Quarterly Letter

October 2023 – Quarterly Letter

By November 6, 2023 No Comments

November 6th, 2023

After peaking on July 31st, the stock market has pulled back in the face of headwinds caused by rising interest rates. Real yields, which are the nominal interest rate minus the rate of inflation, are at their highest level since 2008, prior to the global financial crisis.

Year to date, the S&P 500 is up 13.5%. The individual stocks under our management are up almost 16%. The weakest sectors of the market are those sectors whose performance is most closely linked to the bond market. Utilities are down 11% for the year. Utilities suffer when rates go up as their revenue rates are generally fixed by a regulatory body. They tend to carry a lot of debt as building out utility networks is very capital intensive. When interest rates increase, their expenses rise faster than their revenues.

Consumer staples are down 6% in 2023. Staples, like Proctor and Gamble and Coca Cola are very stable, slow growth companies that tend to pay high dividends. Many investors own them as bond substitutes. As the yield on bonds increases, bonds are increasingly competitive with the yields on consumer staples companies. This is in contrast to the consumer discretionary sector which tends to do well in times of economic strength. Consumer discretionary is up almost 20% year to date, suggesting that fears of economic weakness are diminishing.

The pullback in stocks over the last three months is a result of interest rates moving higher. The July 31st market peak coincided with the Federal Reserve revising its forecast for near-term economic growth. One year ago, Bloomberg News declared that the probability of a recession was 100%. What a difference a year makes. Not only was there no recession within the last twelve months, but the current level of economic strength suggests that a recession within the next twelve months is highly unlikely.

We are moving into what is seasonally, the best time for the stock market. A disproportionate number of investors make their contributions to their 401k plans and IRAs between November 1st and March 31st. After pulling back for the last three months, the market is poised for a substantial rally into the end of the year.

U.S. economic growth in the third quarter was off the charts, coming in at 4.9%. When the economy is strong, interest rates stay high as there is excessive demand for credit. A recession coincides with higher unemployment, lower consumer spending, and lower interest rates. The market is caught between higher long-term inflation and interest rates which could lead to a recession, versus stronger profit growth.

The increase in interest rates is already reversing. After peaking a bit above 8%, mortgage rates are back down to 7.5%. Other interest rates are also substantially lower than their peaks a few weeks ago. Increasingly, investors are sensing that the next move for the Federal Reserve will be to lower interest rates. The current estimate is for four interest rate cuts over the next year, moving short-term interest rates down 1%.

Economic cycles do not always conform to the textbooks. There is currently no economic model that says that inflation falls when unemployment is below 4%. Yet, that is exactly what is occurring. All of the economic forecasters base their forecasts on models of the economy that reflect how the economy behaved in the past. The models cannot comprehend unprecedented economic behavior.

Today, interest rates and economic forecasts are not very useful for figuring out where the market is headed. Markets respond more to the profit cycle than the economic cycle. The best time to own value stocks is when the corporate profit cycle is accelerating. Current earnings estimates suggest that corporate profits have bottomed and are in the early stages of a recovery. Accordingly, we added cheap cyclical exposure in the third quarter.

We will continue to modestly tilt away from the expensive areas of the market that represent the epicenter of concentration risk. Seven large growth stocks represent 30% of the overall weight of the S&P 500. This in and of itself is not that exceptional. What’s unique about these seven stocks is how strongly their returns are correlated. It’s almost as if they are an individual asset class that doesn’t correlate with the rest of the stock market. The Magnificent 7 have returned, on average, over 90% year to date. Without these seven growth stocks, the S&P 500 would be up less than 5% for the year.

The current valuation for the market is a little cheaper than the average for the last ten years. The price-to-forward earnings ratio is 18.4 for the S&P 500. If we equal weight the stocks in the S&P, the forward earnings valuation falls to 14.7.  Over the last thirty years, the forward price-to-earnings ratio of the S&P 500 has been 17 on average. Excluding the highly valued Magnificent Seven, the market looks cheap.

Our investment process focuses on seeking out quality growth stocks in segments of the market that have escaped investors’ interest. Future investment performance depends on the price paid for an investment. If we can initiate positions in quality companies that are currently overlooked, we will greatly increase our potential to outperform the market.

Looking ahead to the next year. I start with the assumption that the economy continues to grow, and that earnings estimates will increase. Overall, the market is about 10% undervalued relative to average historic valuations. Estimates are for earnings to grow 12% in 2024. Lower interest rates would be the final element of a very strong stock market rally.

Eric Barden, CFA