Despite some phenomenal year-to-date strength shown by the “Magnificent 7” (Apple, Microsoft, Amazon, Google, Nvidia, Tesla, and Meta), the broad capital markets could not hold any meaningful strength into 2023 Q3. A look at many of the key factors impacting capital markets shows that almost all of them have a negative bias for earnings growth and investment returns.
Some of the negative factors include rising interest rates, inflation still close to 4%, gas prices hitting 2023 highs, credit card debt at all-time high, Chinese properties under stress, possible U.S. government shutdown, record high bankruptcies in August, student loans start again in October, continuing Russia/Ukraine war, etc., etc.! Nothing here necessarily portends a crisis; it would take some kind of “trigger” to get us into that situation, but the bias is decidedly negative.
A few positive factors like mostly stable credit spreads in the bond markets, stable industrial production, stable unemployment, and rising consumer sentiment do provide a pause for a “bull case”, but it is difficult to see the market going up from here. Equity values are driven by earnings growth and with the overlay of negative factors there is not too much driving growth right now.
Within the context of relative value, a 5%+ risk-free rate from U.S. Treasury Bills provides investors a safe haven to wait out the storm. This relative value play could be siphoning funds out of the equity markets but, since no one can time the market, a strategy to allocate all funds into cash is akin to a play at the roulette table. Treasury Bills are a good place for emergency funds and for a portion of a bond allocation to reduce overall bond duration, but that is it!
As shown from the table below, we seem to be re-entering the “sea of red” that I coined during Q2 and Q3 of 2022 where all markets were big losers! Except for short term investment grade bonds (SLQD) that I follow, all the major assets classes were down during Q3. Notably, core equity holdings like the S&P 500 (IVV) have continued to outperform diversifying positions like small/mid cap equities and international and emerging market equities.
Fixed income, on other hand, has benefited mightily from diversification with short-term investment grade corporates, high yield bonds, as well as bank loans and preferred stocks, all beating core bonds (SCHZ) on a YTD basis. In fact, ironically, core bonds and core equity both generated negative returns of about -3.3% during Q3!
Like I said in my blog post from August 2, 2023, Daring to Diversify, it is important to stay diversified to capture the risk premium embedded in the capital markets and strive to use equities in its role as a long-term inflation hedge:
The performance of various asset classes in July 2023 exemplifies the value of diversification. …in contrast to the core S&P 500 index, several other diversifying equity asset classes, including small-cap (SCHA), mid-cap (SCHM), and emerging markets (SCHE), outperformed, delivering higher returns. This demonstrates that diversification can yield positive results even when the primary market index lags.…
While the S&P 500 has shown impressive recovery in 2023, it should not be the sole focus of investment. Including other major equity asset classes and strategies globally, as well as diversifying within the fixed income space, can provide a more stable and potentially rewarding risk/return profile. Investors should carefully consider their financial goals and risk tolerance when constructing a diversified portfolio to achieve long-term success.