Investors in long-term bonds feel like they are repeating a bad song while investors in stocks are likely not doing as well as the media headlines assume.
In 2022, the Federal Reserve began its campaign to tame inflation by increasing the Federal Funds rate from zero to 4.25% by year end. The 10-year Treasury followed, ending at a yield of 3.88%, up from about 1.5% at the start of the year. Because the price of a bond moves opposite to yields, this dramatic increase in rates led to double-digit losses for bond investors.
After a bit of a reprieve in 2023, bond investors are feeling the pain again. The 10-year Treasury yield fell to 3.25% in April but has since steadily increased to about 4.8%, as the Fed has further increased the Federal Funds rate to 5.25%. With inflation still above the Fed’s 2% target and economic growth strong, it isn’t likely that bond investors will escape another year of losses.
After an 18% decline in 2022, stocks have bounced back with a 13% return this year, at least as measured by the S&P 500. However, individual stock investors building diversified portfolios likely aren’t celebrating. As a market-capitalization weighted index, big moves in the largest companies have an outsized impact on the S&P’s return. The seven largest companies in the S&P 500 – Apple, Microsoft, Alphabet, Amazon.com, Nvidia, Meta Platforms and Tesla – have averaged a 92% gain this year and now make up 29% of the index. In contrast, if performance was measured by equally weighing each company in the index, its return would be flat for 2023. It is likely that most investors don’t concentrate their positions in a handful of companies (nor should they!) and therefore are likely underperforming the favored benchmark index.
What are investors to do? Some in the investment community believe that these seven companies will continue to grow strongly and that overweighting them in portfolios is the way to outperform. There have been other periods in the market, like the dot-com bubble of the early 2000s, where following this philosophy cost investors a lot of money. This is just momentum chasing, as it is much more likely that yesterday’s winners will moderate while laggards begin to get a second look.
The economy is doing its part to help companies succeed. According to the Federal Reserve Bank of Atlanta, third quarter GDP is expected to grow 5.1%, quite a jump from the second quarter’s 2.1%. The granular data seems to confirm that growth, with total retail sales advancing 0.7% in September from the prior month while August saw growth revised up to 0.9%. The September advance was broad based, with strong advances for online shopping, cars, health and personal care, gasoline and restaurants and bars.
Consumers have money to spend because the employment market continues to surprise to the upside, with employers adding 336,000 jobs in September. August also saw an upwardly revised 227,000 new jobs. Unemployment held steady at 3.8% as more people came off the sidelines looking for work. While the bond market didn’t take kindly to the report, initially driving up rates, the 2.5% increase in average hourly earnings is consistent with the Fed’s 2% inflation target. Job growth and increases in income provide the cash flow needed to keep consumers spending and growing the economy.
On the inflation front, the good news is that price gains have slowed markedly from the 40-year highs reached last year. However, the bad news is that progress stalled in September. The CPI rose 3.7% from a year earlier, the same pace as August but down from the 9.1% recorded in June 2022. Core prices that exclude the volatile food and energy categories rose 4.1%, down from 4.3% in August, with progress coming from services and housing cost declines. Unfortunately, the uptick in energy costs, particularly oil and gas, looks to impede progress toward the Fed’s inflation goal of 2%. After the report, the 10-year Treasury yield rose 0.115%, a reaction to the market’s increased belief that the Fed will have to hike the Federal Funds rate another 0.25% from the current level of 5.25%.
While the Fed and the market have coalesced around a soft-landing narrative, history suggests it is going to be very difficult to pull off. This is a particularly tricky period as growth is strong and inflation has not come down enough to take additional interest rate increases off the table, opening the door to a policy mistake if the Fed overtightens.
An additional wildcard is the unprovoked attack in Israel by Hamas. Weak global growth outside the U.S. was exerting downside pressure on oil prices before the attack, but if the Israeli response in the Middle East drags Iran, the U.S. and others into a larger conflict, oil prices will likely spike and bring with it further inflationary pressures.
Companies are coping with inflation, rising wages from the hot labor market and a strengthening dollar. According to the FactSet Earnings Insight report produced by John Butters, blended third quarter earnings for the S&P 500 are estimated to grow 0.4%, the first year-over-year increase since the third quarter of 2022. The largest detractor to overall earnings growth is the energy sector, expected to drop 38%, mostly from sharply lower oil prices. If that sector were excluded, the blended earnings growth rate for the S&P 500 would improve to 5.7%, in line with economic growth including inflation. Looking forward, analysts are expecting fourth quarter earnings to increase 8.1%. 2024 looks even more robust, with earnings expected to grow 12.2% as analysts are not expecting a recession and the earnings drag from the energy sector reverses.
The seven largest companies in the S&P 500 have had their day in 2023, but there are many companies that have continued to grow that haven’t drawn investor attention. In the November 2023 issue of the Investor Advisory Service, for instance, our analysts cover a midsized medical instruments maker that may many investors (as well as customers) sleep better at night, as well as an expanding retail opportunity that's growing under the radar of many analysts and investors.
Now is a good time to give these stocks -- and many others in our coverage list -- a hard look.
The commentary has been excerpted from the issue of Investor Advisory Service published in late October. To receive commentary like this in a more timely matter and receive actionable stock ideas each and every month, subscribe today. The Investor Advisory Service stock newsletter was named to the Hulbert Investment Newsletter Honor Roll for the 14th consecutive year for outperforming every up and down market cycle since 2007
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