John Kenneth Galbraith, the prominent economist and economic advisor to several presidents, once said that “the only function of economic forecasting is to make astrology look respectable.” His sentiment underscores the high unpredictability of economic outcomes and the tendency of the economy to do exactly the opposite of what most expect.
On the whole, the US economy has decidedly exceeded expectations in 2023. Such robust economic performance in light of weak expectations should not be surprising. This performance again underscores the dynamism of US businesses and consumers, proving their capacity to thrive even amidst global uncertainties.
Despite the headwind of tighter Federal Reserve policy and stricter lending standards following the collapses of Silicon Valley Bank and then Signature Bank in March, the unemployment rate has remained below 4% since the start of 2022. Furthermore, the labor force participation rate (age 25-54) is at its highest level in more than two decades suggesting that nearly everyone who wants a job, has a job. All the data tells a clear story about the labor market – that it remains very tight with plentiful jobs and a scarcity of workers.
The domestic economy grew by 2.2% in the first half of 2023 in real terms – above the level of inflation. Additionally, the GDPNow estimate – which accounts for a plethora of reported economic statistics – currently indicates GDP growth of 5.1% in the recently completed 3rd quarter. Service-sector spending – which constitutes 78% of US GDP – has been the key engine of growth as consumers continue to aggressively spend on services.
The glass-half-empty crowd is never void of compelling risks or deteriorating segments of the economy and the current environment is no exception. Both the manufacturing and commercial real estate sectors, which are notably sensitive to interest rates, have been negatively impacted by the Federal Reserve’s significant rate increases. Pessimists can also point to headwinds such as the resumption of student loan payments which will crimp consumer spending, political dysfunction in DC, a looming government shutdown in November, and the threat of even higher energy prices as the Israel-Hamas war potentially chokes off shipping lanes.
What’s going on with the bond market?
Things have taken a turn for the strange when the typically uneventful bond market consistently overshadows stocks in headline news. Welcome to 2023.
Expectations were high at the beginning of the year that the prolonged downturn for bonds was concluding. Firstly, bond yields entered the new year at their highest levels in 15 years ensuring that investors would benefit nicely from regular coupon payments, even without capital appreciation. Secondly, economists and central bankers were in agreement that 2023 would bring an economic slowdown due to the Federal Reserve’s aggressive interest rate hikes. This widely anticipated slowdown would curtail inflation, leading to lower interest rates and subsequently higher bond prices.
Prior to 2022, the Bloomberg US Aggregate Bond Index had never experienced two consecutive calendar year losses and yet here we are – more than ¾ of the way through the year – with another negative sign preceding the bond index’s calendar-year return. Notably, it’s not an insurmountable deficit – The Bloomberg Aggregate Bond Index is down by 1.2% over the first nine months of the year – a gap that could certainly be reversed in the 4th quarter if long-term rates just stop their upward ascent.
The silver lining is that as bond prices decline, expected future returns increase. Consider that the 10-year Treasury yield historically explains 91% of the return an investor realizes over the subsequent decade when holding a portfolio of intermediate-term high-grade bonds (to maturity and reinvesting coupons at the prevailing rate). You would be hard-pressed to find a better forecasting tool in capital markets than the current yield at forecasting future returns.
And to this point, the 10-year yield recently hit its highest level since 2007 driven by the aforementioned economic data which has consistently come in better than expected. The net result to investors (you) is that the expected return for bonds over the next decade is far more compelling now than at any point over the past 15-20 years.
The chart below demonstrates the historic increase in rates over the past three years. While the climb up has not been kind to bond prices, the now higher yields present a much more compelling environment for bond owners.
Additionally, this chart shows the dramatically higher yields provided today by bonds relative to the start of 2022.
Finally, it is worth noting that the prevailing view on Federal Reserve policy – which we can specifically calculate from the interest rate futures – is that the Fed will hold short-term rates steady through the middle of 2024 and then begin gradual rate cuts. Although an unexpectedly high inflation reading could change things, the market-implied probability of any additional rate hike this year or next is less than 30%.
And what about the stock market?
I wrote last quarter about the “Skinny Bull” – a term used to describe how seven stocks referred to as the “Magnificent Seven” accounted for more than 100% of the S&P 500’s return in the first half of 2023. The market dominance of the Magnificent Seven (Microsoft, Apple, Alphabet, Amazon, Meta, Tesla, Nvidia) subsided in the third quarter but the spread between these megacap stocks and the rest of the market has been the dominant theme in the stock market this year.
The following chart shows the 2023 returns of three indices:
- The S&P 50 – the 50 largest stocks in the S&P 500, weighted according to market size such that the Magnificent Seven constitute 49.8% of the index;
- The S&P 500 Index – the widely cited index comprised of 500 stocks, each weighted according to its market size; and
- The S&P 500 Equally Weighted Index – using the same 500 stocks but with each stock equally weighted at 0.2% of the index.
This chart tells the story of what has driven the stock market this year. The S&P 50 Index- with roughly half of its weight comprised by the Magnificent Seven – gained 27.9% in the first 9 months. Conversely, the Equal Weight S&P 500 – a better representation of the broad market where every stock represents 0.2% of the index regardless of the company’s size – posted a relatively meager gain of just 1.7%.
To be fair, the Magnificent Seven have all showcased resilient business models, compelling revenue growth, and excellent profit margins. The proliferation of technology and digitalization, coupled with their robust financial health, has enabled them to navigate through economic fluctuations. They are great companies. But we must remember the most fundamental concept of investing: Price matters. Investors, attracted by the seemingly steadfast growth of these market leaders, have lately abandoned valuation metrics for fashionable stories – buying great companies for their hype even if the valuations bake in outlandish future growth scenarios.
There is a valuable lesson from the founder/CEO of Sun Microsystems, Scott McNeely, speaking about his own company’s stock during the late innings of the dot-com bubble:
At 10 times revenues, to give you a 10-year payback, I have to pay you 100% of revenues for 10 straight years in dividends. That assumes I can get that by my shareholders. That assumes I have zero cost of goods sold, which is very hard for a computer company. That assumes zero expenses, which is really hard with 39,000 employees. That assumes I pay no taxes, which is very hard. And that assumes you pay no taxes on your dividends, which is kind of illegal. And that assumes with zero R&D for the next 10 years, I can maintain the current revenue run rate. Now, having done that, would any of you like to buy my stock at $64? Do you realize how ridiculous those basic assumptions are? You don’t need any transparency. You don’t need any footnotes. What were you thinking?
With the benefit of hindsight, investors now think of the 1999-2000 dot-com valuations as outrageously unsustainable. But consider that Tesla presently trades at 9.7 times revenues – roughly the same level that Scott McNeely described as ‘ridiculous’ when speaking about his own company’s stock. Or if you really want a poster child for the potentially unsustainable valuations of the current market, consider that Nvidia trades not at 10 times revenues or 20 times revenues but at 35 times revenues.
What about stocks relative to bonds?
With the dramatic rise in interest rates over the past three years making bonds more attractive and the rapid ascension of stocks over the past three years arguably making stocks less attractive, is there a case to be made for bonds relative to stocks?
There is a recent argument using a valuation tool known as “The Fed Model” that suggests bonds are attractive relative to stocks for the first time since the dot-com era (it should be noted that the Fed Model data was skewed for several months during the 2008-2009 Great Financial Crisis because of negative earnings for the stock market). The idea of the Fed Model is that we can evaluate the relative attractiveness of stocks and bonds by comparing the earnings yield of stocks (earnings divided by price, also the inverse of the P/E ratio) to the 10-year Treasury yield. This approach gained prominence and its name in the late 1990s when the Federal Reserve cited the relationship between these two metrics.
So what should we make of this? The challenge with this relationship right now goes back to the Magnificent Seven and that so much of the S&P 500’s valuation is driven by its most expensive stocks. Consider that the earnings yield of the equal-weighted S&P 500 right now is 6.3% – more than 1.5% higher than the yield on 10-year Treasuries. This is to say that the valuation of the stock market right now is significantly more appealing if we look past the largest and most expensive stocks.
But here is where we will again make the argument that value stocks present a table-pounding long-term opportunity in investment markets. We explained the case in 2020 and the chart below presents just one visualization of the historical spread between value stocks and growth stocks. That said, we continue to maintain an increased allocation to value stocks in Golden Bell portfolios. This factor tilt provided great benefit to your portfolio in 2022 – a trend that has reversed in 2023 as the relative cheapness of value stocks has widened.
Closing Comments
We will reiterate what we have said before – the primary difference between investing success and failure is the time horizon employed. Unsuccessful investors tend to focus on the short-term whereas successful investors focus on the long-term. There is far too much noise-induced gyration in stocks and bonds to place short-term wagers when the ultimate goal is long-term success.
A big part of the role of high-quality financial advisors is to understand market, political, tax, and economic dynamics to help make wise investment and financial planning decisions. When we make investment decisions, they are always done with a long-term view. It is our hope and expectation that long-term portfolio tilts such as our elevated bias to value stocks will produce attractive benefit over the coming decade but how and when that benefit comes is unknowable.
A secondary role of high-quality advisors is to help explain and decipher market dynamics to clients so that they can better make sense of things. I hope that this letter has helped in that respect and welcome any questions you might have about investments, finances, or your retirement plan.
With Kind Regards,
Jason