Quarterly Investment Letter – Q2 2023

It is remarkable how consistent total returns have been for the U.S. stock market over the long term. For the last 5, 10, and 15 years the returns have been 11.2%, 12.2%, and 10.6%, respectively. During those periods, our country has experienced a generational financial crisis, a pandemic, multiple wars, inflation spikes, energy crises, terrorism, government shutdowns, recessions, and a multitude of stock market declines. In this year alone we had to deal with three of the largest bank failures on record and fears that Congress would throw us into the abyss by defaulting on our debt. It is no surprise that many people have such a cynical view of the future and believe something bad lurks around the corner. In one respect they are right; something bad will happen again and surprises will occur. However, these events are not likely to impact the long-term capital returns investors earn by owning great businesses.

2023 Stock Returns: Defying the Skeptics

2023 stock returns have defied the skeptics. Nearly all stock strategists had a negative outlook coming into the year along with pessimistic expectations for equity returns. The consensus was wrong again. Over the trailing 12 months stocks are up 18.7%, and 13.7% annualized over the last 36 months. A temporary bear market (a decline of greater than 20%) interrupted that growth last year, but there is mounting evidence that stock markets have resumed their upward trajectory.

Historical Evidence and Positive Outlook for Stocks

We are not surprised by these returns. Historical evidence indicated 2023 could be a particularly good year for stocks. History and fundamentals also suggest prices can keep moving up. Since 1950, whenever stocks experienced first-half returns greater than 10%, the balance of the year was positive 82% of the time, with a median return of 10%. Coming out of a bear market, like what occurred last year, returns in the second half have been positive 89% of the time.

Economic Growth and the Federal Reserve’s Monetary Policy

The economy is growing despite the Fed’s most restrictive monetary actions in four decades. Monetary policy typically works with a lag and its effects have not been entirely felt by the economy. Gross Domestic Product (GDP) increased at an annualized rate of 2.0% in real terms and 7.6% in nominal terms during the second quarter. After months of concerns that the economy would fall into a recession, predictions of both the timing and probability of that are changing as economic data keeps improving. The Federal Reserve’s goal has never been to force the economy into a recession, but rather to channel inflation back to or near 2%. It has always accepted the risk of recession and believed the economy was healthy enough to withstand and manage through tighter monetary conditions. The Federal Reserve continues to believe there is a pathway to lower inflation without a meaningful recession. The most recent data and strong labor market are in its favor.

Inflation Fever Breaking and Implications for Monetary Policy

There are also strong indications that inflation fever is breaking, and inflation expectations are falling quickly. This is great news for the economy and economic growth. Lower prices are a stimulant to economic growth and wage growth is now above the inflation rate. Core inflation, as measured by the Personal Consumption Expenditures Index (PCE), is now running mid 3%. Producer prices are now declining month over month and are flat from a year ago. That figure was 9.75% last July. This is what the Federal Reserve needs to see to begin easing off its monetary tightening policy.

Stock Market Performance and the Best Opportunities

The U.S. stock market capped off its third consecutive positive quarter by producing a 7.9% return. Large-cap stocks have led the way, rising 16.7%, as measured by the S&P 500. Small and mid-cap stock returns were not shabby either, gaining between 6%-8%. The stocks that declined the most in 2022 have rallied the most in 2023. And the stocks that performed well in 2022 have made little to no progress thus far this year. Foreign stocks, measured by the All-World ex US Index, have gained 10.4%. The impressive results from large companies make it tempting to jump on the large-cap bandwagon, but we feel the best values remain in the small and mid-cap stock arena. Large companies, with trillion-dollar valuations, need a robust economy to grow, whereas smaller companies have more growth opportunities, and it is easier to compound a smaller capital base. Large-cap stocks are the core asset class inside our portfolios, and we believe their future returns will be satisfactory, but the data suggests there are better opportunities for greater returns outside of the largest companies in the marketplace.

Fixed-Income Investments in an Evolving Economic Environment

The improving economic outlook has caused interest rates to tick up, putting pressure on bond prices. The Bloomberg Govt/Corp Bond Index declined -0.9% this quarter leaving the year-to-date return for fixed income at 2.3%. The 10-year Treasury interest rate rose from 3.5% to 3.8% in the last three months. The last few years have been an incredibly challenging time for holders of fixed-income investments. However, considering the level of interest rates today, along with the prospects for falling inflation, we believe the setup is positive for significantly better fixed-income returns.

The Importance of Discipline and Focus in Uncertain Times

In an uncertain economic environment, investing success will only occur with discipline and focus on your financial plan. Those without a plan are much more likely to make emotional decisions that often lead to poor outcomes. True power is sitting back and observing things rationally. Focus on what you can control and on things that matter the most to you. Have a great summer!

Leave a Comment