Bullish Beginnings & Navigating the Transformative Trends

Surprisingly, 2023 continues to showcase a historically resilient global financial system as easing inflation, exciting technological advancements (AI), and a robust labor market stifle the headwinds of higher interest rates. Despite the fastest interest rate increase in over two decades, select pockets of the market, specifically the ‘Super Seven*,’ have driven the market higher. Interestingly, this narrow leadership is starting to broaden – often one of the hallmarks of a new business cycle and bull market. This broadening is welcome news for all investors after the frustrating past year! Salvador Dali’s timeless painting ‘The Persistence of Memory’ can be interpreted as time passing, but memories lasting. As investors, we use the lessons learned from memories as a guide, yet our focus remains on identifying what makes this new investment landscape different from memories past.  

Market Breadth, Concentration & Sector Participation

As discussed in our previous strategy update, looking at major index returns this year, it appears markets are finally acting better with a steady upward march. When we look under the hood of index performance, the top 10 largest holdings have contributed about 70%** of returns to date. Narrow market leadership is a big concern for our team and many investors this year. While we would still like to see further improvement, the first signs of “life” are starting to emerge.

Fortunately, you own many of these great companies, and even more promising is that this narrow leadership in technology stocks has recently started to broaden out to other sectors. As market indexes retreated in what was a normal, overdue correction during August, you may have noticed that we added several high-quality businesses across more cyclical parts of the markets, including technology shares, since we envision the start of a new business cycle underway.    

Sector Rotation Underway?

Our confidence in the broadening market breadth continues to grow as data related to economic growth, labor market participation, and earnings come in stronger than expected. It’s a much different and constructive backdrop for equities than a year ago when we were deep into the throes of the Federal Reserve-induced bear market. While indexes are up this year, an analysis of sector year-to-date returns shows that most stocks haven’t advanced much, if at all, this year. This phenomenon is another example of the Super Seven tech stocks masking the lack of participation across the broader market. As the Federal Reserve’s war against inflation comes to an end, stocks across many sectors are trading at very appealing valuations - some of which we have only seen at the end of prior bear markets. We envision many of these left-behind sectors powering growth into the new bull market – hopefully, at very attractive returns from these levels.  

While history doesn’t always repeat itself, it often rhymes, and the types of businesses that tend to outperform at the onset of a business cycle are more linked to economic growth. This outperformance can also be true across market capitalization (a company’s size) – hence our inclusion of smaller capitalization stocks. Several examples beyond technology include industrials, materials, consumer discretionary, and financials. These trends are also occurring internationally – for the first time in nearly three decades, we are seeing the Japanese economy come roaring back to life along with select parts of Europe. As you review your portfolio holdings, you will notice companies based in both regions. These early signs of capital flowing out of historically defensive sectors and into more growth-oriented parts of the economy are exciting new developments, further supporting our thesis that a new business cycle and an all-inclusive bull market lie ahead.  

Federal Reserve Policy, Interest Rates, Fixed Income

You may ask, “How is it possible to start a new business cycle while the Federal Reserve is still trying to slow the economy and inflation?” Don’t forget that the stock market is forward-looking! While this cycle has been confusing, financial markets are beginning to reflect that the most challenging times are likely behind us – with economic improvements ahead. We have already seen a few classic “breaks” (Silicon Valley Bank and First Republic Bank), inflation is no longer in an upward spiral (we are closer to the Fed’s 2% inflation target), and profitability has returned to the spotlight (SPACs, pre-revenue, and other speculative companies saw valuations obliterated). The Federal Reserve has also signaled that they are likely done, if not very close to being done, with hiking interest rates. These factors have encouraged us to add equity exposure and have put us at an exciting point in the interest rate cycle to take advantage of elevated rates and lock in attractive yields. The bond market is already pricing in interest rate cuts for mid-2024, so we have strategically positioned our fixed-income portfolios before then. We think it’s too early to speculate on the timing or probability of a rate cut. However, rate cuts are still a reality that we must prepare for whenever we are near the peak in the interest rate cycle.

Artificial Intelligence (AI), Semiconductors & Technological Turbo Chargers

The hype of Artificial Intelligence is well documented. We all want to see AI live up to its promises, generate productivity enhancements, and deliver sustained earnings growth. Still, we would also like to proceed with a healthy dose of skepticism. Why has AI just come to the spotlight when many companies have utilized these technologies for years? What are the most and least practical applications of AI? It remains evident in our eyes that highly specialized semiconductors are an essential piece of the puzzle to scale AI. However, there may be different chips that are more efficient once AI infrastructure has been built out. We have invested in these businesses over the years and look forward to increased exposure. Successfully taking advantage of investment themes such as AI requires our team to ask tough questions – especially during the infancy of a new bull market. Memories remind us to emphasize high-quality, well-capitalized businesses during periods when interest rates are higher. AI has the potential to “turbocharge” the economy, but identifying true innovators from actors simply riding the AI hype is important. We will discuss these nuances during our webinar later this month.

Managing the Risk of Our Current Optimism

As our comments above express, we view the global economy and financial markets through a much more positive lens. However, as we all know, unexpected changes in Fed policy, geo-political turmoil, and many other variables can derail this outlook and send financial markets back into bear territory. For that reason, we continue to apply our time-tested Active Risk Management process. This process includes the flexibility of your allocation to stocks, careful management of your sector exposure, and the use of carefully placed stop loss orders.

Back to School

As we roll into September, it reminds our academic team of the “back to school” season. It provides clients with an excellent opportunity to revisit their Wealth Plan with one of our Certified Financial Planners™. Our last Wealth Planning newsletter outlined a helpful roadmap. We hope you find this update useful, and if you have any questions about our work or have experienced a significant change in your financial situation, please let us know.

Thanks again for your confidence in our firm, and please let us know if we can be a resource for you, your family, or friends.

Your Main Street Research Team