Let’s begin with a recap of the market’s performance as of Q3 2023, and the Fragasso portfolio management team’s expectations for the next few months.
So far, 2023 looks like a mirror image of 2022. Last year, the S&P 500 experienced its second-worst calendar year since 2003. This year, the market initially got off to its second-best start of the last 20 years, led by large-cap domestic stocks in a repeat of a familiar pattern. Interestingly, though, stock prices have risen without commensurate growth in earnings. Instead, valuation multiples have expanded even as interest rates have risen (usually these metrics move in opposite directions)! We’d be more optimistic if increases in corporate earnings were driving stocks upwards.
However, we believe the economic landscape calls for some degree of prudence in portfolios, especially as the Federal Reserve attempts to tame persistent inflation and the wage inflation that often leads to prices spiraling upwards. Most of our clients have seen the impact of labor shortages at local restaurants, in addition to striking workers ranging from Hollywood screenwriters to Detroit automakers. These are signs, in our opinion, that the fight to slow the economy and reduce inflation is not over.
Q. Bonds of all types delivered disappointing performance last year, and interest rates still seem to be climbing. What is Fragasso’s fixed income outlook for the year to come?
A. It’s worth taking a moment to put 2022 into perspective. With the exception of last year, the worst year for bonds in the last 40 years was 1994, when they lost 2.9%. 2022 produced fixed income losses several times larger in magnitude, making it essentially a once-in-a-lifetime event for most investors.
Historically, negative bond market returns have been followed by good performance in subsequent years. That has not yet been the case as interest rates continued to drift upward this year, but we have not seen the same volatility this year, and inflation has come down a bit from its highest levels.
Another cause for optimism is that the biggest driver of long-term fixed income returns is the starting yield. To simplify things a bit, bonds did very well in the 1980s (a decade that started with yields in the double-digits) and poorly beginning in 2020 when yields fell to under 1%. With bond benchmarks yielding 5% or more currently, prospects for future returns seem to have improved.
Q. What has been the driving force behind the exceptional performance of the U.S. stock market in 2023?
A. It’s a recurring theme – technology and a select group of stocks. Over the last decade, we’ve witnessed market leadership evolve from five “FAANG” technology stocks (Facebook, Amazon, Apple, Netflix, and Google) to a “magnificent” group of seven (Facebook, Apple, Amazon, Microsoft, Alphabet/Google, Tesla, and NVIDIA).
Surprisingly, a majority of the U.S. stock market’s gains this year can be attributed to this small group of stocks. This remarkable success of these tech giants has also led to a situation where the S&P 500 is now more concentrated than it has been in the past century, with these seven companies accounting for over 25% of the index. In contrast to the predictions of investment theory, more diversified portfolios have for the most part underperformed large technology stocks in recent months.
Q. Is this concentration in the market something to worry about, or is it creating opportunities? What is the outlook for the market moving forward?
A. We believe there’s no need for excessive concern; this situation doesn’t resemble the dot-com bust. It’s worth recalling that the tech sector had a challenging year in 2022, so part of the current performance can be attributed to recovery of past gains. Even more importantly, we’re dealing with exceptionally strong companies. Just imagine trying to compete with the likes of Google in search or Amazon in e-commerce. Their stock price performance is not irrational–it actually mirrors their growth in revenue and profits.
However, one factor that warrants caution is valuation. Many big tech companies are now worth a trillion dollars or more, making it harder for them to maintain the same growth rates. Furthermore, earnings yields on tech stocks are less attractive relative to risk-free government bonds which now offer nominal yields of around 5%. Tech valuations are also significantly higher than most other sectors of the market.
Short-term market performance is nearly impossible to predict. But we do expect the Federal Reserve’s efforts to tame inflation to result in higher interest rates and slowing economic growth, and growing conflicts around the world do not bode well for investor confidence.
Q. International stocks were a strong performer last year. Is this something expected to continue?
Historically, international stocks have shown resilience when U.S. stocks decline, and 2022 was a great example of that phenomenon. That was a year in which diversification helped, and we expect that will be the case over time.
Most large companies are global to some extent, but the major international markets don’t have the same exposure to technology as the U.S. does. China is a notable exception, but their tech companies are subject to a lot more risk than their American counterparts, to say the least. When tech companies are booming, as in the late 1990s or most of the last decade, it’s hard to beat the U.S. markets.
That said, there’s an enormous valuation disparity at the moment and international stocks are much cheaper on a price-to-earnings basis. 60% of global market capitalization is outside the U.S., but a much lower percentage of international stocks in a portfolio provides a valuable diversification benefit. And after many years of lackluster performance, international stocks are unloved by most investors—making it more likely that bargains can be found overseas.
Q. Many market commentators are proclaiming the death of the 60/40 portfolio after both stocks and bonds fell in 2022. Does the Fragasso portfolio management team believe this criticism has any merit?
A. The fact that fixed income provided little to no actual income for several years was clearly a problem for traditional portfolios. However, it’s important to remember that diversification and downside protection (rather than income) is arguably the most important function of the bond portion of a portfolio. For most of the past century, bonds have fulfilled that role well—for example, the Bloomberg Aggregate Index was up in the first quarter of 2020 when stocks sold off dramatically as COVID spread around the globe. Our client portfolios generally hold a majority of fixed income in “core” holdings that we’d expect to provide good diversification from equities, and even a respectable yield in the current environment.
Investors can also diversify their fixed income risks by adding credit exposure, committing to less liquid instruments (including private credit or real estate), or investing in more complex structured products. When done appropriately these investments can provide additional income, diversification, and potentially higher returns than “core” bonds. Some of these asset classes have traditionally been available only to institutional investors, making a thorough research process and an understanding of client risk tolerance imperative for constructing an appropriate portfolio.
Q. Is a recession looming in 2024, and what steps can investors take to prepare for such an event?
A. Looking at the economic data and geopolitical events, and with another election year on the horizon, it’s hard not to be somewhat cautious moving into 2024. But employment is the most important factor and we are still having problems with a tight labor market, rather than a lack of available jobs!
Regardless of economic developments over the next year, investors should remember that:
- Recessions are normal. Over the last 20 years the markets have risen despite the dot-com bust, a global financial crisis, and a global pandemic. The next downturn is also likely to be manageable with the right plan.
- Portfolios and financial plans are built to navigate through a variety of economic conditions. Diversification is more reliable than prediction.
- The world’s richest people are all long-term investors in companies, not short-term market-timers.