Markets declined in September for the second month in a row. The S&P dropped 4.7%, the DOW declined 3.42% and the NASDAQ slumped 5.77%. Bonds lost 2.54% as rates surged. All sectors declined for the month except for energy, gaining 2.5%. Growth was down more than value, and small caps down more than large caps.
September results:
TWG conservative (60/40) declined 2.8% vs its benchmark declining 3.6%
TWG Moderate (75/25) declined 3.3% vs its benchmark declining 3.9%
TWG Growth (90/10) declined 4% vs its benchmark declining 4.23%
3Q2023 Summary
For the quarter, even with a positive July, markets ended lower. The S&P 500 declined 3.27%, the DOW -2.1% and the NASDAQ -3.9%. The rest of the developed world slipped 4%, while bonds declined 3.23%. Small growth was the worst corner of the style box, dropping over 7%.
QQQ’s outperformed, declining 2.88% and S&P equal weight (RSP) dropped 4.9%, bringing its YTD gains to 1.69%. RPS is more indicative of the overall health of the stock market, as each 500 components are given the same weighting. That RSP is only up less than 2% YTD and QQQ is up 35% underscores the fact that only a handful of the largest companies are driving cap weighted index returns.
Only the energy and communications sector gained, up 12% and 3% respectively. At the other end of the spectrum, utilities and real estate were the worst performing sectors, declining 9.25% and 8.9% respectively.
For the quarter, TWG model portfolios declined, but less than their respective benchmark:
TWG Conservative -2.15% vs its benchmark -3.15% (68% drawdown capture)
TWG Moderate -2.5% vs its benchmark -3.2% (78% drawdown capture)
TWG Growth -2.95% vs its benchmark -3.28% (90% drawdown capture)
Relative outperformance was mainly due to 10-15% of the fixed income sleeve being allocated to FLOT, a floating rate bond fund, which was flat on the quarter, and various levels of exposure in COWZ, which was up 3% for the quarter, and SPGP, which was up 1%. Both COWZ and SPGP have at least 25% exposure to energy which we increased during the quarter. Exposure was avoided in the hardest hit areas of the market, namely small and mid-caps, utilities, and real estate.
Throughout the course of the quarter, allocation adjustments resulted in a 15% reduction of large growth (QQQ), a 12% reduction in S&P 500, and a corresponding increase of large value, mainly via COWZ, GCOW and VTV.
WHAT DROVE THE MARKETS:
Surging rates had a significant impact on market performance with the 10- and 30-year treasury bond reaching their highest yields since 2006. Rising rates resulted in increased borrowing costs to consumers and businesses, which, all things equal, imply lower earnings. With valuations at elevated levels, higher rates discount future cash flows even more, causing market participants to re-price risk assets.
There were other market moving events during September, all of which had some impact on rates and their effects on stocks:
On September 13, Headline CPI data for August increased .3%, bringing the year over year comparison to 3.7%, the highest since May. However, looking through the data most of the increase came from higher energy costs, with gasoline soaring over 10% on the month. Core CPI, which excludes energy and food, actually declined to 4.3%, the lowest since September 2021. Since the Fed’s preferred metric is Core CPI, the market continued to bet that the Fed would not be overly concerned with the headline number.
On September 14th, retail sales showed continued strength. This plus core CPI continuing to decline supports the soft-landing narrative. With the consumer hanging in and maintaining their spending, and inflation continuing to decline, perhaps a recession can be averted.
On September 20th the Federal Reserve held its policy meeting and kept rates steady, opting to continue to pause and await incoming data to determine the future course of rate policy. Powell’s presser reiterated that they may have one more hike left this cycle, and, more importantly, strongly suggested that rates will likely stay elevated through 2024. The market had been pricing in some degree of easing in 2024, so Powell’s comments rattled the market, which sold off 1% following the press conference, and another 1% slide the following day.
Prior to the third quarter, markets were hopeful that inflation and spending would slow enough for the Fed to be able to cut rates by the end of this year. However, as the third quarter progressed, we saw continued economic resilience, namely unemployment remaining below 4%, no material layoffs, and continued strong consumer spending, yet with rising costs in food and energy. All of these factors are likely causing the Fed to feel that rates aren’t working enough to slow the economy, increasing the odds that, as Powell clearly stated, rates will stay higher for longer.
So, what exactly is causing rates to surge to the upside even as the Fed pauses increasing the Fed funds rate? Well, there are several schools of thought, which we’ll dig into below.
First, it is important to note that Fed policy only directly impacts short term rates. However, short term rates also indirectly affect intermediate and long-term rates, as there is some degree of relativity out of the curve. Changes in short-term rates can most easily be seen in bank deposit, CD’s and lending rates, and, to a lesser extent, mortgage rates. Risk free 5-6% rates on cash and T-bills (finally) also become competition for equities, as well as traditional high yielding sectors such as utilities and real estate. Remember TINA? There is no alternative was the mantra in the 2010’s as rates were virtually zero so investors were forced into risk assets in an effort to grow their assets.
One reason we believe rates are soaring is simply due to Econ 101 supply and demand.
On the supply side, there has been an increase in bond issuance over the year, mainly as capitalization is needed to fund our government spending. The Fed started putting bonds in the market as it started its quantitative tightening (QT) program. This is the exact opposite of the quantitative easing (QE) program the Fed engineered during (and way too long after) the Great Financial Crisis of 2008. By buying bonds (QE), the Fed was effectively able to bring rates down to near zero to spur low cost borrowing and make economic expansion cheap to conduct. This time, they are letting maturing bonds roll off their balance sheet (QT), as well as creating new bonds and flooding the market with supply. It is also likely that other countries have become net sellers of U.S. treasuries. Too many bonds, and too few buyers mathematically lower the value of bonds and increases their rates.
On the demand side, there is simply lower demand for bonds in general, at least partially due to last year’s massive sell off. But if bonds are providing yields higher today than in the past 17 years, why would investors NOT be interested in owning a virtually risk-free asset at 5% vs taking risk on stocks to achieve their historical 9% average return? Well, perhaps yields are not high enough, and duration is too long. Remember you can get 5.5% on money markets, which have no set maturity. Through this lens, you can see that perhaps investors are unwilling to take duration risk when they can achieve the same yield without a lengthy maturity timeline.
The final angle on increasing rates is a function of what investors demand in reward (yield) to hold our government bonds. With our federal deficit increasing by the minute, a U.S. credit downgrade earlier this year, and other fiscal challenges around the world, it is likely that investors are not willing to hold U.S. Treasuries unless they are compensated at a higher rate. As rates reach peak yield, and at some point they will due to investors being adequately rewarded, then demand will come back into the bond market to mop up the current supply. We are probably closer to that than not.
LOOKING AHEAD
Markets are acting a little dysfunctional of late as participants re-price risk assets considering surging bond yields, a slowly weakening economy, a resolute Fed, yet a strong labor market and resilient economy. The pricing action over the past months has led the market to be close to washed out levels. Valuations have come in meaningfully over the past two months, and the market is quite oversold. On the other side, bond yields have surged so significantly over the past few months that there is likely to be a near term pause in bond price declines, which should be constructive for stocks.
As of the day of this writing, the S&P 500 is 84% oversold, a level at which we should expect some type of bounce back to more normal levels. The S&P is still above its trendline from the October 2022 low and is only 6.5% below its recent high on July 31. We are not yet at a correction level, which is defined as a 10% decline from a recent high, yet the S&P is no longer 20% higher from the current cycle low from October. The S&P is meaningfully below its 50-day moving average (green line in graphic below), which is also rolling over. 5% pullbacks are quite common, and healthy. In a typical year, the market goes through 2-3 such pullbacks. This current sell off is no different – so far just a run of the mill cooling off, which could lead to a resumption of an uptrend that started last October.
A critical level to watch is now the 200-day moving average (red line in graphic below). In our opinion, if the market stays above this important long-term directional indicator, forward returns have a high probability of being positive. The 200-day MA is still in an upward slope, which started to bend in March of this year. At the July peak, the S&P was 2 standard deviations above the 200-day MA, which is considered extended and usually a sign of froth.
There is still a lot of macro that needs to be sorted out, but at the end of the day, if the earnings recession is behind us, and earnings start to grow again moving forward, then higher asset prices can be justified. We will be keeping a close eye on the 3Q earnings results which start next week.
Overall, there are still numerous concerns ranging from these higher rates, the Fed’s higher for longer stance, resumption of student loan payments etc.. But seasonality is on our side, and November and December are typically strong months. Now that the market has cooled off and valuations have moderated from their elevated levels in July, the stage is set for the market to have a strong finish to the year.
We wish you well.
