Quarterly Review and Outlook – Q3 2023

Quarterly Review and Market Outlook – 3^rd Quarter 2023

“You can only predict things after they have happened.”

– Eugene Ionesco

Conventional wisdom entering this year said that getting inflation under control would require pain, the only question was how much. When the Fed published their economic forecast for 2023, they predicted that higher interest rates would slow the economy and put two million people out of work. Inflation would fall because Americans as a whole would have less income to spend. No pain, no gain.

A funny thing happened on the way to the recession. The Fed raised rates, inflation came down, and the labor market…got stronger. Most measures of economic growth accelerated in the third quarter and the Fed now expects US Gross Domestic Product to grow 2.1% this year, up from 0.5% in their December 2022 forecast. At least until now, there is no denying the hard facts of the economy have outperformed the prevailing bearish sentiment.

We highlighted the Fed’s pessimism at the time and argued against taking the gloomy predictions too seriously. When inflation finally showed clear signs of progress, the Fed slowed the pace of hikes even though the labor market did not behave according to their models. The pandemic economy was weird and hard to forecast. The Fed has over 400 PhD economists, but they do not have a crystal ball.

Markets have come a long way this year, swinging from recession to soft landing to no landing at all. We cautioned against economic pessimism before, now we push back a bit against the optimism. The reality of the pandemic economy has never been as hot or as cold as it seemed in the moment.

Quarterly Review

Investor pessimism has kept asset prices lower than they might be otherwise. The S&P 500 Index fell 3% in the third quarter with similar returns from small and international stocks. Long-term Treasuries sold off due to higher rates while credit-sensitive bonds held up relatively well. The outperformance of riskier segments of the bond market suggests that stock declines were driven by rates more than worries about earnings growth.

For the year, the S&P 500 Index remains solidly positive with performance heavily concentrated in a few large companies benefiting from excitement around artificial intelligence (AI). Other areas within the US large cap universe have produced modest gains reflecting positive earnings momentum, but rising interest rates have kept a ceiling on valuation multiples.

International markets produced broader gains, with many areas outperforming their US peers. However, the US Dollar has strengthened considerably during the year which offset some or all of these gains. Despite the low multiples available in international stocks, we tend to favor US markets for several reasons, one of which is our desire to limit currency risk.

Market Outlook

The technology giants (e.g. Microsoft) that are the core of the US indexes are perhaps the only area within markets arguably priced for optimism. We believe they deserve premium valuations; the question remains how much. They continue to be the foundation of a diversified portfolio because they have characteristics hard to find elsewhere. They possess natural monopolies enabled by the internet and have built fortress balance sheets that can survive and even thrive during a downturn. They earn massive profits and are still able to reinvest those profits at attractive rates of return.

Outside of these names, we see a universe of reasonably priced companies with characteristics we believe drive an attractive return profile regardless of the environment—strong earnings growth, defensive balance sheets, and consistent dividends. With investors focused on the AI story, this “other” group of businesses has grown relatively more attractive. The median S&P 500 stock trades at a Price-to-Earnings ratio 15% cheaper than its 10-year average. The tech-heavy Nasdaq is about 20% richer.

Small company indexes are broadly inexpensive but include many stocks that lack the profitability and balance sheet characteristics we favor. We use strategies to separate the wheat from the chaff and believe long-term investors will be compensated over time.

Fixed Income remains compelling across the board. Attractive yields on cash and short-term bonds protect purchasing power but also pose reinvestment risk. If the Fed has to cut rates next year, those yields could fall quickly. Income-focused investors should consider locking in high-quality longer-term cash flows.

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It is no coincidence the most attractive market entry point of the last decade came during one of the most challenging years. In 2011, the US recovery seemed to be stalling, house prices continued to fall, and there was a banking crisis in Europe. Technology stocks were available at bargain basement prices because it was hard to buy anything with confidence.

While stocks are not in the discount bin today, investors may one day look back with similar nostalgia. Higher returns are available in more places—stocks, bonds, even cash. Diversification may be boring, but it has rarely looked so appealing.

Please reach out with any questions or comments.