Many index investors, after the drubbing taken in 2022, have looked at their statements for the first quarter of 2023 with some relief. The Standard and Poor’s 500 Index is up seven percent this quarter. However, the average stock is up less than one percent.
This pattern is reminiscent of the prior decade when a few stocks dominated the indexes. In the first three months of 2023, Apple climbed 26 percent, counting for over 20 percent of the index’s gain. Microsoft and Nvidia each added over 15 percent to the index. These three stocks made up over half of its performance.
The other 497 stocks added a bit less than half of the index’s return. For a sense of proportion, the stocks that did worst in the quarter such as Charles Schwab (down 37 percent) took only 0.15 percent off the index. First Republic bank (down 88 percent) affected the index only 0.08 percent. Silicon Valley Bank (down 100 percent) started out the quarter at 0.04 percent of the S&P.
We’ve all seen this movie before. It does not turn out well. In the original version of 2011-21, low interest rates made rapidly growing stocks like technology and FANG (Facebook, Apple, Netflix, and Google) seem to grow to the sky. Higher interest rates changed all that in 2022. This time around, lower rates of profit growth, if not lower profits themselves, will be the culprit.
Already there are reports that personal computer sales slid 29 percent in the first quarter, with Apple’s decline exceeding the overall average. Streaming services are locked in a battle for market share, with price wars beginning to erupt.
Adding to this headache is the legacy of Silicon Valley Bank’s demise. Many startup companies are now expected to show profits earlier than was originally the case or no more funding. The days of startups carrying losses for years while being sustained on venture capital and bank loans are over for the time being.
As banks are having to pay up for deposits, expect tighter lending standards to further constrain the economy. Remember that still higher interest rates are in the cards, and there has been no credible scenario outlined of when interest rates will decline.
Will there be another bank run like SVB? It is possible. The position banks find themselves in is not unlike that of the savings and loans in the 1980s. Namely, the income on their loans cannot be adjusted as fast as their cost of deposits rises. If the banks’ cost of deposits stays up for a long period of time, there will be political pressure to prop up the banks in some manner of fashion or to consolidate the same.
Those who prevail in this environment are the companies that have capital structures that support earnings and cash flows. Debt paydown will be a priority for some firms. Companies that provide products and services in demand and who have pricing power should come out well.
The economy continues to slow, but also continues to expand. The consensus seems to be that several government programs will kick in and provide stimulus in the second half of the year. There are several infrastructure projects such as nationwide internet fiber, road and airport upgrades and the like that are to boost the economy. Health care, fed by accelerating demographics, will also boost economic growth.
What could throw a wrench into all this is the debt limit ceiling which has not been seriously discussed by congress. Brinksmanship seems to be the order of the day. Hopefully the nation will not suffer either domestically or internationally as a result.
Inflation is showing some signs of moderation. The problem is that it is not moderating to two percent fast enough to change the course of interest rates, which are rising.
Overlooked by most investors is the ongoing shrinkage of the Federal Reserve’s holdings of government bonds. From an almost $9 Trillion high water mark, it is now estimated to be just above $8 Trillion. Shrinking the government’s bond portfolio results in less money in circulation, which is considered a source of downward pressure on prices and upward pressure on interest rates.
While interest rates did decline a bit during the bank panic last month, they seem to be firming up again. Most banks are advertising five percent Certificates of Deposit with government backing to $250,000.
Virtually all scenarios that claimed to incorporate the Fed pivoting to lower rates have been disproven. It seems a safe bet to assume that until inflation declines to two percent and stays there, interest rates will stay at or even above current levels.
The Stock Market
Stocks are currently priced at nineteen times next year’s earnings estimates. These estimates are being reduced as this is being written. It is reasonable to assume that the average stock is overvalued and is at risk of underperforming.
The best defense in this environment is to purchase stocks that have low valuations relative to the overall market. This ensures that the investor is getting something for his or her investment dollar. When the market goes back up, the same type stocks should lead the way up. As one person observed, the market timer’s Hall of Fame is an empty room.
Warren M. Barnett, CFA
April 13, 2023
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