Update on the Markets:

Index	2nd Quarter 2023	Full Year 2023
S & P 500 (Large US Stocks)	8.74%	16.89%
Russell 2000 (Small US Stocks)	5.21%	8.09%
FTSE All-World ex-US (International Stocks)	2.75%	9.50%
Barclays US Aggregate (Bonds)	(0.84%)	2.09%

July 2023

Key takeaways

► Stocks climb higher

► Resilient US economy

► Bull case for stocks

► Bear case for stocks

► Attractive rates in bonds

Solid quarter for stocks

It was risk-on for investors in the second quarter. Investors bought stocks despite a hawkish Fed (the Fed has raised rates by 500 bps to date), bank turmoil, and a debt ceiling crisis in Washington. A lot of the bad news turned out to be not as bad as feared, especially the absence of the long-awaited recession, and economic statistics surprised to the upside: slowing inflation, good corporate earnings, and a solid labor market. The consumer is happy and healthy. Inflation is dropping, and the labor market remains strong. Many anticipate the Fed near the end of this rate hiking cycle, and most investors expect cuts to begin early next year. Lower rates often bode well for growth stocks. Hence, US growth stocks are enjoying a tremendous year, up over 30% year to date as measured by the NASDAQ composite index.

NASDAQ Composite Performance

Will a recession ever arrive?

So far, the US economy has remained resilient, assisted by a strong consumer, robust labor market, and strong corporate earnings. Despite the Fed’s relentless efforts in fighting inflation, the economy keeps chugging along. A recession has been predicted for over a year now. It’s not happening.

The unemployment rate is 3.6% – a five-decade low – and inflation is slowing significantly, from a headline number of 9.1% in June 2022 to 3.00% last month. Core inflation (ex-food and energy) remains stubbornly high, dropping only from 6.4% in June 2022 to 4.8% last month.

Is the elusive soft landing upon us? A soft landing (a scenario where inflation cools without a recession and high unemployment) is tough to achieve and quite rare. It looks increasingly likely. We’ll have to wait and see. Excess savings continue to support consumers, and though much of it has been spent, most consumers have a job. Have a job? Go shopping! Debt loads are rising, as reflected in credit card debt, but it may be manageable if you have a job. Student loan payments resume in September. At the very least, consumers are slowing down when looking at recent retail sales numbers.

US Retail Sales

For the rest of the year, Fed policy, inflation, the consumer’s willingness to spend, stimulus in China, and more will be critical issues. The future looks partly cloudy.

Stocks going forward

What makes many investors nervous is the narrowness of the stock rally. Big Tech, the top eight stocks (Alphabet, Amazon, Apple, Meta, Microsoft, Netflix, Nvidia, and Tesla), make up 28.2% of the S&P 500 index. This group returned 58.5% in the year’s first half, mostly on euphoria concerning AI (artificial intelligence). Nvidia, the largest AI chipmaker, alone almost tripled in price, up 190%. Meta returned 138%. The S&P 500 index returned 16.9%. Without Big Tech, the S&P return would drop to 2.9%. The rally is beginning to broaden, but it’s still heavily concentrated in these eight stocks. Historically, narrow rallies can last a long time, but they’re not the healthiest bull markets and often collapse if the market doesn’t broaden out. And Big Tech stocks are pretty expensive. The P/E of Nvidia is north of 237!

Inflation still needs to be vanquished. The worst is probably over, but the largest drops are behind us, and from now on, inflation will come down slowly. Getting from 5.0% today to the Fed’s target of 2.0% will take longer. According to the Fed’s projections (the dot plot), we will see 2.0% inflation at the end of 2025. And inflation may bounce back. The Fed may have to keep raising rates beyond the much-anticipated hike of 25 bp in July.

A lot rests on the shoulders of the US consumer. Healthy balance sheets and a strong labor market may keep consumers buying, but they can’t rely on excess savings like they’ve done in the past. It may take a deep recession for consumers to delay purchases severely.

While the economic backdrop is positive for stocks, valuation is one of the biggest obstacles to a move higher. AI euphoria, good news on inflation, a resilient labor market, and good corporate earnings have made stocks a bit rich. The price/earnings (P/E) ratio on the S&P 500 is close to 25X. The historical average since 1990 is 23.3.

Sentiment has turned very optimistic, and there’s a feeling of FOMO (Fear Of Missing Out) in the market. The CNN Fear/Greed Index ended the second quarter at “Extreme Greed” levels. At the same time, the American Association for Individual Investors (AAII) Bullish/Bearish Sentiment Index hit the most bullish level since November 2021. This exuberance doesn’t necessarily mean that stocks are due for a correction. But caution may be in order, considering the still uncertain environment. Also, we’re entering the seasonally vulnerable time for stocks – late summer and early fall. It may be wise to wait for stocks to drop before adding to your positions.

What to do?

I like bonds. You can enjoy higher yields across the board- yields we haven’t seen in years. Even money market funds return near 5.0% and above 5.0% in one-year CDs. Furthermore, the yield curve remains inverted (short-term yields are above long-term yields), as the market expects the Fed to win its fight against inflation eventually, and, hence, rates will settle down. It may be time to lock in attractive long-term bond yields. Returns will be solid even if the Fed continues to hike rates. Total return on bonds comprises coupon income + reinvestment of coupon income + price appreciation (if any). A higher coupon results in the “income” component of your total return being greater overall. Even if the Fed must continue raising rates, the damage to total return will be less due to the more significant portion of total return coming from bond income rather than bond price appreciation.

Please let me know if you have any questions or concerns.

Sincerely, 
Henry 

Henry Gorecki, CFP® 
HG Wealth Management LLC 
401 N Michigan Ave, Suite 1200
Chicago, IL  60611
312-723-5116