It’s Not How You Start, It’s How You Finish

2023 Started out great for investors, but is struggling lately

By Jon Aldrich

2023 started out well enough for investors, with stocks and bonds performing nicely the first few months of the year. Bonds were doing fine until about the middle of May, when interest rates took another leg higher, which is bad news for bonds as higher rates mean lower bond prices. For stocks, it really has been a bi-furcated market. 7 stocks have essentially driven almost all the gains in the S & P 500. Amazon, Apple, Google (Alphabet), Meta (Facebook), Microsoft, Nvidia and Tesla, now make up 30% of the S & P 500. These stocks are going gangbusters this year, while the rest of the market hasn’t really done so hot as is shown in the comparison of the S & P 500 Equal Weight Index to the S & P 500 Index in the chart below. (We will discuss the trials and tribulations of bonds in a bit).

Most indexes such as the S & P 500 are market cap weighted, which means the components of the index are assigned a weight according to how much the total market capitalization of a stock is. For example, Apple makes up over 7% of the S & P 500 index all by itself. This percentage is arrived at by taking the total dollar value of a company’s outstanding shares of stock. The top 7 stocks mentioned above now represent over 30% of the S & P 500 index! Thus, the S & P 500 has had a pretty healthy return for the year (See chart above), while the same index as an equal weight (all stocks comprise the same portion of the index) is about flat on the year.

Many experts agree that such a small swath of stocks driving the market is not a healthy stock market. A healthy stock market has the broad participation of most areas of the market (small stocks, mid size stocks, value and growth stocks), but this market in 2023 has essentially been this narrow slice of just a few mega technology stocks driving the S & P 500, while the average stock in the index is flat or down for the year. What happens when these mega stocks go the other direction, like they did in 2022? Watch out below!

When you look at some other areas of the stock market besides the S & P 500 that most investors own in their diversified portfolios and their performance year-to date through Oct 6 of this year, this is what you get:

Essentially, any index that does not own large amounts of those 7 stocks has not really done so hot. However, things were a lot better earlier in the year. For example, the Russell 2000 was up 14.7% as of July 30th and the Dow Jones was up almost 8% at that time. As you can see in the chart below, since July 31st the stock market has really struggled, and September was particularly nasty:

Performance since August 1 of main stock indices

There are many reasons for the struggle, interest rates spiking, dysfunction in our government, inflation still higher than desired, rich valuations for stocks, worries of an upcoming recession, etc.  Thus, a year that started out so promising has become somewhat disappointing for most investors. September also lived up to its billing as the worst month of the year for investors as it was a very tough month for stocks and bonds.

Speaking of bonds, the year started out rather nicely for bonds after suffering their worst year in history in 2022. In early April the U.S. Aggregate Bond Index was up almost 4.5% as longer-term interest rates started to actually fall a bit. However, since April the yield on the 10 Year US Treasury Bond (the benchmark gauge of interest rates for a good part of the bond market) rose from a low of 3.3% in April to 4.8% where it currently resides and the highest level in about 17 years. Higher interest rates have been a giant headwind for bonds as yields rise, bond prices fall and the total return of the Bloomberg US Aggregate Bond Index is now down 2.36% on the year. Unless things turn around by the end of the year, this will be the third year in a row that the bond market has endured losses.

Total Return of the Bloomberg U.S Aggregate Bond Index for 2023

 Since shorter term bonds are less sensitive to interest rates, funds that invest in very short-term bonds (1 or 2 years or less, including money market funds) have actually had a nice year and many are up 3% to 4% for the year. At some point, though, when interest rates do start to fall (maybe due to an economic slowdown), bonds should start to do very well and stocks would likely suffer. Even if interest rates just level off, bonds will start contributing to investors portfolios, as the coupons on most high-quality bonds are now over 5%. Thus, if interest rates just stabilized, you could earn 5% just from the interest the bonds kick off.

REASONS FOR HIGHER RATES:

Ok, interest rates have really risen over the last couple of months, what is driving this? First, the economy remains resilient, and the Federal Reserve has had to keep its foot on the gas pedal by hiking short-term interest rates to try to cool things off in the economy in an attempt to get inflation to it’s target rate of around 2% to 2.5% or so. The current annual inflation rate, as measured by the Consumer Price Index (CPI) is still hovering around 3.7% or so and still higher than Jerome Powell and the Fed would like. They control short-term rates or bonds maturing over the next 1 or 2 years.

The markets control the longer-term rates (over 2 years) and many believe that the markets (including foreign investors) are avoiding or reducing their U.S. Treasuries holdings because of the dysfunction in Washington DC. Many investors are worried about the continuing spending levels and increasing deficits here in the U.S. that they aren’t as comfortable holding U.S. debt as they were in the past, and have become net sellers, which drives the price of bonds down and the yields up. Many investors feel that is what is happening recently as longer-term rates have spiked.

There is also still talk of an economic “soft-landing” which means that the Fed is able to cool inflation while avoiding a recession. I have mentioned this before, but I think this is a unicorn and is extremely difficult for the Fed to pull this off. Yes, the yield curve has been inverted (which means short term bonds have higher yields than long-term bonds) for a long time, and this has been an extremely reliable recession indicator in the past and yet, a recession still has not occurred. However, if you follow this indicator closely, you will notice that most of the time a recession does not occur until after the yield curve “un-inverts” and longer-term bonds start yielding more than short-term bonds. That is when the clock really starts ticking for a recession, and we are getting closer to that occurring.

The chart above shows the last several times and the number of days the yield curve has been inverted while the grey areas represent recessions. As you can see in the chart, most of the time, recessions do not begin until the yield curve is no longer inverted. We are not there yet, but the wheels appear to be in motion as the yield curve has made significant progress the last few weeks to becoming un-inverted. Also, the chart is a month old, and we are now approximately 240 trading days into an inverted yield curve, which is an all-time record.

Short-term bonds have been the place to be the last couple of years, because short-term bonds are much less sensitive to interest rate changes and do much better with rising interest rates. But if we do find ourselves in a recession, and interest rates come down like they normally do during an economic slowdown, owning longer-term bonds should be very rewarding. Since longer-term bonds are more sensitive to interest rate moves, when rates fall, longer-term bonds should do very well. We may be getting closer to that point before long.

What this all boils down to for investors that do hold bonds in their portfolios is to continue to be patient, as we may be seeing the best environment for bonds soon that we have seen in the last 20 years or so. I know our patience has been tested the last couple of years but conditions point to being rewarded before too long.