A New Bull Market Despite Recession Watch

July 7, 2023 – Against all odds—and contrary to bull market skeptics—the US stock market posted solid gains for the third quarter in a row. The S&P 500 TR, as of June 30^th, has gained 26% since last October’s lows. In a reversal from last year, the market mindset has shifted from economically defensive sectors such as healthcare, utilities, and energy, which provided a haven in 2022, to higher growth sectors.

Market leadership continues to be concentrated in large company technology and communication names such as Apple, Nvidia, Meta, Microsoft, and Alphabet. Fortunately, the list of names making significant gains has broadened in the past few weeks to include smaller companies and sectors outside of tech and communications. This broadening of participation is a reassuring sign of a more lasting market advance.

Large technology companies have led the markets on strong profitability, with an added price boost from the advent of generative artificial intelligence (AI). Nearly every industry is working on plans to utilize AI technology to increase productivity and open new opportunities. As a result, demand has spiked for the picks and shovels of this gold rush: companies that develop the software and manufacture the chips needed are seeing business surge.

Additionally, belief that the Federal Reserve’s rate increases are nearing an end is also helping stocks. The economy has continued to expand despite short-term rates being increased from near zero to over 5% in a little over a year. Inflation is easing as intended, declining to 4.3% in May after reaching a 41-year high of 8.4% last spring.

Even with these market gains, an interest-rate-induced recession is still possible.  But predicting the timing and the market’s response has proven impossible, even during this most unmistakable set-up: the steepest rate hike campaign in forty years.  Many investors were positioned against this bull market last fall and have held that stance since.  Yet in hindsight, no matter what is in store for the second half of the year, no one wanted their stock money sitting on the sidelines the last nine months waiting for the much-predicted recession.

U.S. Stocks – As last quarter, company earnings and forward guidance will be a considerable factor in the direction of U.S. stocks. Corporate profits need to at least meet expectations to help support ever-higher stock prices. US companies have been good at preserving profit margins while expenses have risen and the economy has slowed. Given the outperformance in big tech this year, we are now paying special attention to value and defensive sectors. We are adding to underweight parts of the portfolio and taking advantage of opportunities in defensive sectors and traditional dividend stocks to help balance the higher-priced growth names in tech and communications.

Foreign Stocks – Developed market stock indexes performed well in the quarter, gaining around 10%. In Europe, lower energy prices and a return to economic growth boosted stocks. In Japan, the TOPIX Index has surged nearly 23% this year. In addition, the weakening U.S. dollar is a significant tailwind for foreign stock returns of US investors. China, the largest emerging market economy, has reopened after its pandemic lock down ended, but the economic rebound is slower than expected. Meanwhile, broader Asia is seeing accelerating growth.

Fixed income – Short-term and long-term interest rates climbed higher in the second quarter on expectations of a stronger economy and possibly more Federal Reserve rate increases. The 2-Year Treasury finished the quarter at 4.88% and the 10-Year at 3.82%. With a slowing economy, we continue to be cautious regarding credit quality, replacing lower quality positions with higher quality. We also take advantage of higher rates in intermediate and longer maturity bonds by extending the range of maturities in portfolios. We “ladder” portfolios of individual bonds, with similar dollar amounts in each maturity from two years to seven years. We use tax-exempt municipal bonds in taxable accounts. In retirement accounts and other tax-free or tax-deferred accounts, we invest in CDs, treasuries, government agency bonds, and corporate bonds. For a short-term objective, we may hold money market funds for daily liquidity with yields close to 5%. For portfolios with a timeline of a few months to a few years, short-term CDs and treasury securities—both with current yields above 5%—are suitable options.

While we discuss many areas of the market, our focus is on your particular goal and a personalized strategy to reach that goal. As always, your questions are welcome. Please call or stop by the office any time.