Q2 2023: PFM Quarterly Commentary
Over the years, we’ve shared many traditional adages which investors employ to explain the market’s behavior. Two such familiar dictums are “don’t fight the Fed” and “stocks take an escalator up and the elevator down.” Looking back at the second quarter of 2023, a third sage maxim comes to mind: “bull markets climb a wall of worry.” This phenomenon typically occurs immediately following prolonged market downturns, at a time when investors scrutinize events and economic data through a negatively biased lens. As markets relentlessly march upward, potential investors stubbornly sit on the sidelines and forego participating as they wait for the bear market to resume. For these investors, their confirmation bias causes them to interpret information in a way that supports their pessimism despite the market proving them wrong. The fear of missing out, known as FOMO, eventually becomes too much to bear for many of these folks. Emotion takes over and they capitulate, buying at much higher prices than the ones they rejected months earlier, extending the markets even more.
This particular saying is especially apropos to Q2 because it featured a tsunami of bad news. Nonetheless, on June 8th, the S&P 500 officially entered a bull market after having rebounded twenty percent from the October 12, 2022 low. The much-dramatized debt ceiling standoff in Washington, the second largest bank failure in U.S. history (First Republic), the fastest rate of corporate bankruptcies since the Great Recession, and consistently hawkish monetary policy from the Federal Reserve were just some of the challenges with which the market contended and overcame. Any of these events should have been enough to rattle investors and send stock prices lower, but interestingly, the opposite occurred. Meanwhile, hard economic data and sentiment indicators showed that many investors were still bracing and positioning for the worst even as the markets pushed higher.
We regularly warn of the peril wrought in listening to and acting on sensationalized financial media, since market prices routinely move in different directions than those predicted by the popular narrative. The genesis for this advice is rooted in the fact that markets are forward looking by nature, anticipating and pricing in events that are expected to happen several months (or longer) in advance. Media outlets and individuals, on the other hand, tend to react to data points and economic developments that reflect information weeks or even months old. Perhaps famed market maven Warren Buffett colloquially summarized this point best when he remarked, “be fearful when others are greedy and greedy when others are fearful.” It pays to be aware of and avoid falling victim to herd mentality.
With Buffett’s words in mind, we can’t help but reflect on our Q3 2022 letter when, in the depths of the market downturn, we expressed reasons to be hopeful. A few of these assertions included bullish market cycle patterns, historically negative sentiment indicators, and unprecedented negative positioning among institutions. We further highlighted the month of October as a “bear killer,” it having halted the most bear markets since World War II. Longtime readers will recall our similar contrarian bullishness during the COVID crisis, the “Christmas Eve Massacre” in 2018, and Brexit. Our minority views during times of great stress are derived from employing a data-driven and historically informed approach to investing, in addition to a deep-seeded belief that financial markets over time are the greatest generator of wealth in modern human history. As the S&P 500 closes the quarter less than five percent away from its all-time high on a total return basis, our faith in the financial markets remains steadfast.
Markets have been rising for the last eight months because they foresaw the events and headlines that are surfacing today, most notably, the sharp decline in inflation and the approaching end of the Federal Reserve’s tightening cycle. Inflation, as measured by the Consumer Price Index (CPI), fell to just 4.0% in May. This data point marked the lowest inflation rate since April, 2021 (4.2%), and is significantly down from last June (9.1%). In fact, the decline in inflation was more rapid than the rise to the peak levels last summer. Additionally, CPI is currently in the longest streak of continuous deceleration since the 1920s. Further, inflation at the producer level as measured by the Producer Price Index (PPI) has fallen to just 1.1% for May, 2023, and is at its lowest reading since December, 2020. PPI is an excellent predictor of future inflation at the consumer level and was a tool we used to help forecast the sudden rise in inflation two years ago.
The substantial improvement on the inflation front has allowed the Federal Reserve to soften its hawkish monetary policy stance. The Fed raised interest rates by only .25% during the second quarter and elected not to raise rates following the Federal Open Market Committee’s June meeting. Moreover, the consensus among Federal Reserve Committee Members is that the peak interest rate attained will be 5.625%, meaning, the Fed expects only one more rate hike in 2023, with interest rate cuts expected shortly thereafter in 2024. Given the sharp slowdown in inflation and the approaching end of the tightening cycle, it should come as no surprise that markets have performed so well since last October.
We remain constructive for the remainder of 2023. Our seasonal and cyclical pattern data favors further gains in the second half of 2023, with other more classic measures drawing a similar conclusion. For example, since 1950, there have been twenty-seven times that the S&P 500 rose 7.0% or more by the one hundredth trading day of the year in late May – this year included. In all but three of those previous instances markets gained an average of 9.4% over the balance of the year. Another clue that the markets indeed bottomed in October is that the average price of the S&P 500 over the last 200 days is now trending higher. Over the last fifty years, there have been ten other such instances and not once was a new low made, with further gains being the most likely outcome. Most importantly, a benefit to the Federal Reserve having raised interest rates to such a high level is that they can now cut them significantly should the economy falter – a maneuver they have employed many times in the recent past. This last point is critical to understanding the robust performance of markets from October.
Anecdotal data suggests underlying strength in the wider economy outside of technology could propel markets higher in 2023. The most surprising sector is homebuilders, which hit an all-time high in June despite the highest mortgage rates in a generation. Many major trucking and transportation companies also recently posted new highs which, and given the forward-looking nature of markets, is certainly not indicative of economic weakness. Resilience also persists in the domestic labor market, which has defied analysts’ predictions despite the record tech sector layoffs and bank failures. Perhaps the Fed is going to achieve a “soft landing” for the economy after all.
Choosing to invest in the markets is akin to the familiar proverb about choosing to start a family, “If you wait until you have enough money to have children, you’ll never have them.” Well, similarly, if you wait until there are no problems in the world to invest, you’ll sit on the sidelines forever. Remember, we’re investors too, and empathize with just how difficult it can be to ignore stressful noise and remain even-handed. It’s instead better to focus on the fact that history has repeatedly shown us that with a thoughtfully constructed, prudently managed portfolio, ample patience, and a healthy amount of courage at times, investing is a proven way to participate in economic growth and to generate personal wealth. To borrow another nugget of wisdom from Warren Buffett, more investors could be wealthy, but “nobody wants to get rich slow.”
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Peak Financial Management
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