Q3 2023 Market Commentary: Winners Keep Winning and Increasing Market Risks
This information is meant to be a commentary regarding Consilio Wealth Advisors’ views on the relative attractiveness of different areas of the market, contrasted with our current asset allocation strategy for the near term, 12-18 months.
These views are always made in the context of a well-diversified portfolio and are not meant to be a recommendation to buy into or sell out of a particular area of the market. These views can and will change as new information becomes available, and we will periodically update this brief to keep you informed of changes.
Market Recap
Any properly diversified investor might be asking why their portfolio isn’t keeping up with the S&P500.
If your portfolio is beating the S&P500 this year, there was most likely pain last year. These massive swings indicate there is too much concentration in one stock or one sector. If your eyes are rolling here, there may be a bias assuming what has gone up recently will continue to go up in the future. I know this because I’ve already experienced this in multiple investment cycles. The markets have rewarded small groups before and it normally doesn’t end well.
Big tech, especially the seven biggest, continued a torrid pace in the second quarter. The newly minted “Magnificent 7” (Apple, Microsoft, Amazon, Alphabet, Tesla, Nvidia, and Meta) powered the majority of the S&P500’s returns this year. Combined, those seven companies are up over 97% compared to 20% for the S&P500.
We don’t have to look too far back to find a period where the Magnificent 7 underperformed the S&P500. The group was down -46.36% in 2022 while the S&P500 was down -18.5% during the same period. The chart below measures the downside only. When the lines reach zero, the investment has reached its previous high.
The increase in stock prices has made these companies more valuable, a measurement we call market capitalization (Number of shares outstanding X current stock price). Apple is currently valued at over $3 trillion, for example. As the size of these companies grow, they represent a larger portion of the index. Indexes like the S&P500 are market capitalization weighted, meaning the bigger companies take a bigger portion of the index. The S&P500 index performance is not traditionally made up of 500 equally split stocks. Apple is now 7.5% of the S&P500 index, for example.
The top seven companies in the chart account for nearly 30% of the S&P500.
There are equally weighted versions of the S&P500 that reduce the influence of the Magnificent 7, which simply gives every company in the index the same allocation.
The equal weight S&P500 is lagging the normal market cap weighted S&P500 by more than 10%. It just shows how much of an outsized impact the Magnificent 7 has had on this year’s returns so far.
That doesn’t mean there haven’t been other highflyers in the S&P500 this year. These companies have a smaller weight in the index, so their price movements have a much smaller impact than the biggest seven companies.
Returns as of 7/19/2023
Carnival Corp and Royal Caribbean have benefited from increased travel demand. Their weights in the S&P500 are 0.05% and 0.02% respectively. Their prices aren’t moving the broader index. Amazon sneezes and the index catches a cold.
Outlook
When a single group drives market returns like the “Magnificent 7”, it is time to review how much concentration your portfolio has. Owning the S&P500 today automatically carries 30% of the big tech names. The heavy concentration risks are heightened if you own the Nasdaq, the Russell 1000, or the Dow Jones indexes. Yes, these are all different indices but they all own nearly the same things. I’m not saying the index is wrong, per se, I'm saying it’s important to know what you own.
When you buy a stock, you are buying a portion of ownership of a company which includes a share of the profits. Typically, you don’t get a share of the profits 1 to 1. Stock investors will pay a multiple (or premium) to a company’s current profits with the expectation that those profits grow in the future. We call that the price to earnings multiple (P/E).
Using the price to earnings multiple, the broad market is trading at a premium of 15x. The Magnificent 7 are trading at over 30x. What’s being implied here is that the seven big tech companies can grow their profits at twice the pace than the remaining 493 S&P500 companies. Or another way, the Magnificent 7 would need to grow profits twice as fast to justify today’s prices. That could be setting up for some major disappointment.
Some talking heads are saying this is like the dotcom boom in the late 1990s. To be clear, these winning companies are profitable, many of them are ridiculously profitable. While the market might be overzealous, the big difference between this and the dotcom bubble is the quality of companies pushing this rally.
However, we can point to certain worries with each company going forward.
Tesla has cut prices on their vehicles to try to stimulate lower demand, and it has impacted their margins.
Nvidia previously benefited from increased demand from crypto mining and is seeing demand for AI processing.
Amazon is seeing a slowdown in enterprise spending which puts pressure on AWS. Consumer spending on goods has also slowed, further impacting Amazon’s retail side.
Meta’s Threads is already under regulatory scrutiny due to social media monopolization.
Google is experiencing a slowdown in ad revenue as businesses across the globe are looking to cut.
Microsoft has ridden the AI wave but one could wonder how much of it can be realized or another craze.
Apple has continued to see lower product sales, specifically iPhone sales have slowed as customers aren’t upgrading as frequently.
These are all great companies, but the question will ultimately be how they live up to today’s prices, which reflect expectations. When those expectations are so high, there’s a higher likelihood of disappointment.
Let’s not forget there are thousands of other companies and asset classes to invest in.
Bonds have been relatively stable and are up 3% on the year. With the debt ceiling drama and jumbo rate hikes behind us, bonds are expected to reclaim their role in providing portfolio stability. Credit conditions have tightened but we are not yet seeing an uptick in defaults. If anything, junk rated bonds have done unexpectedly well but that can reverse quickly.
International holdings built up a 2.5% lead to the S&P500 through May but are now lagging the US index by -3%. The US dollar had weakened earlier in the year but stabilized since April. While the reversal coincided with the US debt ceiling drama, we don’t think the recent weakness in international had much to do with the debt ceiling agreement. It is more likely the recent outperformance by the S&P500 has been driven by the Magnificent 7.
China has struggled to reignite its economy despite reopening from COVID lockdowns. There may be another round of stimulus needed to get consumers to spend. The silver lining here is the demand for oil, therefore prices, have dropped globally. Gas prices usually spike ahead of summer travel. While we did see some increase in gas prices, it seems to be muted. Oil is trading at $75/barrel.
Regional bank earnings are getting a lot of attention this earnings season. At this point, it looks like withdrawals have slowed for most banks that have reported so far. Some even experienced an uptick in deposits. Most of the regional banks fall below the $250 billion asset threshold for regulatory oversight so we need to rely on what they report every three months. It looks like banks are finally stabilizing.
Conclusion
The Magnificent 7 can potentially live up to their lofty valuations. Heck, we hope they do! Even if they don’t, the market can still overvalue them for extended periods. Tech stocks were considered overvalued in 1996 and it wasn’t until 2000 when we experienced a true correction.
Understanding what’s driving market returns will hopefully reduce the fear of missing out. The last thing investors should do is chase. Instead, be objective about it. Rebalance if your exposures to tech are suddenly overweight based on your investment objectives. Not every investor needs to have market level returns because that means they’re taking market-level risks.
Investor portfolios should hold the Magnificent 7, but well diversified portfolios hold many other asset classes, sectors, etc. Just because an investment isn’t keeping up now doesn’t mean it’s a poor investment.
And remember, remember, past performance does not guarantee future performance, which could differ substantially!
DISCLOSURES:
The information provided is for educational and informational purposes only and does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor's particular investment objectives, strategies, tax status or investment horizon. You should consult your attorney or tax advisor.
The views expressed in this commentary are subject to change based on market and other conditions. These documents may contain certain statements that may be deemed forward looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Any projections, market outlooks, or estimates are based upon certain assumptions and should not be construed as indicative of actual events that will occur.
This document is for your private and confidential use only, and not intended for broad usage or dissemination.
No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment. All investments include a risk of loss that clients should be prepared to bear. The principal risks of CWA strategies are disclosed in the publicly available Form ADV Part 2A.
Index returns are unmanaged and do not reflect the deduction of any fees or expenses. Index returns reflect all items of income, gain and loss and the reinvestment of dividends and other income. You cannot invest directly in an Index.
Past performance shown is not indicative of future results, which could differ substantially.
Consilio Wealth Advisors, LLC (“CWA”) is a registered investment advisor. Advisory services are only offered to clients or prospective clients where CWA and its representatives are properly licensed or exempt from licensure.
