Q2 2023 Market Update: Take What the Market Gives You

There are lots of cycles for an investor to consider: economic, credit, profit, interest rate, and stock market. Where we are in a cycle has crucial investment consequences. The decade up to the COVID pandemic was a prolonged cycle of modest economic growth, low inflation, extremely low interest rates, and stock market gains that culminated in one of the greatest bubbles in global financial market history. The pandemic caused massive distortions to the economy and in government fiscal and monetary policy that boosted economic activity, inflation, and market speculation. (Remember crypto, SPACs, and NFTs?)

When the Federal Reserve began hiking interest rates in March of last year at the fastest pace in four decades, it jolted both stocks and bonds, resulting in big losses for stocks and the worst year for bonds on record. Regardless of whether the Fed is nearly finished with its rate-hiking cycle, the impact on the economy isn’t finished—it can take up to two years for the effects of interest rate changes to ripple through the economy. On top of sharply higher interest rates, the credit cycle has turned down sharply (fewer loans are being made), as has the money supply. For an economy that relies on credit, that’s not good.

Market Prices Versus Underlying Fundamentals

Investor psychology also has cycles, as herd behavior often overwhelms economic and profit fundamentals for short periods. We saw that in the late 1990s’ dot-com bubble in technology stocks, and we see it today.

In the 1990s, the mania over the internet led investors, large and small, to crowd into the same small number of large technology stocks (Intel, Cisco, Microsoft, Lucent, Dell, Oracle), which drove their prices up in a virtuous circle—price gains attracted even more buying, which led to more gains, etc. Today, the frenzy over artificial intelligence (AI) has done the same. For example, semiconductor stocks are up 65% this year, even though industry revenues have been falling at a rate of more than 20% year over year.

Eventually, however, fundamentals—and valuations—matter. In 2000, Intel had the world’s second-highest stock market value. The virtuous circle which drove more and more cash into Intel and other tech stocks continued—until it didn’t. When Intel in late summer 2000 forecast lower profits than expected, the stock plunged 55% in just six weeks. That was just the beginning. Intel fell 80% in the 2000-2002 bear market, and Cisco, the third-largest stock in the world, fell almost 90%.

In market history, the largest companies in the stock market (often considered “must-own” stocks) have had sharply lower prices after attaining that feat—Japanese banks in 1989, U.S. tech stocks in 2000, and U.S. banks in 2007. Will it be the same this time? U.S. tech stocks now dominate the world’s highest-valued stocks, with Apple reaching a total stock market capitalization of $3 trillion. Its stock is valued at the highest in history, based on revenues and profits. Yet Apple faces a glutted global smartphone market, lower revenues and profits this year, slower growth in its services businesses, and a balance sheet that is no longer bulging with surplus cash. Net cash is only 1.5% of the total stock market value, versus 26% in 2018.

The Bandwagon Effect

Investors have notoriously short memories. The regional bank crisis was only three months ago, yet in response to a large infusion of cash into the system by the government, the prices of large growth stocks have surged, leaving overall stock market valuations near record levels. This is amid falling corporate profits.

Yes, stock prices fell sharply last year into October and have had a vigorous recovery (at least for the Big Tech sector). But was that likely the bear market bottom? That’s extremely unlikely for two reasons. First, bear markets flush out excessive stock valuations and excessive investor speculation (greed). But at last October’s market lows, stock valuations not only didn’t reach historically low levels, they didn’t even dip below average. Second, investor psychology at market bottoms is depressed, with an aversion to stocks. Instead, in this cycle, there was an eagerness to know whether it was time to buy yet.

What Are the Risks and Return Prospects Today?

When times are good, it might seem that risk means being left behind (FOMO). That is especially true for institutional investors, who carry large career risks by trailing index benchmarks for even short periods.

It seems, however, that for prudent long-term investors, the real risk is losing money, perhaps irreversibly. That requires an emphasis on absolute returns, not on short-term volatility of returns versus a benchmark index. We have seen time and time again throughout financial market history that things can change in a hurry. Just because something hasn’t happened yet doesn’t mean that it won’t happen.

Let’s assess today’s risks and opportunities in a historical context. Unlike for most of the decade pre-COVID, interest rates on short-term, risk-free U.S. government securities are about 5% (versus near 0%). Meanwhile, the dividend yield on the S&P 500 stock index is only 1.5%, and the likelihood of substantial capital gains from today’s levels—after one of the greatest decades on record—is very small. This is especially so, given that corporate profits are falling and inflation, which boosted business prices, is falling as well. And remember, bonds have always had a positive total return during recessions.

You might say, “Yes, but the market disagrees, because prices keep going up—at least for Big Tech.” For now.

Pay attention to cycles, don’t desperately chase what is rising, and take what the market gives you. Now, it’s offering risk-free, short-term government bonds for 5%. Take it.