Markets in Review
The first half of the year proved to be a wild and crazy ride. Even with continued rate hikes and a Federal Reserve that was firmly committed to its inflation fight, the collapse of several banks, and significant concerns about the credit markets, performance during the first half of the year proved extremely resilient. The S&P 500 had its best first half since 2019 and the tech heavy Nasdaq Composite had its best first half of the year since 1983!
However, this was not a broad-based market rally. The vast majority of market gains in the first quarter were due to the performance of just a handful of mega-cap growth technology stocks now nicknamed the “Magnificent Seven”. Apple, Microsoft, Nvidia, Amazon, Meta, Tesla and Alphabet (the parent of Google) form this group of seven stocks. As excitement grew surrounding the prospects for artificial intelligence, these stocks produced very impressive returns so far this year. Yet, the impact of their returns was significantly amplified in the market capitalization weighted indices like the S&P 500 and the NASDAQ Composite.
The Dow Jones Industrial Average (DJIA) produced a 3.41% gain for the second quarter. In contrast, the S&P 500 rose 8.30% and the tech-heavy NASDAQ rocketed up 12.81% primarily due to the performance of a small number of constituents.
For example, due to their enormous market capitalization (which is the total value of a company’s outstanding stock), the Magnificent Seven make up approximately 22% of the weight of the S&P 500 Index. This means that out of 500 stocks, those seven stocks alone contributed over 5.4% of the index’s 8.3% quarterly return. In the NASDAQ Composite, it was even more apparent as the Magnificent Seven make up approximately 40% of the weight of that index of around 2,500 stocks and contributed over 9.4% of the index’s 12.8% quarterly return. In short, the second quarter was anything but a broad-based market rally.
The Russell 2000 Index, which includes 2000 of the smallest companies in the market, rose 4.79% for the quarter.
Value-based investing, which focuses on buying companies that exhibit quality fundamentals but appear to be undervalued, exhibited worse returns relative to growth-based investing this quarter. Similar to the Dow Jones Industrial Average, the Russell 3000 Value Index rose 3.43% for the quarter. The Russell 1000 Value Index and Russell 2000 Value Index performed similarly, returning 3.48% and 2.54% respectively. Value-based investing continued to suffer on a relative basis so far this year as the Growth stocks that were destroyed by high interest rates and economic uncertainty in 2022 came charging back due to the aforementioned technology exuberance.
Investors continued to deal with the fight against inflation and tighter monetary policy this quarter including one more 0.25% interest rate hike followed by a “hawkish pause” in June when the Federal Reserve Board did not raise rates but signaled that more hikes were still to come. This sent yields – which move in the opposite direction of prices – higher again during the quarter following the temporary decline in rates that occurred in March of this year.
With the backdrop of less drastic monetary tightening but signs of looming credit concerns, the Bloomberg US Aggregate Index, which includes a broad cross-section of U.S. fixed income assets overall, dropped -0.84% for the quarter.
Are We in the Clear?
Many investors are looking at the bullish market returns from the first half, noting that there are some signs of disinflation combined with a slightly brighter economic outlook, and presuming that the Fed has successfully orchestrated a soft landing. However, we must remember that monetary policy acts with a lag, and this has been an extremely rapid cycle, so we would not expect to have seen the full economic impact yet of tightening monetary conditions by any means. This is especially true as many companies and households refinanced at record-low rates during the pandemic period between 2020 and 2021.
Things may feel good right now, but there could still be some significant pain ahead of us. Consumer demand for discretionary goods appears to be dropping. Corporate profits have declined for several quarters in a row. Cracks in the commercial real estate market are likely to become craters which will materially impact the balance sheet quality of regional banks that carry the loans. Senior loans which are used most often by companies with lower credit ratings are seeing an increase in default rates. All of these elements have already started to create tighter lending conditions which will lead to further defaults and an inability for companies and individuals to obtain credit as cheaply as they did over the past decade.
Finally, the current yield curve inversions, which occur when long-dated rates fall below short-dated rates, are some of the widest that we’ve seen in decades. Historically, yield curve inversions have been a good predictor for an economic recession. Specific yield curve inversions, such as the spread in yield between a 3-month Treasury Bill and a 10-year Treasury Bond, have preceded almost every recession over the past eighty years, although the inversion itself does not mean the recession is imminent. Frequently, the recession does not occur until the inversion ends and short-dated rates fall back below long-dated rates. So, a recession is likely still something we would expect to see at some point in the not-too-distant future. In short, we aren’t in the clear yet!
The Newest Sure Thing?
Is artificial intelligence (“AI”) the new automobile? Should we expect the same type of paradigm shift that occurred when horses became the inefficient way to travel and cars were purchased by anyone who could afford one? Looking back in history, investors have obviously become excited and plowed money into some of the biggest innovations like the automobile, the airplane, the television, the computer, the internet, and so on. These products each certainly changed the world and produced massive returns for many investors. But many other investors picked the wrong “horse” and lost plenty of money as they tried to gain exposure to the newest innovation.
Think back to 1999-2001 when people plowed their life savings into anything that had a “.com” at the end of the company name. If you were smart or lucky enough to invest in a specific company that was trying to compete against brick-and-mortar book retailers (Amazon.com), you probably did quite well for yourself as long as you held onto your shares. But if you expected the internet boom to make you rich by investing in a different company that competed against brick-and-mortar pet food stores (Pets.com), you would have lost almost your entire investment between February of 2000 when the company went public and November of 2000 when the company collapsed.
This year, we have seen excitement around artificial intelligence which has bolstered sentiment towards technology stocks but has also lifted the broader market as discussed above. If you had exposure to Nvidia, Meta, Microsoft or Tesla, you absolutely benefitted from each company’s exposure to this new innovative technology. Furthermore, if you blindly invested in anything related to AI during the first half of this year … you probably made a healthy profit. However, history will repeat itself again so be careful.
Not every company will successfully harness the power of artificial intelligence. Many companies will fail to gain enough market share or will create a product that no one wants. Even though there will be hundreds (or more) of new companies looking to get in on the action, there will be just as many acquisitions and bankruptcies over time. Even though the market is largely riding the AI hype right now, prepare for violent pullbacks due to government regulations, trade restrictions, or corrections in demand estimates.
In other words, there is real potential for artificial intelligence to materially impact the way we live our daily lives, but investors cannot randomly throw money at anything claiming to be part of the AI revolution and expect success. At WBI, we utilize our own portfolio management technologies and process to search for those companies which we believe will succeed and become key contributors to any innovative trend over time, rather than those which are just riding the wave for the moment.
Looking Ahead
At WBI, we believe that the most important aspect to investing is to protect capital. Over the past 5 years, the company has continued to invest heavily in our investment and wealth management technologies. Our mission is to provide investors with better investment performance and a more successful client experience.
Unless otherwise indicated, the source for all price and index data used in charts, tables and commentary is Bloomberg.
IMPORTANT INFORMATION
Past performance is not a guarantee of future results.
The views presented are those of Steven Van Solkema and Don Schreiber, Jr. and should not be construed as personalized investment advice or a solicitation to purchase or sell securities referenced in the Market Commentary. All economic and performance information is historical and not indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product referred to directly or indirectly in this newsletter, will be profitable, equal any corresponding indicated historical performance level(s), or be suitable for your portfolio. Moreover, you should not assume that any discussion or information provided here serves as the receipt of, or as a substitute for, personalized investment advice from WBI Investments or from any other investment professional. To the extent that you have any questions regarding the applicability of any specific issue discussed to your individual situation, you are encouraged to consult with WBI Investments or the professional advisor of your choosing. All information, including that used to compile charts, is obtained from sources believed to be reliable, but WBI Investments does not guarantee its reliability. Sources for price and index information: Bloomberg (unless otherwise indicated). WBI Investments pays a subscription fee for the use of this and other investment and research tools. WBI Investments and Bloomberg are not affiliated companies.
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Annualized Rate of Return is the return on an investment over a period other than one year (such as one quarter or two years) multiplied or divided to give a comparable one-year return.
The Dow Jones Industrial Average (DJIA or “The Dow”) is a price-weighted average of 30 of the largest and most significant blue-chip U.S. companies.
The S&P 500 Index is a float-market-cap-weighted average of 500 large-cap U.S. companies in all major sectors.
The NASDAQ Composite Index (NASDAQ) is a market-value weighted index of all common stocks listed on NASDAQ. The Russell 3000 Index is a float-adjusted market-cap weighted index that includes 3,000 stocks and covers 98% of the U.S. equity investable universe.
The Russell 1000 Index is a float-adjusted market-cap weighted index that includes the largest 1,000 stocks by market-cap of the Russell 3000 Index.
The Russell 2000 Index is a float-adjusted market-cap weighted index that includes the smallest 2,000 stocks by market-cap of the Russell 3000 Index.
The Russell 3000 Value Index uses the value characteristic book-to-price ratio to create a style index based upon the Russell 3000.
The Russell 1000 Value Index uses the value characteristic book-to-price ratio to create a style index based upon the Russell 1000.
The Russell 2000 Value Index uses the value characteristic book-to-price ratio to create a style index based upon the Russell 2000.
The Bloomberg U.S. Aggregate TR Index is calculated based on the U.S. dollar denominated, investment grade fixed-rate taxable bond market including treasury, government-related, corporate, MBS, ABS and CMBS debt, and includes the performance effect of income earned by securities in the index.
The Bloomberg Global Aggregate TR Index is calculated based on global investment grade debt from twenty-four local currency markets including treasury, government-related, corporate and securitized fixed-rate bonds from both developed and emerging market issuers and includes the performance effect of income earned by securities in the index.
