3Q23 Market Outlook

This Market has Tina Turner’s Legs

John P. Swift, CFA, CPA Chief Investment Officer
312-259-9595 or [email protected]

Summary:

• This year, the market has climbed a Wall of Worry to produce solid yet underappreciated returns.
• This year many investors shunned the Mega-Cap technology companies that have powered this rebound due to their dismal 2022 performance. Our top 5 stocks entering 2023 were Nvidia (NVDA), Microsoft (MSFT), Apple (AAPL), Alphabet (GOOGL), and Adobe (ADBE). We have more than fully participated in this rebound.
• This next “leg up” in the market will need to fight through negative economic headlines.
• Investors are bearishly positioned, and the Fear of Missing Out (FOMO) may push returns as investors potentially reposition. • Corporate earnings growth looks to remain solidly paced by Mega-cap Tech with artificial intelligence strengths but also by industrial stocks backed by $2.2 trillion in infrastructure, semiconductor, and green energy projects funded by federal spending bills.
• The War on Inflation rages on with persistent labor inflation, which will result in higher-for-longer interest rates. • Narrowing spreads on high-yield debt suggest a dramatically reduced threat of a deeper recession and point to a modest and short slowdown in economic activity, bolstering the “soft-landing” position.

This Market Has Legs

Sadly, Tina Turner passed away at her home in Zurich, Switzerland, this past May. In 2021, Tina joined Stevie Nicks and Carole King as the only female performers to be inducted into the Rock and Roll Hall of Fame twice. In addition to being one of the best-selling recording artists of all time, selling over 100 million records, Turner was an accomplished author and actor who starred in over 39 movies and TV programs. But what Tina was best known for were those strong, dance legs.

From where we sit, this market also has strong legs for long-term investors, albeit less good-looking and underappreciated. Unappreciated Bull Rally

The market has climbed a wall of worry this year, and every day a long line of doubters will tell you this market will fall and is merely a “bear market rally.” These nattering nabobs of negativity argue that the Federal Reserve has rapidly lifted interest rates raising the cost of capital across the economic landscape.

Moreover, they point to a slowing economy (which is precisely what the Fed wants to combat inflation) which has slowed to the point that it is when, not if, the recession will begin. Finally, they will argue that a handful of large technology companies were growing earnings, and most companies’ profits stagnated.

But despite all this negative news, including a mini-banking crisis, a debt-ceiling standoff, and slowing earnings, the market has performed remarkably well. What the bears have not appreciated is that the market is a forward-looking evaluator of future profits, and the market has already suffered through its own “recession” during the dismal days of 2022. The stock market has been rallying off its October 2022 lows due to the notion that the economy will avoid a hard landing which it had priced into the market by late 2022, that the Fed is close to being done raising interest rates because inflation is headed back to the Fed’s two percent target rate, and that earnings growth will accelerate again in 2024.

Furthermore, with economic growth proving to be resilient, the Fed pausing on interest rates hikes, an earning reacceleration made more feasible by the promise and early returns of artificial intelligence, and the average stock now joining in on the rebound, this market appears to have some solid legs.

A Bull Market with a Recessionary Start

This bull market will probably need to fight through a period of economic recession, which may be unavoidable due to the persistence of high-interest rates, the impact of which is seen in the housing market that has been hard hit by higher mortgage rates and the banking sector where the mini-crisis of the collapse of Silicon Valley Bank, First Republic Bank, and Signature Bank has resulted in a tightening of lending standards.

But a recession does not necessarily mean that the market will collapse. The balance of 2023 will feature lousy economic headlines but will also usher in a more durable bull market beyond these challenging moments. Investors are poised to buy on any weakness which limits the overall downside to equities.

Investor Positioning and the Fear of Missing Out (FOMO)

Investors are presently positioned for the worst outcome; nobody believes or trusts this rebound. In our October 1, 2022, client note entitled, “The Hard Landing Recession Talk is Overstated,” we argued the following:

• The market “generals” are the last to fall in the bottoming process, and Apple is the General McArthur of the investment markets. This past week, it took a big hit on fears of slowing iPhone sales. The General has fallen.
• Fear and volatility peak near the end of a bear market. Historically, high volatility and poor market sentiment have provided the best periods for bargains among risk assets.
• High inflation is mainly a supply-side problem, and the Fed can only affect the demand side of the supply-demand equation. Fears of the Fed making a mistake are well founded.
• The foundation of our economy is now stronger and more diverse than most investors recognize.
• A more diversified economic foundation should help us absorb tighter monetary policy and avert a “hard landing” recession through more durable consumer spending across income levels.

On October 1, 2022, the S&P 500 was at 3,601.50, and it closed recently at 4,393.75, representing a 22% increase since our October note which encouraged investors to invest despite all the negativity that existed at the time, and which still exists today.

Coming into 2023, our top 5 largest positions and their year-to-date performance as of June 23, 2023, are as follows:

Stock (Ticker)	YTD Price Performance as of 6/23/23
Nvidia (NVDA)	195%

Apple (AAPL)	50%
Microsoft (MSFT)	40%
Alphabet (GOOGL)	37%
Adobe (ADBE)	44%

According to BMO Capital Markets Chief Investment Strategist Brian Belski, when a small group of stocks outperforms the S&P 500 to the extent they have in 2023, the S&P 500 gains 11%, on average, over the following twelve months. Mr. Belski states, “Once the relative performance of the mega-cap technology stocks has subsided, the broader market has historically held up just fine, with gains being more common than losses.”

Expected Earnings Growth

Analysts expect earnings growth next year, with the S&P 500 aggregate EPS expected to grow 12% to $245 in 2024. That results in the S&P 500 trading at 17.7 forward earnings today. According to FactSet’s analyst consensus estimates, some of the future growth will be driven by artificial intelligence stocks such as Nvidia, Microsoft, and Alphabet, which are expected to grow profits at 36% per year for the next three years, on average. But earnings growth will also be driven by consumer discretionary and industrial company gains.

Industrials stand to benefit over the coming years due to the massive amount of fiscal stimulus now entering the market in the form of various infrastructure projects federally funded by the Infrastructure Investment and Jobs Act ($1.9 trillion), Inflation Reduction Act ($369 billion), and the Chips & Science Act ($52.7 billion). This fiscal largesse puts the U.S. in the early stages of a manufacturing and industrial Supercycle. Projects are slated in renewable energy, electric vehicles, batteries/charging stations, semiconductors, ports, highways, and airports. Foreign companies have taken note, and there has been a significant spike of foreign investment into the U.S. from $150 billion in 2020 to over $350 billion and climbing in 2023, double the amount of foreign investment entering China.

War on Inflation

Inflation has significantly improved from approximately 9% last year to 5% today. Our outlook is that the Core Personal Consumption Expenditures price index (the Fed’s preferred measure of inflation) will end this year at 3.3% and, by the end of 2024, will be back near its 2% inflation target.

Most of the progress regarding inflation reduction has been on the supply side of goods disinflation as supply-chain disruptions were resolved. That’s encouraging, but we must see the demand side diminish, especially wages and the labor market. Labor enormously impacts service prices, which is the Fed’s primary concern.

The labor market has been cooling but remains tight. Earlier this year, two jobs were available for every unemployed person who wanted a job. That ratio has dropped but is still at 1.8 and needs to be closer to 1.1.

The Fed attempts to cool the labor market so that those excess job openings close but tries not to overshoot causing excessive layoffs and a deep recession. That is a difficult needle to thread.

Historically, when unemployment spikes in a recession, half of it is attributable to layoffs or fewer job openings, and the other half from people reentering the workforce and not finding a job immediately. This time is different in that we don’t foresee labor force participation increasing the way it has historically. This is due to demographics and multiple other reasons. Still, it effectively puts a lid on unemployment rising past 5%, which makes the Fed’s job of cooling labor-side inflation more difficult.

As a result, the Fed will hold rates in restrictive territory for the remainder of the year because it is necessary to slow the economy, cool the labor market, and contain inflation.

Lower High Yield Bond Spreads Suggest a Soft Landing

The high-yield spreads have narrowed over 100 basis points since the stock market bottomed in October 2022. The 2023 recession calls that were the base narrative during 2022 were overblown. The Bears have been wrong, but never in doubt. They’ll keep pushing the recession date out further, now sometime in 2024, until we see a slowdown. Presently their recession narrative centers around households running out of the surplus cash provided to them during the pandemic. What is underappreciated is how strong household balance sheets have become after the last recession in 2008-2009. Households aggressively paid down debt in the aftermath of that recession, and we presently stand at all-time lows of Debt Service as a percentage of Disposable Personal Income, as seen in the graph below from the Federal Reserve Bank Board of Governors data.

The relatively calm demeanor of high-yield spreads supports the soft-landing proponents. The tightening high-yield spreads run counter to the recession outlook presumably being presaged by 14 straight monthly declines in the Leading Economic Indicators index and households presumably running out of spendable cash.

The Q1 real GDP growth was 1.3%, and the latest Atlanta Fed GDPNow model estimate for Q2 real GDP growth is 1.9%. For a forward looking market, one must respect that high-yield spreads aren’t suggesting more significant economic problems down the road. Tighter high-yield spreads may explain why the stock market continues to ignore the inversion in the Treasury market and shows some broadening in this year’s gains beyond a handful of mega-cap technology stocks. It likely also explains why the countercyclical utilities, health care, and consumer staples sectors are underperforming the market-cap-weighted S&P 500 and the equal-weighted S&P 500 this year.

Thus far, regarding recession views, the stock market has shunned the naysayers and has been the “Proud Mary that keeps on burning. Rolling, rolling, rolling down the river.” Rest in peace Tina Turner.