Q3 2023: PFM Quarterly Commentary
Have you ever had the eerie feeling that you’ve experienced something before? The French call this déjà vu, when the sensation of a new experience is somewhat familiar, although it’s often difficult to identify or pinpoint why. In this case, we’ll apply the literal translation of déjà vu, “already seen”, to the current investment environment. It was only one year ago that the equity markets were in turmoil, interest rates were spiking, the war in Ukraine was in full swing, global central banks were relentlessly hawkish, most economic data was weakening fast, and the market pundits were calling for a crash.
Well, not much has changed since then. The S&P 500 closed the quarter by dropping 6.5% on a price basis over August and September, the yields on 10-year US Treasury bonds rose dramatically to levels last seen in late 2007, the Ukraine conflict continues unabated, major central banks around the globe, including our own, further raised interest rates, all the while the news and data cycle conveyed a solidly bearish tilt. Naturally, many of those same talking heads in the media are once again calling for a precipitous drop in stock prices.
At first blush, one can understand the negative sentiment given the events that unfolded during the quarter. Most notably, on August 1st, the ratings agency Fitch downgraded the credit rating of the United States from AAA to AA+. Such a move is rare; the previous occurrence was when another major credit ratings agency, S&P Global Ratings, applied the same downgrade in August 2011. It’s worth noting that the AA+ rating is still considered excellent, however, the language Fitch used to describe the nation’s runaway debt was disconcerting at best, qualifying their decision on a “fiscal deterioration” and an “erosion of governance”. Perhaps the country crossing $33 trillion of debt in September, adding over $1 trillion of debt in just three months while in peacetime, and moving ever closer to $1 trillion in annual interest expense had something to do with Fitch’s decidedly sharp tone.
The resulting abrupt increase in interest rates during the quarter, particularly longer-term interest rates (ten years and beyond) trickled down to other sensitive parts of the economy. Most notably, the average 30-year mortgage rate skyrocketed, closing the quarter at 7.83%, its highest level since August 2000. In addition to significantly reducing home affordability, the decades-high mortgage rates were the primary contributor to the weakest existing monthly home sales and new home starts since 2020 (during the pandemic). To add insult to injury here, 15.7% of pending home purchases fell out of agreement – one of the highest percentages ever recorded. All of this resulted in only 1% of existing homes in the US changing hands so far in 2023, thus far a record low.
It wasn’t just housing that reeled under soaring interest rates. Durable goods orders tumbled 5.2% in July, their largest monthly decline since the Covid lockdowns. Commercial office mortgage delinquencies experienced the largest six-month spike ever recorded and corporate bankruptcies reached their highest level since 2009, with corporate debt defaults through the first half of 2023 surpassing the entirety of defaults in 2022. Consumers also strained under inflation and higher interest rates as they leaned heavily on credit cards after exhausting the Covid savings surplus to cover their income shortfall. Credit card balances jumped to an all-time high at the same time interest on credit cards soared to 22.2% on average–another record of the wrong sort.
Sky-high interest rates have also plagued the investment markets, most notably fixed-income securities. Bonds underperformed stocks on a rolling one-year basis for 35 straight months, matching the record set in the early 1980s. Moreover, unless bonds stage a remarkable recovery in the fourth quarter, the US Treasury bond market is on pace for three consecutive calendar year declines which hasn’t happened since the Roaring Twenties. In truth, the stock market has suffered even more than the headline numbers would indicate. On a price basis, the S&P 500 has been flat since June 2021, which is over 800 days without any return. For small companies, as represented by the Russell 2000 Index, investors have not experienced any price appreciation for nearly three years.
Even the S&P 500’s respectable return on a price basis so far in 2023, 11.6%, doesn’t accurately tell the story of how increasing interest rates affect the average stock due to the excessive weighting within the index toward a handful of mega-sized technology companies (now known as the Magnificent Seven) such as Apple, Microsoft, and Google. Another version of the S&P 500 that weights each company in the index equally as opposed to size has returned a meager 0.3% through the end of September 2023. Similarly, the Russell 2000 Index, an index comprised of two thousand domestic small companies, has returned just 1.4% so far this year. Similarly, the S&P Midcap 400 Index is up only 2.9%. Despite the often-cited S&P 500 showing low double digit returns in 2023, the average stock in the US, regardless of size or sector, has experienced almost no appreciation at all.
Most investors would attest to these extended periods of low or no returns as being incredibly frustrating. Well, we wholeheartedly agree. The silver lining is this: historically, markets use these long stagnant periods to build up energy before moving on to new highs. For example, from February 2015 to November 2016, the S&P 500 moved sideways before beginning a bull market that spanned two years and saw the index rise nearly 40%. We expect this ongoing long span of consolidation will eventually resolve itself by moving higher.
Despite the widespread bearish case made by many, for the second year in a row, we find ourselves concluding our Q3 commentary by sharing signs of bullishness and optimism. For starters, the well-researched, long-standing four-year Presidential election cycle dating back to 1928 has been exceptionally accurate in forecasting the stock market’s direction, especially during the Biden administration. Should the pattern hold, the major domestic equity indexes will begin a year-end rally that continues throughout most of 2024.
Additionally, despite its infamous reputation, October is undoubtedly the best performing month as defined by both the number and frequency of upward daily moves in the S&P 500 that are equal to or greater than 1%. Since the New York Stock Exchange adopted the five day trading week in 1952, October leads all other months with 14.1% of its days registering a positive return of at least 1%. And you guessed it; the second-best month behind October is November with 12.2%. Further, annual seasonal patterns in the equity markets derived over the last twenty years have tracked with high precision in recent years. Should the S&P 500 continue tracking this seasonal pattern closely, the steep decline in stocks that began in mid-September will bottom in early October before beginning a robust end of year rally.
Even more esoteric trading patterns point to brighter days ahead. For example, since 1950, there have been eight other instances where the S&P 500 was up at least 10% from January through July and down both in August and September. In each of those instances, the fourth quarter delivered positive returns averaging a very respectable 8.6%. Diving even deeper over this same time period, after declining by more than one percent in both August and September, the S&P 500 was higher in October nine of ten times with the last three instances in 2011, 2015, and 2022 posting returns of 10.8%, 8.3%, and 8.0%, respectively. The stock market is a complex system, and its direction will ultimately be determined by events and variables that are borderline impossible to predict and challenging to forecast. However, investor behavior is fairly consistent over time, which is why we find value in identifying and applying historical trading patterns like those discussed above. Perhaps our view of the future can be summarized as follows: the S&P 500 remains in a bull market that began October 13th, 2022. Unless this trend is nullified, we anticipate that the poor market performance in the third quarter will prove itself an uncomfortable pullback in the broader context of the larger bull market. Accordingly, we will maintain this perspective unless the market offers convincing evidence suggesting otherwise.
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Peak Financial Management
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