Quarterly Market Review and Outlook
Q3 2023 Market Re-Cap
The stock market experienced significant headwinds in the third quarter. September is historically the most volatile month of the year for stocks and that pattern played out again this year. U.S. Large Caps, as represented by the S&P 500 index, remain 12% below their all-time high set in 2021 and 8% from their high point in 2023.[i] As typical during volatile periods, U.S. Small Cap stocks have declined at a steeper rate. International stocks are also substantially underwater from their all-time high.
The bond and fixed income markets struggled in the third quarter as well. The culprit here was an unexpected spike in long-term interest rates.
The economy continues to deliver surprises, some good and some negative. Oftentimes, the financial markets overreact both on the good and bad news—that accounts for some of the whipsawing we saw last quarter.
A Quick Review of What’s Happened Over the Last Several Years
You can’t understand where you are headed if you don’t understand where you have been! Here is a quick synapsis of the last four years:
- In response to COVID and government-imposed shutdowns, the U.S. government printed approximately $6 trillion in support payments and programs of various kinds. This was on top of regular government spending. This amounted to a 45% increase in the money supply (known as M2) in COVID’s first two years.[ii]Historically, M2 has been mostly stable with a modest 2% rate of annual growth. We’ve never had such a substantial increase in M2.
- Dramatically increasing M2 caused the worst inflation in 40 years, which peaked at 8% plus last year.[iii]
- In response to high inflation, the Federal Reserve Board, starting in early 2022, implemented a series of interest rate increases, an end to quantitative easing, and unwinding the Federal Reserves balance sheet. The rate has been increased from .25% to 5.5%.[iv]This is designed to increase borrowing costs and to slow the U.S. economy. Historically, this isn’t necessarily designed to produce a recession but often produces one. These actions have so far helped calm inflation, currently at around 3.7%.[v]
- Generally, the financial markets don’t like sudden and dramatic rate increases. As a result, last year, the stock market declined approximately 20% and the bond market had its worst year in 50 years. This year, both the stock and bond market have struggled to move positively forward.
- Recession indicators have been strongly flashing over the past twelve months. Among the many indicators, the yield curve has been inverted since last October. There is no better and more accurate indicator of a pending recession than a persistently inverted yield curve.[vi]
Q4 2023 Economic Outlook & Beyond
With that history being recounted, the obvious question is, where are we headed now?
We have been saying for the better part of a year that we believe a recession is likely. We continue to hold that view. Why? And why hasn’t one occurred yet?
We have already said that M2 increased 45% over the first two years of COVID. Again, that amount of money being printed and put into circulation is unprecedented. Trying to predict the timing of the recession is hard, in our view, because most of that money is still in the system. It will take time for that to get flushed out of the economy.
One of the reasons we are adamantly in the “recession camp” is because of interest rates. We have learned to pay a great deal of attention to interest rates. In particular, the relationship between short-term interest rates and long-term interest rates. In a healthy yield curve, long-term interest rates are higher than short-term interest rates. When short-term interest rates are higher than long-term interest rates, we call that an inverted yield curve.
Currently, the yield curve has been inverted for the longest consecutive stretch since 1962.[vii] Additionally, the difference, or spread, between short-term and long-term rates has not been this significant in over 40 years.[viii] The current 3-month U.S. treasury yield is 5.5%—the 10-year yield is 4.78%! The relevance of an inverted yield curve is that it has preceded the last eight recessions.[ix]
Sure, this time could be different. The U.S. government spent money in a way it never has. Perhaps that spending has, or can, postpone an economic downturn. However, we would adamantly argue that eventually excess government spending will not solve the problem but be THE problem—there are limits to the “Full Faith and Credit of the U.S. Government.”
Our stance remains that a recession is much better than a coin flip probability over the next 12 months. In fact, the Federal Reserve Bank of New York puts the recession probability at 57% in January 2024.[x] That probability increases to over 70% by June 2024.[xi] We don’t think its smart to fight the Fed!
Why does this matter to the stock market? There have been several periods of recession when the stock market did not decline by at least 20%. However, more times than not a stock market crash is directly linked with a recession. Further, in every recession since 1957, the stock market’s earnings have declined during a recession.[xii] If the economy is in contraction mode and corporate earnings are declining, that doesn’t make us want to fully allocate to stocks. Generally, accounts are currently under-allocated to stocks.
Finally, for the sake of transparency, the 3rd Quarter GDP is likely to be very strong. The Atlanta Federal Reserve’s GDPNow model is suggesting that 3rd Quarter GDP will be 4.9% annualized.[xiii] On the surface that is not the number that one would expect heading into a recession. However, as we stated earlier, these are unusual times coupled with unprecedented spending by the Federal government.
Stock Market Values & Account Strategy
As we evaluate stock market valuations and strategies, we look at an enormous amount of data. Some of the data is tied to the economy, some to the bond market and some directly to the stock market. Below are a few points that factor heavily into our thinking.
- Stock Market Short Term Return Potential vs. Cash
Cash rates, as represented by the 3-month Treasury, are at 5.5%. That’s the highest rate in over 20 years.[xiv] The stock market appears to be declining, in anticipation of the recession. Even though stocks
return 10% over long periods of time[xv], the short-term picture looks cloudy. When the cash rate is high, demand is high. When the short-term outlook for stocks is negative, the demand for stocks is lower. We
view this as a simple supply and demand issue. When demand is high, prices are high. When demand is low, prices are low.
- Stock Market Valuations
We are “value” investors. Are stocks cheap right now? As we mentioned earlier, the S&P 500 remains below its all-time and yearly highs. We’d argue that from a 30,000-foot perspective, the U.S. stock market is not cheap.
First, we’d go back to our previous newsletter, where we mentioned that the bulk of year-to-date returns of the S&P 500 have been generated by a small handful of firms. The top 10 weighted stocks in the S&P 500 make up 31.9% of YTD returns.[xvi] Based upon P/E ratios, those 10 stocks are about 28% overvalued relative to their historic norms.[xvii] Second, while the remainder of the S&P 500 is not quite as expensive, the other 490 are about 6% overvalued based upon historic P/E valuations.[xviii]
If we go a step further to consider Yale economist Robert Shiller’s CAPE P/E (which factors in inflation), then we discover that the S&P 500 is likely 27% overvalued compared to its average since 1980.[xix]
Based on that, we think the S&P 500 remains overvalued between 10% to 30% despite being below its all-time historic high.
- What To Do?
We have largely been under allocated to risk for the past year and a half. Said differently, we have held larger than normal amounts of cash and had a lower allocation to stocks.
We are finding some value in the bond market and have been allocating money to various fixed income securities. We think a 5% municipal and a 7% corporate bond rate are worth buying.
We don’t advocate market timing and aren’t day traders. We think that is foolish because nobody’s crystal ball is that accurate over short periods of time. We focus on fundamentals and there are some stocks that have low valuations or high growth potential to warrant holding. In fact, we are holding those.
Our thought in this environment is to simply remain under allocated risk until we get clarity on the stock market finding a bottom. When we do, our plan is to increase allocation to stocks and risk assets in general. There are many exciting companies and areas like artificial intelligence that offer incredible investment opportunities. We are developing a “buy list” of things we want to buy when valuations are better.
As always, we want to stick to your goals and objectives. This is why we offer periodic meetings to ensure that we remain aligned with your unique situation. None of us can control the stock market, interest rates, the Federal Reserve, etc. However, you do have a great deal of control and influence over your savings rate, spending habits, goals, and objectives.
Higher for Longer?
When a recession does occur, the Federal Reserve often cuts rates in an effort to stimulate economic growth. As we sit here today, we are not saying the same thing won’t occur when the recession comes. However, the Federal Reserve is bound by two mandates: inflation and unemployment.
Should a recession hit, but inflation remain high, the Federal Reserve may be stuck between a rock and a hard place. We only mention this to say that we should consider tempering expectations that the Federal Reserve will return to its near 0% tool chest immediately. Rather, if inflation remains stubbornly high and the recession is not severe, then the Federal Reserve may be compelled to keep interest rates elevated or only make slight decreases. Currently, the projections are for only two cuts in 2024.[xx] We have done a lot of reading about “stagflation” in the late 1970’s. We aren’t saying that will repeat, but we would be foolish to not be open to the possibility.
We live in strange times—government shutdowns, civil unrest, runaway government spending, rising interest rates, political chaos, and war in the Middle East. We urge clients not to spend too much time listening to the various mainstream media outlets. As we have said before, we think the U.S. mainstream media is detestably corrupt. When you watch a heavy dose of news, what do you learn?
It is not a prudent philosophy to base our own investment decisions upon the talking heads on TV, podcasts, social media or the internet. These people don’t know you and certainly don’t care about you and your family.
Alternatively, we suggest focusing on data. While not foolproof, we can remove a lot of emotion from the pure data. We are confident that in the long run, facts provide a higher probability of success than emotions when it comes to investment philosophy.
As always thank you for your continued trust and business. We are very thankful to count you as clients and friends. Should you need anything, please let us know.
We hope that you and your family have a great rest of 2023!
[vii] Xie, Ye. “The Bond Market Has Never Sounded Recession Alarms for This Long”. Bloomberg. September 14, 2023.
[ix] Xie, Ye. “The Bond Market Has Never Sounded Recession Alarms for This Long”. Bloomberg. September 14, 2023.
[xii] DeSpirito, Tony. “Take Stock: Q3 2022 Equity Market Outlook”. BlackRock. June 24, 2022.
[xvi] J.P. Morgan Asset Management. “Market Insights: Guide to the Markets®”. Page 11. J.P. Morgan Asset Management. September 30, 2023.
Content is prepared solely for informational purposes, and nothing contained herein should be construed as an offer to buy or sell, or a solicitation to buy or sell, any security or other investment product or to participate in any particular trading strategy. No information contained herein should be regarded as a suggestion to engage in or refrain from any investment-related course of action. All views expressed and materials presented are subject to change without notice and are not intended and should not be construed as investment, tax, or legal advice. Please consult legal or tax professionals for specific information regarding your individual situation. All information is believed to be from reliable sources; however, no representation is made as to its completeness or accuracy. Due to various factors, including changing market conditions, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained herein serves as the receipt of, or as a substitute for, personalized investment advice. To the extent that a reader has questions regarding the applicability of any specific issue discussed to his/her individual situation, he/she is encouraged to consult with the Financial Professional of his/her choosing. For important additional information and disclosures regarding newsletters and market commentary, please click here or go to https://walkerhigginsassociates.com/disclosures/
Securities offered through First Heartland Capital ®, Inc., member FINRA/SIPC. Advisory Services offered through First Heartland ® Consultants, Inc. Walker, Higgins & Associates, LLC and Walker, Higgins & Associates Wealth Management, LLC are independent of First Heartland Capital ®, Inc. and First Heartland ® Consultants, Inc.