Second Quarter Market Review

“The individual investor should act consistently as an investor and not as a speculator.” – Benjamin Graham

The first half of the year has been a pleasant reprieve from the investor experience last year. The S&P 500 is up 16.9% during this period, almost making up the -18.1% loss in 2022. In fact, it’s the 14th-best start of a year for the index. That said, nearly 90% of the return the index experienced this year is attributable to the meteoric rise in seven tech names (Alphabet, Apple, Amazon, Meta, Microsoft, Nvidia, and Tesla). These stocks were some of the worst performers last year but have benefitted from falling inflation, a strong labor force, solid economic growth, and, most notably, the positive market sentiment surrounding Artificial Intelligence (AI). AI-related advancements were a key contributor to the vast outperformance of these seven mega-cap stocks. The rapid gains in these names have pushed the price-to-forward earnings (P/E) ratio on the S&P 500 to over 19x. To put this in perspective, the 25-year P/E ratio for the index is 17x. Breaking this down further, the forward P/E of these 7 stocks is over 29x while the forward P/E of the remaining 493 stocks in the index is 17x, matching 25-year averages for the S&P 500. The valuation disparity between these 7 names and the rest of the index demonstrates the narrowness of market participation during the quarter. Value-oriented large-cap stocks, which held up better than their growth counterparts in 2022, have trailed this year, gaining 5%. The best-performing asset class last year, commodities, is this year’s worst-performing asset class, down almost 8% year-to-date. This year is yet another reminder of the importance of investing wisely through diversification and discipline and not following the hottest investment in hopes of striking it big.

The Federal Reserve raised interest rates by 25 basis points to 5.00%-5.25% in the second quarter. However, in June, the Fed “skipped” its interest rate hike as inflation moderated, allowing the Fed to assess the lagged economic effects of rapidly raising rates. This snapped a streak of 10 consecutive rate hikes since March of 2022, the most aggressive hiking cycle in U.S. history. Despite the pause, they did note that rate hikes are probable in the second half of the year as there is more work to be done on the inflation front as the Fed targets its benchmark rate of 2% inflation. It’s important to remember that U.S. inflation fell from a high of over 9% in 2022, to 3% in June of 2023 in just one year. Core inflation remains stickier as shelter costs have yet to ease meaningfully, but wage growth is steadily elevated. Unemployment has decreased to 3.6% while companies continue to hire, keeping employment robust. This strong labor market has given the Fed more room for additional rate hikes to combat decreasing but still elevated inflation. The Barclay’s U.S. Aggregate index rose 2.1% year-to-date, rebounding from its worst calendar year performance as rates begin stabilizing and investors are finally experiencing meaningful income/yields.

All Eyes on the Fed

When the Fed met at the end of June, they left the current benchmark interest rate unchanged. During the meeting, most Fed officials expected the federal funds rate to peak at 5.50% to 5.75%, indicating the potential for two more 0.25% rate hikes to bring inflation down to their 2% target. The timing and size of future hikes depend on how quickly inflation decelerates, the growth of the economy, and the strength of the labor markets.

There is some good news. History has shown that stock and bond returns after the last hike in an interest rate cycle can be strong. In the previous 30 years (or five rate hike regimes), the 12-month returns after the last hike for U.S. equities averaged over 24%, while U.S. core fixed income securities gained over 11.5%. In fact, there has only been one instance in the last 30 years that equities had a negative 12-month return following peak rates, which was during the dot-com bubble. On the other hand, bonds have never experienced a negative 12-month return following peak interest rates.

As long-term investors, our job is to position client portfolios to weather the peaks and troughs within market cycles. With ample market speculation and investors’ fear of missing out, it can be easy to chase the highest-flying investment in hopes of outsized returns. The most recent example is the AI revolution, a relatively nascent technology. Many early-stage businesses might not be the ultimate beneficiary as this knowledge progresses. Instead of rushing into the hype, the better strategy is to take a more research-based approach and invest in more established companies with strong balance sheets and earnings that can benefit from this developing technology.

Benjamin Graham’s quote still rings true today. As well as markets performed so far this year, investors must remain disciplined. We must act as investors and not chase performance. It’s prudent to optimize long-term returns through diversification and maintaining appropriate asset allocation in portfolios throughout the duration of an investment plan.

Important Note: This material is for informational purposes only and is not intended to serve as a substitute for personalized investment advice or as a recommendation or solicitation of any particular security, strategy or investment product. The opinions expressed herein are those of the named advisors at the time written. Actual economic or market events may turn out differently than as presented. Any reference to an index is included for illustrative purposes only, as an index is not a security in which an investment can be made. Indices are unmanaged vehicles that serve as market indicators and do not account for the deduction of management fees and/or transaction costs generally associated with investable products. © 2023 Madison Wealth Management