Investment Management Newsletter - 3rd Quarter 2023

Wake Me Up When September Ends

As of quarter-end, the return on the S&P 500 so far this year was 13.1%, but that masks a dramatic difference in returns for value stocks, which were up 1.8% (Russell 1000 Value) and growth stocks, which were up 25.0% (Russell 1000 Growth). The benchmark return of more than 13% also masks declines in the broad index of 1.6% during August and 4.8% in September. Seasonally, September tends to be the weakest month of the year, and the end of September tends to be the weakest part of the month. That pattern repeated this year with the drop during September concentrated in the second half of the month.

With the market now down 6.2% from its high for the year in July, we are in what’s termed a “pullback” which refers to any drop in stock prices of 5% or more. These pullbacks tend to occur roughly three times per year, on average, and are a natural, healthy part of equity price movements. The question of how stocks might behave from here depends largely on earnings. As of quarter-end, the price/earnings ratio, a key gauge of stock valuations, was nearly 18x for the S&P 500 compared to a historical average closer to 16x. This suggests that equities remain somewhat more expensive than usual, even after the pullback.

Equities outside of U.S. large caps have not fared as well this year. As measured by the S&P 400 Mid Cap index, mid-sized stocks are up 4.6% year-to-date while small caps, are barely positive with a total return of just 1.4% as of September 30 (S&P 600). If we were in the early stages of a bull market, small stocks would typically be outperforming large stocks. This, coupled with elevated valuations, a decreasing proportion of stocks hitting new highs, and continued U.S. dollar strength which has pressured returns for non-U.S. stocks, lead us to believe the markets may have more volatility in store for the months ahead.

On a positive note, the wide range of returns this year has created an environment that is supportive of active management. With sectors like Communication Services and Technology each up over 30% on a year-to-date basis and sectors like Utilities dropping almost 15%, the market has provided ample opportunities for stock selection to add value to portfolios. To that point, names like Alphabet, Apollo, Blackstone, Broadcom, Comcast, Meta and Nvidia, are some stocks in our portfolios that have enjoyed the biggest price increases during 2023.

Fixed Income

The bond market has arguably been more volatile than stocks, as evidenced by the average annual return of -5.20% on the Bloomberg U.S. Aggregate bond index over the past three years. Higher yields mean lower bond prices. Over the last quarter alone, the yield on the 10-year U.S. Treasury increased by 0.75%.

The yield curve, which plots the yields on U.S. Treasury debt that have maturities from three months through 30 years, started the year inverted. Normally, the longer the maturity, the higher the yield, but this has not been the case for over a year now. When the Federal Reserve begins to trim short rates as the economy slows down during a recession, the yield curve typically normalizes, meaning it regains its upward slope. This time, however, the yield curve is becoming less inverted, not because of rate cuts, but because longer-term rates are increasing. That method of yield curve steepening is atypical and is largely due to continued inflation fears. The upside, however, is that bond yields are now as attractive as they have been at any time since the Great Recession. With rates on cash balances set to fall when the Federal Reserve pivots to rate cuts, this marks an opportune time to lock in these rates by purchasing high-quality bonds. Because markets are forward-looking, if investors wait to deploy cash until the Fed completes its hiking cycle, the opportunity to secure attractive longer-term rates may pass.

Economics

As measured by real GDP, the U.S. economy expanded by 2.1% during the second quarter and may have grown by more than twice that pace between July and September, though economic growth is only loosely associated with stock price appreciation. Earnings tend to be a bigger driver and have recently been affected by above average inflation rates. For instance, rising gas prices are pressuring input costs across numerous industries and end-products. To that end, crude prices increased by more than a third from their low for the year in March year before ending the quarter at $90.89. This could put renewed pressure on margins and, thus, earnings.

Of equal importance is how wage inflation continues to impact jobs. Continued tightness in the labor market is a key concern as far as inflation is concerned. The Fed now sees year-end unemployment at 4.1% (down from prior expectations of 4.5%) and 4.7% at the end of next year, both of which are significantly lower than the long-term average unemployment rate which has averaged 6.2% in the U.S. The outlook for earnings going forward is, therefore, dependent to a large degree on inflation and unemployment rates which tend to move in opposite directions.

The View from Washington DC

Although the effects of pandemic-related fiscal stimulus have largely worked their way through the economy, the 8.7% cost-of-living adjustment to Social Security checks this year has helped support consumer spending, as have the multi-year lows in unemployment rates. However, with the deficit for the fiscal year that ended on September 30 likely around 6% of GDP and accumulated debt-to-GDP nearing 125%, politicians have little room to offer additional stimulus, should the economy slow over the months ahead. The 2024 presidential election will also begin to make headlines, as will the commensurate influence on markets. This reinforces our conviction that stocks could experience a bumpy couple of quarters. Yet, even with similar volatility in the past, stocks have consistently delivered 9-11% average annual returns over a full market cycle, and we believe they will do the same going forward.

For questions or comments on any of the topics included in this newsletter, please contact Broadway Bank’s Wealth Management team at [email protected].