Quarterly Commentary for 2nd Quarter 2023
The Rally Marches On
Equity markets posted impressive returns in the second quarter, with the S&P 500 Index advancing by 8.7%, marking the third consecutive quarter of positive returns. Similar to last quarter, the technology sector was the top performer and helped to propel broad equity indices higher. However, market breadth improved dramatically, with nine of the eleven S&P 500 sectors posting positive results. Positive developments included easing of banking sector stress, a resolution to the debt ceiling, continued moderation in inflationary pressures, and another quarter of better-than-expected corporate earnings results.
Bond yields were stable and rangebound for most of the second quarter. However, strong economic data and renewed hawkish commentary from the Federal Reserve in late June sent bond yields higher and translated into modest quarterly declines for most core fixed income indices.
We close the books on the first half of 2023 with broad domestic stock indices up roughly 16%. A better result (so far) than we expected at the beginning of the year when we predicted a 6%-8% return for equity markets in 2023. We’d primarily attribute the better-than-anticipated results to two main factors. First, investors have been forced to push back the timing of their recession forecasts. A recessionary outcome has been thwarted by the strong demand for workers, a resilient housing market, and consumers that are still supported by excess savings. Second, early-year calls for a 10%-15% decline in corporate earnings are looking too bearish at this point. Corporations have managed profit margins very well and are benefiting from operating leverage. Analysts are currently projecting full-year 2023 corporate earnings to be roughly flat compared to 2022. We view these expectations as credible, given the recent string of quarterly earnings results surpassing forecasts.
The continuation of the downward trend in inflation has also been a contributing factor to market performance. June’s headline inflation reading of 3% represents significant progress from the peak of 9.1% registered 12 months ago. Core inflation is still too high and will take some time to return to long-term trend levels. However, encouraging progress is being made and indicates the Federal Reserve’s tightening process is working to better balance supply and demand.
The massive outperformance from the mega-cap technology stocks warrants some additional comments. The six largest technology stocks (Apple, Microsoft, Amazon.com, Nvidia, Alphabet, and Meta Platforms) are up between 35%-189% through the first six months of 2023 and are responsible for two-thirds of the S&P 500 Index’s year-to-date return. Some of this outperformance can be attributable to a rebound from the dismal performance of 2022, when the tech sector declined by 28% as soaring interest rates and bloated cost structures weighed heavily on investors’ appetite for technology stocks. In our opinion, high-quality tech companies were unjustifiably punished last year by the undiscerning mass exit from unprofitable and speculative tech stocks.
The dynamics within the technology sector have changed drastically over the past six to eight months. Sector level valuation has moved from cheap and attractive territory to a 40% premium compared to longer-term averages. Investor sentiment has shifted from last year’s fear of further price declines to fear of missing out on future returns. The go-to justification for the ravenous demand for the mega-cap tech names has been their promising prospects in “AI” or artificial intelligence. While we certainly wouldn’t bet against the ability of AI to increase and enhance productivity levels, we do get skeptical when the Wall Street hype machine kicks into full gear. The current exuberant sentiment surrounding anything AI related feels very similar to other “revolutionary” technologies, such as blockchain and the metaverse, that have yet to take over the world.
Going forward, we see more attractive opportunities in areas such as healthcare, energy, and financials that haven’t fully participated in the market rebound and are currently out of favor. Valuations aren’t demanding, business fundamentals are strong, and we’d expect these sectors to be significant near-term beneficiaries if market breadth improves and broadens into areas that have lagged the broader market on a year-to-date basis.