Outlook | AIM

Market Commentary for Second Quarter 2023

Written by Brian Huckstep, CFA, CFP®, Chief Investment Officer

Asset Class Recap for the Quarter

Stock returns produced a third consecutive quarter of positive, above average returns for all broad asset classes that we track below. Encouraging earnings report and fervor over stocks related to artificial intelligence (A.I.) fueled optimism for equities. Bonds saw prices drop across most asset classes, as longer-term interest rates slowly marched upward. Only High Yield bonds were able to break the pattern to post a positive return, as waning concerns about a recession pushed prices for High Yield Bonds up more than rising interest rates pulled their prices down.

As we look down the Year-To-Date column, we can see that every asset class has experienced a rebound in 2023, but not quite enough to recoup 2023’s losses yet (ignoring Cash). US Growth Stocks look like they are very close to covering last year’s losses, with a +29.0% return for 2023 so far, vs a -29.1% loss for 2022. However, the way percentages work can be misleading… An investor needs to have a +41.1% return to offset a -29.1% loss, so investors may need to be prepared to wait a few more quarters before account values get back up to high water marks - - the Fed’s rate rising campaign cut deep!

Bond prices dropped for most bond types in Q2 as interest rates rose. The yield on a 10 Year Treasury Bond rose from 3.49% at 3/31/23 to 3.82% at 6/30/23. For bonds with a 6 duration (a typical duration for the type of Intermediate Bonds that dominate many investors’ portfolios), that results in an estimated 1.98% price drop (= -1*(3.82%-3.49%)*6). That foots with a -0.84% total return for the Bloomberg US Agg Bond index, if we assume that we also received coupon payments for 1.14% (total return of -0.84% = price return of -1.98% + yield return of +1.14%). After the record-breaking negative returns that investors suffered through in fixed income in 2022, these additional losses will Not be welcome when conservative investors review their quarterly statements.

High Yield was the only fixed income asset class with a positive return last quarter. High Yield credit spreads were at elevated levels during March, as the regional banking crisis and recession concerns created anxiety about potential defaults for some High Yield Bonds. Credit spreads are a measure of how much extra yield investors are being paid to accept higher risk in some bonds versus guaranteed treasury bonds with a similar maturity date. High Yield credit spreads peaked at 5.20% on 3/15/23 and then dropped down to 4.05% by 6/30/23. The median High Yield credit spread since 1/1/1996 has been 4.76%, indicating that bond investors expect that markets may be safer than average in today’s environment – a positive signal for the economy, however, a bit less exciting if you are buying High Yield Bonds today and you must accept a credit spread that is below average. If High Yield Bond prices increase and credit spreads drop much further, we will reduce our High Yield Bond exposure in our Advyzon portfolios.

The US Fed meets 8 times per year to discuss the economy and to agree on a target level for the Fed Funds Rate. To combat high inflation, the Fed started raising interest rates in March 2022. They raised rates at 10 consecutive meetings. But at the 6/14/23 meeting, they elected to not raise rates. This was terrific news for stocks, because interest rates are an important input into many investors’ valuation models.

There has been a lot of conversation among economists about whether the Fed’s actions at their remaining four 2023 meetings will be to raise rates, stay put, or lower rates. The Fed has a “dual mandate” to keep employment at healthy levels and to keep inflation at reasonably low levels. They are “data dependent” and monitor many variables to make their decisions. With employment at very acceptable levels and with inflation clearly dropping back toward the Fed’s 2% target, we expect the Fed to hold rates where they are at for the foreseeable future – until the next, unpredictable, inevitable macroeconomic event pops up. At the current target rate of 5.125%, we are at roughly the level where they stopped raising rates last time things were “normal”, in 2006 and 2007 (the red boxes below).

Growth stocks have produced terrific returns Year-To-Date in 2023. The Russell 1000 Growth index is up a whopping 29.0%, while Value stocks are up a pedestrian 5.1%. Anyone who follows the financial press has been inundated with news about advances in Artificial Intelligence and experts who predict that A.I. will revolutionize the workplace and world. Rising stock prices for companies related to A.I. have been the major driving factor behind Growth’s strong recent performance run. Exciting advances in this field will certainly lead to additional profits for corporations that are able to bring true advances to consumers or expense savings to businesses - but we should always watch out for bubbles that can result in permanent loss of principal for late market entrants.

To examine valuations for excess frothiness, we pulled up Year-To-Date returns for all 500 stocks in the S&P 500 index. 19 of those stocks are up more than 50% this year. We also retrieved earnings for those firms and calculated Trailing Twelve Month Price-to-Earnings ratios.

Not all of the 19 stocks with 50%+ returns are officially categorized as Technology sector stocks, but most are in the Tech sector, or clearly lean that way. The current P/E for the overall S&P 500 index is roughly 26 today. The P/E column on the right above, identifies stocks with P/Es above average in red. Some of these stocks are very far above normal valuation levels. Certainly, most Growth stocks deserve to have P/E values that are above average, as their growth prospects are bright, but NVIDIA’s 216 would require that this mature company quadruple their earnings to come back down to a more reasonable 54 P/E! These valuation levels for these Growth stocks lead us to feel that Growth may be overvalued and that A.I. hype may be a little overdone. Our Advyzon portfolios are slightly overweight to Value and we are maintaining that overweight.


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Written by Brian Huckstep, CFA, CFP®, Chief Investment Officer