2023 is shaping up to be a mirror image of last year. The 2022 stock market rout was principally led by four sectors: Communications (-40%), Consumer Discretionary (-38%), Technology (-29%) and Real Estate (-28%). Three of those four sectors now have a commanding lead in performance through the first half of this year. The best performing sector in this group is the technology sector which is up a whopping 43%. This is followed by the communications and consumer discretionary sectors which have gained 36 and 33 percent this year. Conversely, the other eight sectors only have a combined return of around 8%.
The same phenomenon has held true this year based on company size, although to a lesser extent. Last year’s stock market performance based on market capitalization ranked best to worst was small, mid and large. Through the first half of this year, that ranking has flipped to large, mid and small.
These past couple of years have been a good example of why it’s important to own a wide range of stocks in your portfolio and not to try and guess which stock or industry is going to be the next great thing. You just never know. While this year’s lack of broad-based returns is especially pronounced, the phenomenon of a handful of stocks driving the overall market isn’t anything new. Studies have shown that, historically, approximately 10% of the companies in the S&P 500 have contributed to roughly 90% of the index’s gains in a given year. Currently it’s even less than 10%. Microsoft, Amazon, Apple, Nvidia, Google and Facebook now comprise a fourth of the index.
The same can be said of the trading days in a year. Studies have shown that the majority of the positive returns in the stock market can also be attributed to a relatively small percentage of trading days. For instance, an analysis of historical returns has shown that approximately 80% of the gains in the S&P 500 were generated within approximately 20% of the trading days in a given year. This means that the bulk of the market gains can be concentrated in as few as 10-20 trading days.
If you were to either miss out on those trading days by trying to time the market or have a narrowly focused portfolio, you’d likely only experience a fraction of the index return. This is the real reason why diversification matters.
On the economic front, the Federal Reserve is nearing an end to their aggressive rate increases. Last month was the first time in eleven meetings that they chose to keep rates unchanged. The fed-funds target rate currently stands between 5 – 5.25%. That being said, the fed governors are indicating the likelihood of two more quarter point rate increases this year. These increases are having their intended effect as inflation has come down quite a bit in the past year. The latest CPI report shows that that the overall rate eased to 3% compared to a year ago. That’s still a percent above the Fed’s target of 2%. However, core inflation, which excludes food and energy, rose 4.8%. Fed officials see core prices as a better predictor of future inflation than the overall inflation rate and this is the reason we’re likely to see at least one more increase.
More than a year after the Federal Reserve began rapidly raising interest rates to tame inflation, the widely expected recession remains at bay. It appears the lingering effects of the pandemic shutdown have left consumers and employers playing catch-up. Americans are splurging on the things they skipped during the lockdowns, such as travel, dining and entertainment. And employers are hiring aggressively to meet this demand. All of this has been fueled by the trillions of dollars the government pumped out over the last three years.
Our expectation for the stock market for the remainder of the year is positive. The expectation of a recession from the Fed tightening keeps getting pushed back farther into next year. This is also good for income investors since longer-term bond yields have been driven by those expectations. On one end of the spectrum, you have the Fed pushing short-term rates higher while recession fears want to hold longer-term rates lower. This is why the yield curve remains inverted, meaning rates are lower for longer maturities. Something will have to give. Either short rates will decline, or longer rates will go up. As bond investors, we’d like that later and see our client income continue to grow.