What to Make of This Year’s Equity Rally

Following the most aggressive monetary tightening cycle in the past 40 years, stock prices are approaching the threshold of a new bull market - rising almost 20% from the bear market low last October.  A cursory look at U.S. equity price movement so far in 2023 would suggest that stocks have been able to shrug off a wide range of troubling issues.  As measured by the S&P 500, U.S. equity prices are now up 4% since the debt ceiling deal was reached.  And, the index is up over 11% since the failure of Silicon Valley Bank last threatened a more widespread banking crisis in March.

However, as is usually the case, there is more to the story and the details of the recent rally are a bit more complicated.  Even as the equity benchmarks have been trending higher, the average stock is lagging badly.  Higher prices have been generally limited to only a handful of mega-cap technology stocks, particularly those having some level of involvement with artificial intelligence.  Remarkably, just 7 of the largest stocks in the S&P account for nearly all the positive return in May, while the 493 smallest stocks in the index were negative.

Those areas of the market that held up best in 2022, including high dividend payers or energy stocks, have been falling sharply.  The Dow Jones Dividend ETF (DVY) actually declined more than 7% in May.  Underscoring how thin the rally has been, about one-half of all stocks in the Bloomberg World Index are negative on the year and about two-thirds were down over the past month.  The valuation spread between a very few large technology companies and the rest of the market has widened to levels likely unsustainable.

As for the pace of economic activity in the U.S., the Federal Reserve's Beige Book regional survey shows the U.S. economy has displayed signs of cooling in recent weeks, with hiring and inflation experiencing slight easing.  The report, published two weeks before each meeting of the policy-setting Federal Open Market Committee, currently reveals an economy that is barely growing, and is doing so at a declining rate.

An important understanding of the American economy is that it relies on the success of small businesses.  According to the U.S. Small Business Administration, small businesses generate about 44% of national economic activity and create two-thirds of net new jobs.  Accordingly, small business owners represent an excellent barometer of how the country is faring.

The National Federation of Independent Business' (NFIB) latest release of its Small Business Optimism Index paints an alarming picture of just how tough conditions are becoming on Main Street.  The survey asks respondents questions on hiring plans, sales expectations, and their overall outlook for business.  Recently, the index fell 0.8 points to a reading of 90.  This marks 15 consecutive months in which the index was well below its 49-year average of 98.

The Conference Board Leading Economic Index® (LEI) for the U.S. also declined for the thirteenth consecutive month in April.  It was down 4.4% over the six-month period between October 2022 and April 2023, representing an accelerating rate of decline when compared to the 3.8% contraction over the previous six months (April–October 2022).

Late-cycle macro conditions continue to align with our base case that the economy is heading into recession; one we believe will be relatively short and shallow.  This said, late cycle conditions such as these are notoriously difficult to navigate, and we are not entirely surprised to see stock prices moving higher with investor hope that the economy can still avoid a recession.  Even so, we remain cautious as the S&P 500 Index now trades at stretched valuations – driven largely by a few mega-cap technology stocks which now trade at nearly 40 times forward earnings.   

Loyal readers of my Private Client Letter know that we have been very concerned about the current debt ceiling debate.  Last week the House of Representatives passed debt-limit legislation negotiated by President Biden and Speaker McCarthy, potentially removing a significant concern over the economic chaos that would result from a U.S. default.  The legislation received bipartisan support, with 314 votes in favor and 117 against. It has gone on to be approved by the Senate and was signed into law by the President.

It is important to recognize that resolution of the current debt ceiling deadline does not suggest that the country no longer has a debt problem, only that a crisis has been averted – for now.  For a more in-depth discussion of debt ceiling difficulties, please read The Debt Ceiling: A Crucial Component of Fiscal Policy with Far-reaching Consequences, by James Chapman in this month’s Thought Leadership package. 

Finally, Federal Reserve officials have recently hinted at their intention to maintain interest rates at their current level in June, while also keeping the option open for potential rate hikes in the future.  They have now entered their blackout period in preparation for the upcoming monetary policy meeting scheduled for June 13-14.  We think a “pause” will be the outcome of the June meeting, however we believe core inflation will remain challenging and investors hoping for rate cuts later in the year are likely to end up quite disappointed.

From our perspective, we anticipate more issues for the economy, and the markets, may yet materialize in the coming months.  We have an economy that is slowing at an accelerating pace, a stock market rally predicated on incredibly narrow breath, small business optimism in the doldrums, and a Fed that we believe will keep rates higher for longer in their battle with inflation.  All of this suggests to us that things could still get worse before they get better.  We would love to have a more positive near-term outlook, but until the data begins to indicate bottoming conditions, we prefer to remain defensive.

 As always, thank you for your continued confidence as we navigate this challenging part of the economic cycle.  Please reach out should you have any questions or concerns.

 John E. Chapman

Chief Executive Officer

Chief Investment Strategist