Equity markets surged in the first half of 2023 thanks to resolved debt-ceiling concerns and improved banking conditions in the United States. But that’s not all! The excitement surrounding advancements in artificial intelligence, coupled with ample cash reserves and a sturdy economy, paints a promising scenario for stocks in the short term.
Encouragingly, the market breadth has steadily improved this quarter. While seven mega-cap stocks continue to lead the way, an increasing number of stocks are seeing improved price momentum. For example, as of June 14th, a significant 61.8% of S&P 500 stocks were trading above their 50-day moving average. The majority of S&P 500 companies have reported positive earnings surprises, making it the best performance relative to Wall Street estimates since 2013’s fourth quarter.
AI’s potential as a speculative mania, similar to the 1990s tech bubble, should not be overlooked. Many investors got caught up in the tech bubble, unaware of the excessive focus on technology in mutual funds. Our approach to stock portfolios remains cautious, as the “Super 7” stocks do not meet our criteria for relative value.
Investors need not worry about missing out on sudden price surges in a few AI stocks. Artificial intelligence will gradually revolutionize numerous industries, boosting productivity and profitability across the board. Goldman Sachs predicts that AI could increase U.S. labor productivity growth by 1.5% per year over the next decade, providing a substantial boost to corporate profit margins. We maintain a patient approach to investing.
The Tortoise and Hare
The S&P 500 capitalization-weighted index has dominated the market this year, outperforming the equal-weighted index. This divergence raises an important question about which yardstick is the best measure of performance. At Fortis, we believe in taking a long-term approach to investing and adopting a risk-conscious strategy. Looking at the past 20 years, the equal-weighted index has typically outperformed the market-cap-weighted index by about 1% annually. However, this year we are seeing a reversal as larger companies take the lead, which introduces more risk. While this can be beneficial during good times, it can also be destructive if things go south and your portfolio is too concentrated in larger companies.
Beware of Speculation: Lessons from the Tech Bubble
The illustration below shows the performance of the “Super 7” stocks alongside their respective valuation scores, which are rated on a scale of 1 to 100. When concentrated stocks with low relative value scores drive the market, we have observed increased downside risk, reminiscent of the fable, “The Tortoise and the Hare.” As we enter the second half of 2023, we recommend prioritizing the quality factor by focusing on stocks with low debt and stable earnings growth. These stocks tend to perform well during economic slowdowns and currently offer an opportunity due to their relatively low price compared to the rest of the market. Slow and steady wins the race!
For example, the real risk in Nvidia’s stock lies not in the company’s financial performance, but in the high expectations embedded in its stock price. Currently valued at over $1 trillion, which is 27 times the average analyst estimates for fiscal 2024 revenue., this sky-high valuation hinges on the belief that the AI boom that will continue for years to come and that no significant competition will challenge Nvidia’s dominance.
Asset Allocation: Gradually Increasing Equity Exposure
This year, we have strategically boosted our equity exposure in our asset allocation strategies. The first half of the year saw positive returns in all major fixed income sectors, thanks to declining long-term yields. Bond prices surged during periods of uncertainty, particularly in March and April when concerns about the stability of the banking industry were rampant. It’s a relief to witness the return of the normal inverse correlation between stocks and bonds after last year’s simultaneous downturn. While commodities haven’t performed as well, we anticipate a reversal of this trend in the near future. Unlike the Tortoise or the Hare, our asset allocation tactics strike a balance for optimal results.
Exploring the Current State of the Economy
The economy has been through a rollercoaster of ups and downs over the past three years defying conventional economic patterns. This fast-paced cycle calls for an active investment approach, and we are confident in the current state of the economy based on various indicators such as inflation, wage growth, and consumer behavior.
Looking ahead, we must acknowledge the risks, including the possibility of a recession. However, amid all of the noise, there is positive data. Headline inflation has peaked in most regions, mostly due to decreasing energy prices. On the other hand, core inflation, which excludes food and energy, has been more resilient. Nonetheless, it is starting to trend downward in the United States. Economic growth is still ongoing, supported by factors like earnings growth and potentially lower inflation and interest rates. While growth may be slower, this could result in lower rates that would benefit the markets.
Consumers are showing commendable financial responsibility. Many have avoided accumulating high-interest credit card debt and have taken advantage of mortgage refinancing opportunities. As a result, the average American household’s financial obligations in relation to disposable personal income are currently at an unprecedented low.
Overall, we have seen a lot of extremes in the markets this year. Despite the challenges, investors should remain calm and focus on taking a long-term approach to investing. By emphasizing quality stocks with strong relative value scores, smart momentum factors, and appropriate asset allocation strategies, we believe investors will be well positioned, even against a backdrop of increased market volatility.
Past performance is no guarantee of future results. An investor cannot invest directly in an index.
