Within large-cap domestic stocks, there was wide divergence that merits additional comment. We don’t often refer to the Dow Jones Industrial Average or the NASDAQ Composite in our commentary, but their results year-to-date highlight the dichotomy: while the Dow only delivered a 0.9% return, the NASDAQ gained 17%! Again, it is worth noting that this variance simply unwound last year’s dramatic outperformance by the Dow over the NASDAQ, but it also highlights where the strength and weaknesses were within the market. Financial stocks declined (disproportionately impacting value strategies and the Dow) and large-cap technology stocks gained (disproportionately impacting growth strategies and the NASDAQ). This divergence is further illustrated by the outperformance of the Russell 1000 Growth Index vs. the Russell 1000 Value Index: 14% vs. 1%.
Interestingly, in the early part of the quarter, value was actually leading growth, but the failure of Silicon Valley Bank caused a steep sell-off in several specific regional banks deemed most at risk of a similar fate, and indiscriminate selling in the rest of the financial sector, as fears of another financial crisis took hold. (A fear, by the way, that we see as overblown.) As money left the banks (meaning both the withdrawal of deposits and the selling of shares), the greatest beneficiaries were the stocks deemed to be the least at risk in a financial crisis or credit crunch, namely the large-cap tech stocks. We would caution that we don’t see this as the beginning of a trend but rather an idiosyncratic reaction to a specific event.
However, even if the failure of a small number of banks does not lead to contagion that results in a full-blown crisis, we do expect a tightening of credit that will have longer-range implications. This has added yet another layer of complexity to the Fed’s upcoming decisions on interest rates.
Which brings us to the look forward. We still expect all the markets in which we invest to be highly sensitive to the outlooks for inflation and interest rates. The problem is that the Fed and the bond market are sending seemingly conflicting signals. The Fed is telling us to be prepared for continued rate increases (although they’ve indicated we may be near the peak of the current cycle), and for rates to stay higher for longer. The bond market, on the other hand, vis-à-vis the steeply inverted yield curve, is telling us a recession is imminent and yields are headed lower. Finally, the stock market seems to be pricing in hope that, somehow, the Fed can get inflation under control without significantly higher rates and without triggering a recession. To reconcile the mixed messages from the Fed and the bond market, we must assume that the Fed will continue to raise rates, but only until the combination of tighter financial conditions and higher rates causes a steep enough recession that they are forced to start cutting rates again. So, either we get higher rates and a strong economy, or lower rates and a weak economy. But we do not foresee a world in which we get lower rates and a strong and growing economy. Which is a long-winded way of saying that stocks may be currently pricing in an unrealistically rosy set of circumstances.
Notwithstanding our somewhat cautious near-term outlook for stock prices, we think the most probable outcome is that any recession will pave the way for both lower rates and an economic recovery to follow, and that stocks will, and should, remain the asset class of choice for long-term investors. In the meantime, we are heartened that during volatile periods for stocks we can earn yields in the form of dividends on stocks and interest on bonds, Treasury securities, and even money market funds that we haven’t seen in years.
As a final matter of housekeeping, please remember to keep us informed of any changes to your contact information or financial circumstances. And please make sure your beneficiary information is up-to-date and consistent with your estate plan.
Eddie Carlisle Doug Muenzenmay Julius Ridgway
SoundPath Investment Advisors
