Occasional Daily Thoughts: Preview of the 3rd Quarter / Review of the 2nd

By LaRue Gibson on July 10, 2023

Just as in the first quarter of 2023, the second quarter confounded and frustrated economic and market pessimists. Risk assets advanced further, with technology, consumer discretionary, and communications sectors outperforming the S&P 500 significantly and the yield on 10-year Treasury Notes rising nearly 3/10^ths of a percent. While most stocks struggled to stay even this year, the NASDAQ Composite Index recorded its best first half since 1983!

Investors’ serious concerns about the banking system’s health at the end of the first quarter and the Federal Reserve’s relentless year-long (and then some) tightening regime have done little to halt the ongoing bull market surge since last October. Regular readers would have expected a strong rally off the October 12^th market lows based upon the Mid-Term Election Cycle theory, but they may have expected broader market participation rather than the narrowest market advance in history. As July gives way to the seasonally weak August through October period, we advise caution due to several emerging and ongoing factors:

• The yield curve’s historically long and deep inversion
• A suspected contraction in the money supply as measured by M2 to contract
• The corporate profits recession
• Banks’ tightened lending standards which historically precede job losses
• The Federal Reserve’s ongoing tightening regime
• A rarely discussed liquidity squeeze related to an expected Quantitative Tightening resumption and replenishment of the Treasury’s General Account
• Higher market interest rates which may see the 10-year Treasury Note approach and exceed the cycle high of 4.35%

Two primary explanations exist for why these factors have not materially affected risk asset performance yet:

1. Perhaps the promise of artificial intelligence (AI) will lead to meaningful increases in productivity as the internet, the semi-conductor, the tractor, and the light bulb did. Nvidia’s astounding quarterly result in May could foretell the ascendancy of AI as a major economic driver. Thus, are investors discounting a revolutionary change in the economy that will render old economic and financial assumptions useless?
2. The twin challenges of the debt ceiling and the failure of a handful of banks earlier this year required a liquidity influx into the financial system. The Fed’s balance sheet ballooned by $300 billion in March, while the Treasury Department’s General Account shrank from approximately $580 billion in January to $23 billion by early June. Increased liquidity typically supports risk taking.

Both, one or the other, or neither of these explanations may prove correct. However, the dual liquidity stimuli contradict inflation-fighting goals, so we anticipate a significant liquidity contraction for both the economy and the markets in the second half of the year. This liquidity drain will affect both the bond and equity markets in the near term.

Jerome Powell, the Fed Chair, will pursue the much-touted 2% inflation as he unequivocally stated to Congress in June. We take the chair at his word and expect more tightening in 2023. In our opinion, the relationship between unemployment and inflation holds the key to a “pivot” or change in course for interest rate policy. We would not expect an easing regime to commence until the unemployment rate exceeds the rate of inflation as measured by the Consumer Price Index. That has not occurred yet. We should point out that recessions tend to follow the current policy actions.

Furthermore, we believe the Fed will wish to see short-term inflation expectations to anchor more closely to its 2% inflation rate target. As the following graphic illustrates, inflation expectations have improved, but more is required.

The bond markets clearly project a recession for the U.S. economy. As the below illustration demonstrates, the Federal Reserve’s benchmark interest rate exceeds the yield on 30-year Treasury Bonds by greater than +1.4% and has done so for several months. Recessions have followed.

Additionally, we note that the Conference Board’s Index of Leading Economic Indicators (LEI) strongly correlates with expansions and contractions in economic activity. We spy a deterioration in the Board’s LEI lately.

Yet, the relative performance of consumer discretionary shares to consumer staples shares communicates a risk-on posture in the equity markets. Which is correct — bonds or consumer discretionary stocks?

As mentioned earlier, the S&P 500 Index has fulfilled our post mid-term election predictions thus far. Regular readers remember that after a difficult mid-term election year for equity markets, history suggests a robust rebound from the cycle low. As of this writing, the S&P 500 Index has recovered over 24% from the October 12, 2022 low.

The recovery has been narrow with only seven to ten mega-cap stocks accounting for nearly all the performance of the S&P 500 Index. These stocks predominately hail from technology or technology-related industries. By some measures, the current narrow leadership within the U.S. equity market is the narrowest in history including the record setting period of the late 1990s technology bubble. When we measure the performance of the NASDAQ 100 Index (a useful proxy for technology stocks and the mega-caps dominating performance today) versus the MSCI All Cap World Index ex USA Index (a much less heavily technology influenced index), we observe how demonstrably the technology mega-cap stocks have outperformed non-technology equities recently. What astonished us is that when comparing the technology bubble of the 1990s to the narrow, technology dominated performance of 2023, we see similar outperformance; however, the late 1990s period of relative strength was followed by approximately nine years of underperformance. Consider the following graphic that shows the technology bubble’s relative outperformance followed by an extended period of poor relative and absolute performance. Interestingly, the current period of technology relative outperformance makes the outperformance of technology companies in the 1990s appear mild in comparison. Caveat emptor!

Although often portrayed as optimistic and opportunistic, growth investing really implies a negative view of future economy-wide earnings growth, and extremely narrow leadership implies only a handful of companies will be able to grow. Today’s historically narrow markets suggest not only a deep profits recession, but even questions corporate survival for the broader global equity market. We do not share this morose view of the global economy. We have little doubt that a profits recession began in the second half of 2022, but we espouse a more traditional view that supports overweighting defensive sectors when the profits cycle decelerates.

Many investors today portray investing in technology stocks as both growth and defensive investing; however, data demonstrate that the profit cycle strongly influences technology companies making them more akin to cyclical sectors rather than growth sectors. Surprisingly to most of our audience, consumer staples companies, a historically defensive sector, have enjoyed superior profit growth in each of the last three quarters! The relative performance of the sectors do not reflect this fact.

The original Nifty 50 stocks of the 1970s subsequently underperformed because their universal acceptance as the only companies that offered earnings growth implied a dire economic forecast that proved incorrect. In fact, many non-Nifty 50 companies ultimately had significant earnings growth. Similarly, we expect today’s version of the Nifty 50, the Super Trend Ten (?) to underperform. Returns are greatest where capital is scarcest. It is hard for us to imagine that there are no other growth opportunities anywhere else in the world, and the concentration of capital in such few names offers opportunity for the discerning investor, in our opinion. History has borne this out after every speculative bubble.

As the lazy days of summer arrive, we remind you of the seasonal rhythm of the markets. The third calendar quarter has provided the lowest average return of the four calendar quarters in the past.

Furthermore, we know the adage “Sell in May, and go away,” but data does not support it. We advise our clients to “Have their powder dry by the end of July.”

2023 has offered yet another challenging environment where one must lean against the prevailing winds to avoid disaster and to position oneself for underappreciated opportunities. LRG Wealth Advisors stands ready to provide support through clear, sober data assessment and, if necessary, some good, old-fashioned hand holding. Enjoy your summer. It is hot out there! Take good care.