI will prove a durable secular trend, but we also believe much of the coming years’ capital creation and earnings growth is well-reflected (if not excessively reflected) in current stock prices.

If these 7 stocks don’t continue to lead the market higher, will the other 493 stage a catch-up rally and lift markets higher in the second half of the year? Clearly, this is the most logical bullish argument. We are skeptical. Normalized for very high-profit margin levels, the current forward price-to-earnings ratio (P/E) of the S&P 500 of over 19x is not exactly bubble territory (we got to 21.5x at the January 2022 market peak and 25x in 2000), but also not an entry point historically consistent with above-average future returns (major bear market bottoms since 1996 have occurred at forward multiples over 10-15x, whereas the May 2023 low was around 18x).

A decade of abnormally low interest rates helped to boost P/Es, but now that we’ve entered a period of “higher for longer” normalized interest rates, one would think this should pressure valuation multiples (along with other structural headwinds such as deglobalization and higher future taxes).

The stock market seems to be firmly pricing in an economic “soft landing.” As a friend recently described it, the bull case for the stock market from here is straightforward: investors are taking the current 2023 S&P 500 earnings estimate of $225 and assuming 10% EPS growth in 2024 and 2025. If we put an 18x multiple on those 2025 earnings, that gets us to a fair value of 4800-4900 a year from now, so around 10% upside. Simple enough. But does the weight of the evidence support this idea of straight-line earnings growth over the next 6-24 months? Here again, the data are not so encouraging in aggregate. On the positive side:

• The labor market remains historically strong (unemployment rate of just 3.7% nationally) and consumers still have relatively healthy balance sheets, thanks to COVID-era fiscal stimulus.

• The global economy has been resilient in 2023, with the JPMorgan Global Composite PMI rising from recession territory in 4Q22 to levels consistent with strong economic expansion. 

• The banking system, despite the panicked headlines we saw in March following the collapse of Silicon Valley Bank, remains as healthy as it’s ever been in terms of capital reserves and credit quality.

But the macro negatives are more than a few:

• The US has been in an “earnings recession” since 4Q22, with corporate earnings declining year-on-year the past 2 quarters, and more of the same expected in fiscal quarter 2Q23. While the Wall Street consensus is for a swift resumption of earnings growth in 2H23, this is not consistent with the historical relationship between leading economic indicators and realized corporate profit growth.

Source: Factset, Bloomberg, Haver, Morgan Stanley Research

• While the banking system is sound, lending standards have tightened and loan demand has weakened. Both metrics were already at levels historically associated with a recession prior to the bank failures in March. Credit quality, while still very good, has only one way to go, and data from the weakest parts of the credit landscape (leveraged loans, credit cards) tell us that it’s beginning to deteriorate.

• Consumer spending has begun to slow. This is confirmed by official headline data as well as more anecdotal evidence like recreational vehicle sales, or consumer-facing companies’ comments on earnings calls.
• While the housing market remains strong, with new home sales especially robust, affordability is the worst it has ever been. Higher mortgage rates are good news for those who locked in a fixed low-rate mortgage prior to 2022. But those homeowners now have little incentive to move, knowing their new mortgage would be at a much higher rate. Unless income skyrockets (unlikely with a Federal Reserve laser-focused on curbing both wage inflation and housing/rent inflation), homes are unaffordable to new buyers. As a result, new home sales have remained robust, since they are effectively the only source of incremental housing supply. (Again: scarcity!) So, either the number of transactions in the housing market resets to a semi-permanent lower level (unlikely), home prices fall (not good for consumer confidence), or rates come down (implying a weaker economy).

In short, these economic headwinds appear to constitute more than the proverbial “wall of worry,” and the not-insignificant economic tailwinds mentioned above also mean that the Fed is likely to remain restrictive for longer than market participants expect. Core inflation remains at nearly 5% and we anticipate it will be hard to get this number much below 4% before year-end. A rebound in oil prices could also lead to a re-acceleration of inflation in 2H23. Fixed income markets are pricing nearly 2% of Fed Funds rate cuts in 2024. This seems like a stretch, given the inflation backdrop. Importantly, there remains a real disconnect between forward interest rate markets and the stock market: If the Fed does feel the need to cut rates that aggressively, it implies an economic “hard landing.” If equity markets are correct in pricing a “soft landing” in 2H23/1H24, it implies much tighter forward financial conditions than priced by the bond market, which in turn implies a need for risk assets to reprice lower. Our view is still that the potential for a forward liquidity crunch is being underpriced by the markets.

So, how to position in this confusing environment? Our answer continues to be roughly the same as it’s been since late 2021 when interest rates began to rise in earnest: from 2019-21 there were no credible investment alternatives to the equity market, and stocks doubled. Since early 2022, we have argued that reasonable alternatives exist:

• EQUITIES: Stay in the stock market, but tilt defensive, focus on quality, and seek out pockets of idiosyncratic value. We favor US large cap defensive value and quality growth companies. A weakening dollar has been a tailwind for emerging market stocks, and we have added exposure in this area, as well as idiosyncratic stories within larger secular trends like Expedia (online travel) and Equinix (datacenters, cloud computing).
• FIXED INCOME: Tactical, value-oriented fixed income exposures can generate reasonable yields and act as a deflation hedge in the event of a hard landing. If we see the US 10-year Treasury trade back above 4%, this would represent an attractive entry point in terms of adding portfolio diversification and reasonable risk/reward.
• INFLATION PROTECTION: Natural resource companies (such as cash-flowing energy stocks), direct commodity exposure, and diversifying alternatives can all provide protection in the event that inflation remains higher than expected.
• CASH: With risk-free money market yields approaching 5% (and likely to rise above 5% when the Fed meets in July), only slightly lower than the current earnings yield on the S&P 500, we are generally holding elevated levels of cash. If and when a recession hits, it will create outstanding investment opportunities for patient investors. Cash represents a call option on other assets with no expiration date, and being paid 5% to hold that option (in prudent size) seems sensible to us at this point in the cycle.

The end of the economic cycle always presents challenges to investors, as asset valuations begin to diverge from underlying fundamentals, but economic growth is not yet obviously rolling over. At the same time, investors place their hopes on a “Fed put” that will put a floor under markets as they begin to ease policy. As market leadership narrows, investors then chase those few, scarce outperformers as they rush to keep up with benchmarks as they “melt up.” We saw this same behavior in 2000, 2007, and 2019. While we doubt the end of the cycle will prove as violent as those cycles did, we continue to think this is a time for patience and discipline. We continue to diversify portfolios at an asset class level and seek out quality investments with a margin of safety, an approach that has benefited clients for many years and we believe will continue to do so in the future.

 

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