2023 Second Quarter Investment Market Report

A Strong First Half for Stocks… Or Was It?

Closing out a quarter where the financial headlines kept using the word “crisis,” whether it be regarding banks or the debt ceiling battle, those issues are in the rear-view mirror for now, and the stock market seems unworried about the prospects of a long-predicted recession. The S&P 500 climbed 8.7% for the quarter and 16.9% so far in 2023 to finish the first half of the year very strongly, at least on the surface.

International Markets posted a solid quarter, providing some valuable diversification, although notably absent was the key driver of headline returns in the U.S., which we will be discussing in-depth. We still have strong conviction in the long-term opportunities in these markets as they continue to trade at significant discounts to the U.S. markets from a valuation perspective, even though they have posted very solid returns year-to-date.

S&P 500: Market Proxy or Mega-Tech Index?

So far, 2023 is looking like the year of Artificial Intelligence (AI). Moving well beyond Siri and Alexa, Chat bots and everything AI have gone beyond “viral,” propelling stock prices upward for those companies that have staked a claim in this new frontier.

All the companies below (with year-to-date returns) have made headlines regarding the value of artificial intelligence to their businesses in the future…

• Apple: +50% so far in 2023
• Microsoft: +43%
• Amazon: +55%
• Nvidia: +189%
• Alphabet: +36%
• Tesla +113%
• META (Facebook): +138%

These 7 companies have an eye-popping average return of 89% so far in 2023! They also happen to be the top 7 companies in the S&P 500, accounting for almost 28% of the entire index!

In late May, if you removed these 7 companies from the return of the S&P 500, the rest of the index had generated no return this year at all. Over the past month, we did see some participation from the other 493 companies in the index, although these 7 mega-tech stocks accounted for about 12.3% out of the 16.9% return for the S&P 500 in the first half of the year, meaning that without them, the index was up approximately 4.6% for the first half of the year. A version of the S&P 500 where all companies are weighted equally returned 7.0% in the first half – nearly a full 10% below the benchmark market cap-weighted version.

As you may know, all of these mega-tech stocks suffered significant declines last year. Some have moved to new record highs and some have yet to catch up to where they were before the 2022 selloff, but our attention is focused on the degree to which this small group of stocks has driven most of the “market’s” return this year, and as a result, the S&P 500 has become even more heavily concentrated in “Big Tech.” As mentioned earlier, the market capitalizations of these seven companies have grown so large that they now represent almost 28% of the entire S&P 500, up from 20% at the beginning of the year. Apple alone represents almost 8% of the index, and it closed out the quarter by passing the $3 trillion dollar mark for market capitalization.

Generally, stock market rallies that show broad participation among companies across the stock market are considered to be much healthier and sustainable than when very large moves by a small handful of stocks drags the entire index higher. Over the past month, it has certainly been refreshing to see the rest of the “market” begin to participate in this year’s rally, but clearly the concern from a risk standpoint is that if these top stocks reverse course, they will again have a disproportionate impact on client portfolios. In addition, if we look at the likely causes of any such reversal, certainly a cooling of the current excitement about all things AI could do it. If this should happen at the same time the economy does actually slow down, which could then hurt much of the rest of the stock market, then that concentration risk would exacerbate the pain of a down market for US Large Caps and the S&P 500.

Fortunately, this narrow rally has benefited many clients so far this year, but with many potential storm clouds on the horizon including persistent inflation uncertainty, increasingly strong warning signs of recession risk, and geopolitical headline risk, we want to make sure clients are increasingly diversified to keep them on track to meet their financial objectives while minimizing the wild swings of boom/bust cycles that can hinder that progress. We do not try to time or predict these events, we help clients build portfolios that endure them while staying on track to achieve their goals.

With the risk that stocks and bonds can be more correlated in inflationary environments, we will continue to show you where risks are becoming more concentrated, and we will continue to show you new ideas on how we can further diversify portfolio risk.

The Fed and Inflation

From a market perspective, all is much calmer on the monetary policy front than it was a year ago. Last year the markets were being rocked by quarterly rate hikes of 0.75%, which eased to 0.50%, then 0.25%, and now the Fed just let the first opportunity pass without a rate increase in over a year. Fed Chairman Powell has left the door open for another couple of small hikes this year, and there is still the risk that inflation remains “stickier” than the markets expect, but the pace of action has decidedly slowed, and we appear to be getting closer to the peak interest rates that will mark the end of the rate hike campaign.

As for the bond markets, the reduction in Fed activity led to fewer headlines about inflation, and some of the panic buying of bonds during the March banking “scare” was unwound, leaving bond indices slightly negative for the quarter, but still positive for the year.

Outlook

As mentioned above, there are still numerous headline-worthy risks that are likely to continue to cause market volatility. Questions regarding the direction of the economy, inflation, and geopolitical conflict seem likely to persist well into 2024. In addition, we are likely to hear much more about the commercial real estate market in the second half of the year as there is an increase coming in the amount of debt payments owed for office buildings that are still struggling with low post-pandemic occupancy rates.

Therefore, it seems appropriate to close with our concluding paragraph from our last quarterly investment commentary:

…we continue to focus with clients on improving portfolio diversification for the purpose of smoothing out potential ‘bumps in the road’ ahead. Seeking improved diversification and recognizing that market leadership may change in the next bull market, we have been discussing the risks posed by the concentration of technology exposure in the U.S. large cap market and how owning the market’s favorite individual technology stocks can amplify those risks. Continued volatility seems very likely, but good defense through diversification can make a big difference over the long-term for investors.