July Market Update & 2nd Quarter Key Takeaways
Global equities continued to rally in the second quarter, led by surging U.S. mega-cap technology and growth stocks, particularly anything related to Artificial Intelligence (AI). While the strength of mega-cap stocks in the first half of the year was unexpected following a very difficult 2022, the headline has been their divergence from the rest of the market.
The market-cap-weighted S&P 500 Index’s rally this year has been one of the narrowest on record, with less than 28% of the index’s constituents beating the overall index return. In an average year, around 49% of the index’s 500 companies beat the overall index (the only other year comparable to this year was 1998, as the Tech/Internet stock bubble was inflating).
More granularly, with the sudden frenzy in all things AI, the average YTD return for Amazon, Google, Meta, Microsoft, NVIDIA, and Tesla is 96%. The gains in these six mega-cap tech stocks are responsible for almost the entire S&P 500 return for the year. Moreover, the combined market cap of these six stocks (plus Apple) now comprises over 27% of the total index, the largest concentration in history for the top seven stocks. Investors should be cautious in the current environment. Chasing returns can be dangerous, and concentrated portfolios with a lack of diversification can lead to wealth destruction.
It remains to be seen whether this extremely narrow market rally resolves via the rest of the market catching up or the mega-cap tech stocks referenced above “catching down,” but improved market breadth would be a plus. On a positive note, it appears the rally is potentially broadening; the small-cap Russell 2000 index shot up 8. 1% in June, while the large-cap Russell 1000 value index climbed by 6%.
The S&P 500 index gained 6.6% in June and 8.7% in the second quarter. The technology-heavy Nasdaq Composite has driven the majority of returns in U.S. stocks.
Outside the U.S., stocks in Europe and emerging markets have also posted solid results. Developed international stocks (MSCI EAFE Index) rallied 4.6% in June, gaining 3% for the quarter. Emerging markets stocks (MSCI EM Index) rose 3.8% in June, resulting in a 0.9% gain for the second quarter.
Moving to the fixed-income markets, core bond returns (Bloomberg U.S. Aggregate Bond Index) were slightly negative for the quarter as interest rates slightly rose/prices fell. The benchmark 10-year Treasury yield ended the second quarter at 3.8%, up from 3.5% at the end of March. Municipal bonds (Morningstar National Muni Bond Category) were generally flat on the quarter.
INVESTMENT OUTLOOK & PORTFOLIO POSITIONING
Macroeconomic data remains mixed. On the one hand, the U.S. economy has been more resilient than most expected through the first half of the year, with the labor market remaining strong, supporting consumer spending; and headline inflation dropping meaningfully, thanks to a sharp decline in energy prices. On the other hand, key leading indicators of an impending recession exist, including a deeply inverted yield curve and tightening credit conditions.
We are not ruling out the possibility of a recession in the next few quarters. Each cycle is somewhat different, and this one is considerably so due to the pandemic dislocations, and there have been three instances (out of 13) where the Fed tightening cycle ended without a recession.
The key drivers of this year’s strength include the fact that the economy and corporate earnings have held up better than many expected, optimism that the Fed will soon end its tightening cycle, and, most importantly, investor euphoria around Artificial Intelligence.
Specific to the last point, while it is likely Ai will have a huge impact on society and the global economy, that doesn’t necessarily mean these companies’ underlying earnings fundamentals are justified. It may be in some cases, but we remember the tech/internet stock bubble in 1998-2000. Very few tech stocks were priced appropriately in early 2000, and even successful tech giants like Cisco are still below their tech-bubble highs of more than two decades ago.
Our portfolios maintain significant exposure to U.S. stocks overall, including many of the mega-cap tech stocks mentioned previously. We are not ruling out the possibility of continued strength in technology and AI-related stocks. Clients in our more active sector rotation strategy may have observed a shift from an anti-inflation approach to a larger position in technology stocks.
Meanwhile, our view of the U.S. fixed-income markets is positive. With rising yields over the past year, most bond market sectors now offer attractive expected returns relative to their risk.
While we believe a recession is a potential outcome over the next 12 months, we see reason for optimism as we extend our time horizon over the next five to 10 years. Within the U.S. stock market, there are companies and sectors that are reasonably priced and offer attractive return potential. The fixed-income landscape is also attractive, thanks to higher yields and inefficiencies that can be exploited by skilled active managers.
We also see strong total return potential from international markets, which have been out of favor and underperforming for more than a decade. These markets are not “priced for perfection” as the U.S. market seems to be. They appear more susceptible to “upside surprise” – better-than-expected earnings growth and valuation expansion, creating an attractive five-year return outlook.
Successful investing requires a balance between offense and defense. Earning superior long-term returns requires one to take calculated risks when opportunities present themselves and exercise caution during periods of market exuberance. By maintaining a disciplined and balanced investment approach, we are well-positioned to weather the inevitable market storms and capitalize on the opportunities that are also sure to arise.
As always, we thank you for your trust and welcome any questions you may have.