“On Wall Street today, news of lower interest rates sent the stock market up, but then the expectation that these rates would be inflationary sent the market down, until the realization that lower rates might stimulate the sluggish economy pushed the market up, before it ultimately went down on fears that an overheated economy would lead to a reimposition of higher interest rates.” – Robert Mankoff, Cartoonist for the New Yorker Magazine, published October 12th, 1981
Review
Investors were whipsawed during the first three months of the year in the bond and stock markets as they tried to digest the latest economic news along with forecasting the future direction of interest rates. Nevertheless, the equity markets on a worldwide basis got off to a strong start in January. Investors were bullish to start the year as inflation was declining and many anticipated the Federal Reserve would soon change course from raising interest rates to cutting them later this year. Then when stronger than expected economic reports were posted in February, investors were met with lower stock and bond prices as the market anticipated the Federal Reserve would have to raise interest rates longer than expected. The largest swings in volatility occurred during March when Silicon Valley Bank and Signature Bank both collapsed. According to the FDIC, Silicon Valley Bank and Signature Bank were the second and third largest US bank failures in history and the first since October 2020. With their total assets of $319 billion, 2023 already ranks as the second largest year for US bank failures trailing only the $374 billion of assets for banks that failed in 2008.
Even with all the volatility during the first quarter, the S&P 500 was up 7.03% during the quarter while the Dow Jones Industrial Average was up only 0.38%. The standout index was the Nasdaq, which was up 16.77% during the first quarter as investors gravitated toward many of the beaten down large tech stocks. The first quarter was the Nasdaq’s best quarter since the second quarter of 2020. The best sectors for the first quarter were technology, communication services, and consumer discretionary, which all gained more than 15%. The lagging sectors were financials, energy, and healthcare, all three posting negative returns. In general, the best performing sectors thus far in 2023 were the worst performers in 2022, and vice versa.
The yield on the 10-year U.S. Treasury Note, which influences everything from mortgage rates to student loans, fell to 3.49% from 3.82% to start the year, resulting in positive gains in fixed income markets. The decline in yields was the largest quarterly decline since 2020. The Bloomberg US Aggregate Bond Index, a proxy for the broad US bond market, was up 2.67% for the quarter. The U.S. labor market continues to be strong with employers consistently adding jobs during the first quarter. The U.S. unemployment rate remained very low at 3.5% in March. However, recession concerns remain due to the Federal Reserve’s aggressive interest rate increases to reduce inflation, the recent banking turmoil, and significant corporate layoffs primarily in the technology industry.
Outlook
A real conundrum for investors at this time is the hawkish language used by the Federal Reserve to tamp down inflation compared to what the Fed is projecting for Gross Domestic Product (GDP) growth. At the Federal Reserve meeting in March, the Fed lowered their forecast for GDP to 0.4% for 2023. For the first
quarter, the Fed is predicting GDP to come in at a healthy 3.2%. However, the Atlanta Fed’s GDP Now tracker, which is widely followed by the markets, is now forecasting only a 1.7% growth rate for the first quarter, down from a forecast of 3.5% just a few weeks ago. Therefore, if the Federal Reserve is correct GDP will only be 0.4% for the entire year, that would mean the economy must average negative growth over the next three quarters. The market is interpreting these Fed forecasts as predicting a recession, and in turn why the market is anticipating interest rate cuts later this year. The bond and Fed Futures markets are reflecting the Federal Reserve will have to lower its short-term interest rates 2-3 times later this year even though none of the members at the Federal Reserve will hint at that possibility.
Inflation remains at high levels, but it has been trending lower recently. Consumer prices rose 5% from a year earlier in March, the smallest gain since May 2021. It is interesting to note that the Consumer Price Index (CPI) may decline on a year-over-year basis over the next several months if the current trends continue. According to Bespoke Investment Group, “Because of base effects and the roll-off of huge spikes in inflation in the first few months of 2022, we will likely see year-over-year CPI at least in the 3s (3-4%) and maybe in the 2s (2-3%) by the time the June CPI print is released in mid-July. The Fed’s inflation target of 2% is something we could easily be close to by June. Anecdotally, we don’t hear people talking about this simple math enough. Yes, consumer prices will still be well above levels they were at just a couple of years ago, but in terms of the year-over-year number that everyone talks about, we’re likely to see a reading in the 2s or 3s (down from 5% as of March) by June or July.”
After many years of low interest rates, homeowners who locked into fixed rate mortgages and decided not to move have limited their exposure to the impacts of increasing interest rates experienced over the past year. According to Ellen Zentner, chief U.S. economist at Morgan Stanley, “Before the 2008-2009 financial crisis, nearly 40% of mortgages were adjustable rate, so Fed rate hikes drove payments up and served to choke off household spending. Today, that share is just 10%. Rates on student debt payments and most auto loans are similarly locked in.” This has enabled consumers to utilize a relatively larger portion of their disposable income in order to keep up with rising prices. One reason that many market prognosticators are projecting a shallow recession, if it occurs, is that many homeowners have a large equity position in their homes. According to the Federal Reserve Economic Data (FRED), U.S. households are collectively sitting on $31 trillion in owners equity of real estate. Real estate equity has increased by $11.5 trillion or 60% since the fourth quarter of 2019 just before the COVID pandemic started.
Currently, the S&P 500 trades for about 17.5 times projected earnings of $221 per share for 2023. While the 17.5 times multiple is not terribly extended based on historical norms, the risk is if projected earnings do not come in at the expected number the market would likely decline. The market is always looking ahead at least 6-9 months where earnings are currently projected to be $247 per share for the S&P 500 in 2024. That level would be up about 14% from the end of 2022. From a seasonal perspective, April has typically been one of the best months for the stock market. It is notable the S&P 500 was up during April in all ten prior years where the index fell in the prior calendar year and then increased in the first quarter of the new year. Additionally, this is the third year of the Presidential term which is usually the best of the four-year cycle. According to Bespoke, “Since World War II, the S&P 500 has averaged a gain of 3.1% in April of year 3 of the Election Cycle, and it has averaged a rest-of-year gain of 8.57% in these years.”
A popular contrarian bullish indicator is when the general investing public is negative regarding the prospects for the stock market. According to the Bespoke Investment Group, “The percentage of consumers expecting lower stock prices in the year ahead exceeded the percentage expecting higher stock prices for the 15th straight month in March based on the Conference Board’s monthly survey. Since 1987,
the only longer streak of net negative sentiment towards the stock market was surrounding the Financial Crisis spanning 18 months from November 2007 through April 2009.” Several recent economic reports such as the Manufacturing Purchasing Managers Index (PMI) for March dropped to 46.3 which is its lowest level since May 2020 and the fourth consecutive reading below 50 which signifies weakness in the manufacturing sector. Also, recent reports for construction spending, auto sales, real estate transactions, and other interest rate sensitive activities are reflecting that rate hikes by the Federal Reserve have slowed down economic activity.
As we move through 2023 the focus for the stock market will inevitably turn to the outlook for 2024 and what the projected earnings will be for the various components of the S&P 500. Professor Jeremy Siegel, retired Wharton Business School professor, noted recently “I enter the second quarter with a cautious outlook. I would like to see the Fed recognize the cumulative impact of its tightening and that inflationary pressures are no longer a primary concern. I would go with a pause at the next Fed meeting, but we still have six weeks to go. We will be getting CPI data, employment data, and a lot more anecdotal data on lending and borrowing impacts to gauge the Fed’s likely outcome.” Moving forward, all eyes will be on the latest economic reports and the future actions by the Federal Reserve.
We continue to remain positive for the future prospects for investors. As we stated in our Fourth Quarter 2022 Review & Outlook, since 1928, the market has been positive 64 out of 95 years, or 67% of the time. Investors with long-term horizons have been rewarded handsomely for remaining in the market during volatile periods of time like we have witnessed over the last several years. Please let us know if you have any questions or if you would like to discuss your financial situation in detail. Thank you for being clients of our firm.
Sincerely,
Marietta Wealth Management, LLC
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