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”Markets in Focus
Timely analysis of market moves and sectors of opportunity
Last week was great for the Nasdaq Composite Index – and pretty much nothing else. While the Nasdaq was up 3.6%, the S&P 500 Index was flat, and its equal-weight counterpart was down 1.2%. This builds on the trend that has existed all year where the stock market continues to trounce the “market of stocks” as the vast majority of gains have accrued to just a handful of the largest companies.
“The big just keep getting bigger,” said Matt Orton, CFA, Chief Market Strategist at Raymond James Investment Management.
In particular, most of this year’s gains largely reflect a surge in optimism about the prospects of a very small number of mammoth companies – perhaps linked to speculation about recent breakthroughs in artificial intelligence (AI) – rather than a strong economic backdrop for corporate America in general. And while the current level of narrowness is historically extreme, Orton said it’s worth noting that the S&P 500 has seen prolonged “top-heavy” rallies in the past with the most recent following 2020’s COVID-induced lows.
During those periods, however, Orton noted that other large-, mid-, and small-cap U.S. stocks also generally made strong gains, even if those gains weren’t quite as large as those from the mega caps.
“Breadth needs to increase if these top-heavy gains are to be sustained over the longer term,” he said. “This is one key reason why I have remained defensive and have encouraged investors to lean into quality and lower-volatility companies. Don’t forget the U.S. Federal Reserve (Fed) is still a headwind with the potential for June interest rate hike now back on the table.”
Consequently, he said now is a good time to manage position sizes among winners and look for opportunities on pullbacks to build exposure in some of the high-quality pockets of the broader market that haven’t participated in the rally this year.
Source: Bloomberg, as of 5/28/23
Source: Bloomberg, as of 5/28/23
Just to put some numbers behind the extreme narrowness within U.S. equities, a market-cap weighted portfolio of the largest five companies in the S&P 500 has returned about 40% year to date, compared to an average of only about 2% for the next 95 largest constituents and an average of less than 1% for the remaining 400 firms. Framed differently, year to date about 70% of the current constituents of the S&P 500 have risen in price by less than the overall index, around half have fallen, and about a quarter are more than 10% lower.
This trend became most evident after March 8 when the regional bank challenges accelerated. The timing of the acceleration in market narrowness leads Orton to suggest that there probably is an element of a “liquidity premium” at play, adding to the enthusiasm around AI. Tighter liquidity conditions in the aftermath of regional bank failures have highlighted the importance of balance sheet strength and stable funding of the mega-caps compared to the shorter-maturity debt profiles of many other smaller companies.
Source: Bloomberg, as of 5/24/2023
Source: Bloomberg, as of 5/24/2023
Moving past the distraction of the debt ceiling should help to improve investor sentiment, which has been a meaningful headwind to the broader market over the past few months, Orton said. The market had mostly priced in a positive resolution, so the impact on price going forward will likely be muted.
There have been some encouraging signs on the economic front as well with the trend of generally better than expected data continuing last week. The more positive economic backdrop coupled with a boost to sentiment from averting a self-imposed debt-ceiling catastrophe may help bring money back into the market – and Orton said he would expect any institutional assets coming back to be selective and to move into active management, which could help increase breadth. In this case, he said he would expect quality to keep winning.
“It’s unlikely that we see highly cyclical companies or ones with high earnings volatility get rewarded,” he said.
Also, don’t forget that the Fed is still a headwind. Multiple interest rate cuts are priced into the market with a June hike back on the table. Any normalization in pricing out these cuts should impact the lofty valuations of the higher-duration winners over the past few months. Should investors take some profits in the big winners of the year and redeploy those assets, breadth would also get a boost (again, those assets likely go into higher-quality companies, particularly those that are second- or third-order offshoots of the AI trade.
With the ascendance of AI-related technology, the market has largely ignored the recent run-up in yields, both nominal and real, that could prompt some re-assessment of positions that have massively outperformed the past few weeks. The equity risk premium (defined as the S&P 500’s earnings yield minus the 10-year Treasury yield) is now at its lows for the entire cycle, and indeed at its lowest level since October of 2007. It’s hard to argue that this immunity to higher rates will continue in perpetuity, Orton said, especially as recent hawkish Fed commentary has shifted the debate from “will the Fed pause in June?” to “will the Fed hike in June or skip to July?”
“Please note: I absolutely do not want to get in the way of the AI freight train,” Orton said. “Rather, I’m advocating for not chasing this trade higher and looking for better opportunities to build a balanced portfolio for the long term with rates and the market of stocks at their current levels.”
In particular, Orton said there are plenty of higher-quality opportunities across domestic and international markets. That means embracing diversification across asset classes and focusing on companies that can consistently grow, which is particularly important as economic growth continues to slow. He said he continues to prefer health maintenance organizations and pharmaceuticals within healthcare, as well as aerospace and defense in industrials, and select high-quality technology companies. While tech has strong momentum and is improving with respect to quality, he said there still aren’t too many companies at the top of the screen for both quality and low volatility. Breadth in technology also isn’t great, so selectivity is very important. Overseas, Orton said he prefers emerging markets, particularly Asia ex-China and India. One sector that does not make an appearance in quality screens both in the United States and globally is financials.
“I continue to believe it is too early to look to bottom-fish in the financial sector, especially banks,” Orton said. “There are plenty of attractively valued opportunities elsewhere.”
With many focused on AI and the turbulence in European luxury goods makers, Orton said the strong gains to Japanese equities have largely gone unnoticed. The Nikkei 225 is up more than 7% in May and almost 20% year to date. There have been record net purchases of Japanese equities by foreign investors over the past six weeks, but we haven’t seen significant domestic money start to participate.
Orton said it’s also worth noting that the recent burst of foreign enthusiasm for Japanese equities seems different from that for Eurozone equities earlier in the year in one important respect: it does not reflect a sharp upward trend in 12-month forward earnings per share (EPS) estimates. Instead, shareholder value/activism have been key focuses, supported by comments from Warren Buffett. But the accommodative stance of the Bank of Japan may be playing a key role in encouraging switches into Japan out of other markets. They key question is whether the recent gains are sustainable. This will be an important component for whether international developed markets can continue to outperform the U.S. given that Japan is the largest single-country weight in the MSCI EAFE® (Net) Index. Orton said he worries that sentiment is stretched and that the market is overbought in the short term. The medium-term charts look more promising. Orton said he would wait for some consolidation and then get exposure through the MSCI EAFE or a currency-hedged vehicle given persistent weakness in the yen..
With the debt ceiling nearly resolved, investor attention should shift back to the Fed and signals around the potential for recession. The headline economic report this week will be the May jobs report on Friday where a drop in monthly additions to payrolls are expected to drop from 235,000 to 180,000. Average hourly earnings will also be important, expected to decline from a gain of +0.5% in April to +0.3%. Assuming data comes in close to expectations, Orton said the Fed is likely to stand pat with rates.
| Tuesday | U.S. Conference Board Consumer Confidence Index; Eurozone confidence measures; Japan retail sales |
| Wednesday | U.S. Mortgage Bankers Association weekly mortgage applications, Job Openings and Labor Turnover Survey (JOLTS); Japan Consumer Confidence Survey, housing starts, and foreign stock/bond purchases; Germany Consumer Price Index and Import Price Index; France producer price index, consumer spending, and gross domestic product |
| Thursday | U.S. nonfarm Productivity and Costs report, initial jobless claims, ADP® National Employment Report™, Institute for Supply Management manufacturing Purchasing Managers’ Index, plus employment and new orders data; U.K. consumer credit data; Eurozone Harmonised Index of Consumer Prices. |
| Friday | U.S. Bureau of Labor Statistics Employment Situation Summary nonfarm payroll report; France industrial and manufacturing production |
Risk Information:
Investing involves risk, including risk of loss.
Diversification does not ensure a profit or guarantee against loss.
Disclosures:
Index or benchmark performance presented in this document does not reflect the deduction of advisory fees, transaction charges, or other expenses, which would reduce performance. Indexes are unmanaged. It is not possible to invest directly in an index. Any investor who attempts to mimic the performance of an index would incur fees and expenses that would reduce return.
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Definitions:
Defensive stocks provide consistent dividends and stable earnings regardless of whether the overall stock market is rising or falling. Companies with shares considered to be defensive tend to have a constant demand for their products or services and thus their operations are more stable during different phases of the business cycle.
A liquidity premium refers to any additional compensation that is needed to attract investment in assets that cannot be easily and efficiently converted into cash at fair market value. In bonds, a long-term bond is relatively illiquid and thus will carry a higher interest rate than a short-term bond to compensate investors for taking on the additional risk.
Short-maturity debt is debt that must be paid on a near-time time horizon, often in less than a year or even in a matter of months.
Cyclical stocks have prices influenced by macroeconomic changes in the economy and are known for following the economy as it cycles through expansion, peak, recession, and recovery
Equity duration is the cash-flow weighted average time at which investors can expect to receive the cash flows from their investment in a company’s stock. Long-duration stocks include fast-growing technology companies, including those that may not pay any dividends in their early years, while short-duration stocks tend to be more mature companies with higher ratios to dividend to price.
A real interest rate is an interest rate that has been adjusted to remove the effects of inflation. Once adjusted, it reflects the real cost of funds to a borrower and the real yield to a lender or to an investor. A real interest rate reflects the rate of time preference for current goods over future goods. For an investment, a real interest rate is calculated as the difference between the nominal interest rate, which is not adjusted for inflation, and the inflation rate.
A real interest rate is an interest rate that has been adjusted to remove the effects of inflation. Once adjusted, it reflects the real cost of funds to a borrower and the real yield to a lender or to an investor. A real interest rate reflects the rate of time preference for current goods over future goods. For an investment, a real interest rate is calculated as the difference between the nominal interest rate, which is not adjusted for inflation, and the inflation rate.
An equity risk premium is the excess return that investing in the stock market provides over the rate of return of a risk-free asset such as a U.S. Treasury security.
Hawkish, dovish, and centrist are terms used to describe the monetary policy preferences of central bankers and others. Hawks prioritize controlling inflation and may favor raising interest rates to reduce it or keep it in check. Doves tend to support maintaining lower interest rates, often in support of stimulating job growth and the economy more generally. Centrists tend to occupy the middle of the continuum between tight (hawkish) and loose (dovish) monetary policy.
Earnings per share (EPS) is calculated as a company’s profit divided by the outstanding shares of its common stock. The resulting number serves as an indicator of a company’s profitability.
Forward earnings per share is an estimate for the next period’s earnings per share for a company’s profit divided by the outstanding shares of its common stock.
Currency-hedged vehicles are transactions structured to protect an existing or anticipated position from an unwanted move in currency exchange rates. An example of a hedging vehicle is a currency forward, which is a binding contract in the foreign exchange market that locks in the exchange rate for the purchase or sale of a currency on a future date. Currency forwards can have customized terms.
The Consumer Confidence Index (CCI) is a survey administered by The Conference Board that measures how optimistic or pessimistic consumers are regarding their expected financial situation.
The Mortgage Bankers Association Weekly Applications covers mortgage application activity that includes purchase, refinance, conventional, and government application data, weekly data on mortgage rates, and indices covering fixed-rate, adjustable, conventional, and government loans for purchases and refinances.
The Job Openings and Labor Turnover Survey (JOLTS) program produces monthly data on job openings, hires, and separations compiled by the U.S. Bureau of Labor Statistics.
The Japan Consumer Confidence Survey, released monthly by the Economic and Social Research Institute and the Cabinet Office of the Government of Japan, is carried out to provide a quick understanding of shifts in consumer perception as a tool in evaluating economic trends.
The German Consumer Price Index is a monthly report on Germany’s inflation rate released by the Federal Statistical Office and based on prices paid for a wide range of goods and services including energy, food, and rents.
The German Import Price Index, published by Germany’s Federal Statistics Office, tracks prices on a monthly basis for imports to Germany that include crude oil, natural gas, and mineral ores
The France producer price index, published by the French National Institute of Statistics and Economic Studies, measures trends in transaction prices, exclusive of valueadded taxes, for goods from industrial activities and sold on the French market. Producer price indices in industry for foreign markets show trends in transaction prices (converted into Euros and therefore including exchange rate effects) of goods from the activities of French industry sold on foreign markets. The combination of these two indices determines the producer price indices for industry (French and foreign markets). These indices are calculated using the monthly price reports on some 24,000 products collected from a representative sample of 4,200 companies in the framework of the Industrial Prices and Corporate Services Observation Survey.
The U.S. Productivity and Costs report, released by the Bureau of Labor Statistics, tracks quarterly trends in nonfarm business sector labor productivity and unit labor costs in the nonfarm business sector. Labor productivity describes the relationship between real output and the labor time involved in its production. Measures of labor productivity growth show the changes from period to period in the amount of goods and services produced per hour worked. They reflect the joint effects of many influences, including changes in technology; capital investment; level of output; utilization of capacity, energy, and materials; the organization of production; managerial skill; and the characteristics and effort of the work force. Unit labor costs describe the relationship between compensation per hour and labor productivity, or real output per hour, and can be used as an indicator of inflationary pressure on producers. Increases in hourly compensation increase unit labor costs; labor productivity increases offset compensation increases and lower unit labor costs.
The ADP® National Employment Report™ is published monthly by the ADP Research Institute® in close collaboration with Moody’s Analytics. The ADP® National Employment Report™ provides a monthly snapshot of U.S. nonfarm private sector Employment based on actual transactional payroll data.
The Purchasing Managers’ Index (PMI) measures the prevailing direction of economic trends in the manufacturing sector. It is created by the Institute for Supply Management (ISM), and consists of an index summarizing whether market conditions as reported in a monthly survey of supply chain managers are expanding, staying the same, or contracting.
The Eurozone Harmonised Index of Consumer Prices is a composite measure of inflation in the Eurozone based on changes in prices paid by consumers in the European Union for items in a basket of common goods. The index tracks the prices of goods such as coffee, tobacco, meat, fruit, household appliances, cars, pharmaceuticals, electricity, clothing, and many other widely used products.
The U.S. Bureau of Labor Statistics (BLS) payroll report, known as the Employment Situation Summary, is a monthly report tracking nonfarm payroll employment and the national unemployment rate, with data on changes in average hourly earnings, and job trends in public and private sectors of employment. The report is based on surveys of households and employers
Indices:
The Nasdaq Composite Index is the market capitalization-weighted index of over 2,500 common equities listed on the Nasdaq stock exchange.
The S&P 500 Index measures change in stock market conditions based on the average performance of 500 widely held common stocks. It is a market-weighted index calculated on a total return basis with dividend reinvested. The S&P 500 represents approximately 80% of the investable U.S. equity market.
The S&P 500® Equal Weight Index is the equal-weight version of the S&P 500. It includes the same constituents as the capitalization-weighted S&P 500, but each company in the S&P 500 Equal Weight Index is allocated a fixed weight, or 0.2% of the index total at each quarterly rebalance.
The S&P 100, a subset of the S&P 500, is designed to measure the performance of large-cap companies in the United States and comprises 100 major blue chip companies across multiple industry groups.
The S&P MidCap 400® provides investors with a benchmark for mid-sized companies. The index, which is distinct from the large-cap S&P 500, is designed to measure the performance of 400 mid-sized companies, reflecting the distinctive risk and return characteristics of this market segment.
The S&P SmallCap 600® Index seeks to measure the small-cap segment of the U.S. equity market. The index is designed to track companies that meet specific inclusion criteria to ensure that they are liquid and financially viable.
The Nikkei 225 Index is a price-weighted equity index that consists of 225 stocks in the first section of the Tokyo Stock Exchange, excluding exchange-traded funds, real estate investment trusts, and preferred equity contribution securities.
The MSCI EAFE® (Net) Index measures the performance of performance of large and mid-cap securities across 21 developed markets, including countries in Europe, Australasia and the Far East, excluding the U.S. and Canada. The MSCI EAFE® (Net) Index subtracts any foreign taxes applicable to US citizens but not applicable to citizens in the overseas country.
M-389900-2023-06-02 Exp. 9/30/2023
