“… full oft we see Cold wisdom waiting on superfluous folly.”
-Shakespeare, All’s Well That Ends Well
Stocks started this year strong, extending the run of positive months to five. Small US stocks and non-US stocks posted more than respectable returns of 4.5% and 5.2% for the quarter (that’s up over 19% on an annualized basis!) But the star of the first quarter was US Large stocks as the S&P 500 returned 10.6%. Blended global stocks (our benchmark, incorporating large and small, US and non-US stocks) returned 8.2% in the first quarter and our managed equities generally matched that – something we seldom see in such strong markets.
Bond yields rose a bit as prices fell, and the taxable bond index declined 0.8% in the quarter. Listed real estate securities (REITs) declined 1.3% in the last three months but other diversifiers were generally strong, including solid results from insurance-linked securities, and most “market risk hedges” sleeves produced returns above 5% so far this year.
Given a rare year-over-year decline in the US money supply, and recession signals from both the usually reliable Index of Leading Economic Indicators and the Treasury “Yield Curve,” most economists expected a recession by now. But that hasn’t occurred. Instead, it increasingly looks like we may achieve the always sought but seldom-seen “soft landing” for the economy – that is, a substantial reduction in what was raging inflation a year or so ago without tipping the economy into a recession. Most economists now expect an economic slow-down over the rest of this year, while a few who we follow and respect still anticipate a recession later in the year. We’ll see. But so far, so good.
Recent stock gains have been largely fueled by anticipation that the Fed will soon begin a series of interest rate cuts. Often, it seems like that has been the market’s sole recent focus. But for all the attention on prospective rate cuts, we seldom see anyone ask: Why?
We, on the other hand, think that is a useful question. The economy is growing. Inflation remains stubbornly higher than the Fed’s 2% target. Labor markets are tight. The stock market has been strong. Coming rate cuts against this backdrop may risk reigniting inflation. So, why take that risk? We conceive of only two possible reasons, and neither is a sign of underlying economic strength: 1) US federal debt is now so large that unfunded payments on that debt at current interest rates could add enough to federal borrowings to depress bond prices and push up interest rates more in a vicious cycle. Or 2), the Fed perceives the economy is too weak to persist in expansion mode given anything like “normal” interest rates for very long, and that it needs a boost from accommodative monetary policy just to keep expanding.
An effort to mitigate either or both of those possible risks would be the only reason we can imagine that would compel the Fed to risk fueling more inflation by cutting rates soon. We think the Federal Reserve has generally done a good job of late, but it’s in a tight spot with little room for error.
Recent stock strength has raised US stock market valuations to about 21 times forward earnings estimates, so there is little room for error there either. S&P 500 earnings estimates for the quarter that just closed are expected to have grown only 3% from the prior year. For the full year, earnings growth is expected to grow about 11%. The market has anticipated this earnings growth acceleration in its recent advance. A significant risk for markets is if earnings growth comes in softer than expected.
In other risks, geopolitical hazards have risen in the first quarter. Election years add a different uncertainty to the mix (though election years tend to be positive ones for stocks.) Widespread market speculation is evident in many ways: digital currency prices, extreme market concentration in a few very large companies, the resurgence of interest in new “meme” stocks, and more.
As concerning as the overall market valuation is, the valuations of a few very large, very well-known, strong-performing US Tech and Tech-adjacent stocks are much worse. The equal-weighted price-to-earnings ratio of the so-called Magnificent 7 stocks (MSFT, AAPL, NVDA, GOOG, AMZN, META, and TSLA) is now just under 38x.
But there is always a wide distribution of market valuations, and most stocks are not as expensive as those darlings, and many valuations today are not extreme. Moreover, small stocks and international stocks generally represent much better valuation opportunities than large US stocks. The same looks to be true for many diversifiers now, including private credit, insurance-linked securities, (increasingly) real estate, and some inflation hedges.
That’s another way of saying that while we always believe diversification is a critically important tool in investing, outside of late 1999, we’ve never seen a time where we believe it has been more important to be diversified and to be underweight those largest, most popular Tech stocks now.
We thank GMO for the chart below, and we thank them for permission to share it. We just added the dotted trend lines: red for the long downtrend, and green for the three shorter uptrends. This shows the last 65 years of relative performance comparing the largest 10 stocks in the S&P 500 Index to the other 490 (each group equal-weighted, and regularly reconstituted). When the solid line fell (as it has done most of the time), the largest 10 stocks underperformed the rest of the S&P 500. When it rose (as it has most of the time in recent years), the largest stocks did better than the rest of the market:
Past performance is no guarantee of future results.
A glance at the chart above reveals several things: 1) the largest stocks underperform the other stocks (and the market overall) in the long run, 2) that underperformance doesn’t occur in a straight line, and in fact, strong counter-trend moves occur from time to time that result in the largest companies outperforming for years at a time (as in the late 1960s to early 1970s, most of the 1990s, and recently), and 3) the current countertrend run of largest company outperformance looks a bit long-in-the-tooth relative to the other similar runs. What can’t be seen on the chart, but which we’ll add, is that the counter-trend upswings in the largest stocks result in the market getting increasingly concentrated in the largest companies, and that both the late-1960s to early 1970s outperformance of the largest companies and the one that occurred through most of the 1990s were each followed by significant bear markets.
We don’t know when the very largest companies will revert to their long-term mode of generally underperforming, or when this bull market will end, but when it does, it may likely coincide with the end of this episode of outperformance of the largest stocks. For now, there is an abundance of much cheaper and much more attractively priced investment opportunities in smaller US stocks, international stocks, and some alternatives.
Investment even in those relatively very cheaper corners of the stock market won’t likely be able to do well enough to overcome the pull of a bear market and leave portfolios with positive returns during a broad market decline. However significant relative strength in such an environment should be enough to materially mitigate declines. This means the present looks like a good time to emphasize playing defense by embracing the reasonable valuations available outside of the high-flyers and by increased attention to meaningful diversification. This is another reason it looks like an unusually bad time to be overweight the largest stocks that have performed so strongly in recent years and have been so tempting.
One common market pitfall is to think that five or even ten years of recent history constitutes a “long time” from which to draw historical conclusions. But that often proves a trap, as “long term” in markets generally means 20 to 30 years and more. The “cold wisdom” of a truly long-term perspective on markets often requires considerable patience while shorter-term “superfluous folly” plays itself out. History shows markets ultimately reward patience and discipline.