AI!
With the debt ceiling resolved and excitement over artificial intelligence bordering on irrational exuberance, risk appetites for stocks increased in June. As in recent months, investors continued to favor technology stocks over the rest of the market. The main reasons for this preference are twofold. First, technology stocks may offer better protection against a full-blown recession. Second, the application of artificial intelligence could unleash enormous growth opportunities and productivity enhancements across many industries. These two reasons have driven extraordinary outperformance in technology shares this year. June was no different as the technology heavy Nasdaq surged over 11% while the more cyclical Dow Industrials remained flat during the month.
To further illustrate this unusual dispersion, we track the performance of the seven largest technology stocks [1] in the S&P 500 index versus that of the rest of the stocks in the index. These seven stocks comprise 27% of the S&P 500 index and taken together have risen 58% this year. Meanwhile, the rest of the index members are up just 4% this year. From our perspective, dispersion like this creates opportunities to both ride the AI wave and find overlooked stocks in the rest of the market.
Source: Bloomberg, Lear Investment Management research.
A Study on Stock Market Pullbacks
Our core investment philosophy is predicated on adjusting the amount of risk in portfolios depending on where we are in the market cycle. During periods of heightened volatility, the goal is wealth preservation and during periods of bull markets the goal shifts to wealth creation. New market cycles generally begin when the market has bottomed out after a dramatic pullback. In the last two decades, we have experienced three major meltdowns. The market fell -57% during the Global Financial Crisis, -34% at the onset of the Pandemic and -25% most recently due to record inflation and surging interest rates.
Once a new market cycle begins the stock market typically begins a steady multi-year climb. This march higher, however, will typically experience bouts of volatility. So, we examined the three most recent market cycles (cited above) to see how many times the market pulled back by at least -5% - let’s call these “material” pullbacks. Specifically, we studied the first two years after the market bottomed out during the Global Financial Crisis (“GFC”), the rally post-Pandemic collapse that lasted until 1/3/22 and then the current rally we are in after the market bottomed on 10/11/22. For each cycle, we calculated the average size of the “material” pullbacks and the average rally afterwards until the next “material” pullback. You can see the results in the graph below.
Source: Bloomberg, Lear Investment Management research.
Our first observation is that “material” pullbacks are a common feature in any market rally. In fact, during the post-GFC and post-Pandemic market uptrends there were five pullbacks of more than -5% in each. The average pullback was -8.5% post-GFC and -7.1% post-Pandemic. Importantly, the largest single pullback was -16.0% - bad but not a total disaster. In the current rally, there have been only two material pullbacks (although this rally is much less mature) but those pullbacks have averaged -7.5%. It’s interesting how similar these pullbacks are in terms of size.
We also studied the duration of these pullbacks and ensuing rallies in each cycle. The average length of these “material” pullbacks was around 3-5 weeks but the average length of the subsequent rallies was substantially longer. During the post-GFC and post-Pandemic uptrends, rallies in between material pullbacks lasted over ninety days on average (see graph below). The current rally the S&P 500 is experiencing is 107 days old, so it is a little long in the tooth but not dramatically so. In fact, during the post-Pandemic period the market rallied for 307 days without pulling back -5% or more. Similarly, post-GFC the market experienced a 231-day rally. Interestingly, both winning streaks occurred very late in each cycle, suggesting that the longer a rally endures the more complacent market participants become.
Nevertheless, the message to take away from this is that once a new market cycle takes hold, it pays to buy these “material” pullbacks.
Source: Bloomberg, Lear Investment Management research.
Market Outlook
The context for sharing the analysis on pullbacks is appropriate today because it is possible a material pullback is on the horizon if for no other reason than technology stocks take a breather from their torrid run. The seven technology stocks cited above are driving virtually all of the market’s gains this year and are trading at nearly 30x earnings, which is fairly stretched on a historical basis, so a period of profit taking would not be unusual. We have trimmed some of our winners for that reason. In addition, in just a couple of weeks, another earnings season will be upon us and there could be corrections if earnings expectations are not met. These are potential drivers of a material pullback, which if our analysis holds could present an opportunity to further increase our exposure to equities.
The key risk that a material pullback breaks the current market uptrend in our view is a Fed policy error. The biggest risk to this market is if the Fed raises interest rates too far and strangles the economy. So far, the economy has shown remarkable resilience despite the Fed increasing the overnight rate from 0% to 5.25%. While various parts of the economy have entered recessions already, the Services sector has remained strong. Moreover, inflation is steadily declining. Our favorite inflation indicator from Truflation, now shows inflation running at just 2.46% [4]. Is the economy going to succumb to a further 25-50bps in rate hikes? Probably not but given that there is historically some lagged effect to the economy, we just do not know where the breaking point could be.
Looking to the Fed Funds futures curve, which tells us what the market thinks the Fed will do, it is pricing in a 50% chance that the Fed hikes rates one more time and then will begin cutting rates by March next year. The curve implies that the Fed will continue to cut rates through the rest of 2024. From an economic perspective, cutting rates implies that inflation has returned somewhere near its 2% long-term target and that economic growth will become sluggish and need a little boost. In our opinion, this data does not signal a full-blown recession, but this could change over time.
Source: Bloomberg.
Conclusion
To conclude, we remain patiently optimistic. The economy continues to show resiliency in the face of higher interest rates and inflation continues to fade. This is a constructive backdrop for investing in attractive themes like artificial intelligence and clean energy (to name two of our favorite themes) as well as overlooked stocks where there is significant value. In fact, we are finding so much value in non-technology names that it seems inevitable that they will start to close the performance gap created by technology stocks. It also remains the case that fixed income provides excellent yields that enable us to wait patiently for pullbacks in stocks and greater clarity on the direction of the economy. As these hurdles are met, we will take more risk in portfolios.
Disclosures
LIM is a Registered Investment Advisor based in Dallas, Texas and registered with the Securities and Exchange Commission. Registration does not imply a certain level of skills or training. LIM is a company with purpose, dedicated to creative and unique thinking. We focus on portfolio valuation and research, along with superior client experience. We seek to identify investment opportunities by looking at economic factors, security valuation and human behavior. We start with the fundamentals of portfolio management and valuation. Then we build on these fundamentals with unique thinking and creative intelligence gathering to form a viable investment thesis. We believe this approach leads to dynamic global portfolios with increased return and managed risk. LIM utilizes Charles Schwab & Co. Inc. (“Schwab”), a FINRA-registered broker-dealer, member SIPC, as its custodian of assets. LIM is independently owned and operated and not affiliated with Schwab.
Additional disclosures:
This document may contain forward-looking statements based on LIM’s expectations and projections about the methods by which it expects to invest. Those statements are sometimes indicated by words such as “expects,” “believes,” “will” and similar expressions. In addition, any statements that refer to expectations, projections or characterizations of future events or circumstances, including any underlying assumptions, are forward-looking statements. Such statements are not guaranties of future performance and are subject to certain risks, uncertainties and assumptions that are difficult to predict. Therefore, actual returns could differ materially and adversely from those expressed or implied in any forward-looking statements as a result of various factors.
This material represents an assessment of the market and economic environment at a specific point in time and is not intended to be a forecast of future events or a guarantee of future results.
Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions.
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Definitions
The S&P 500 Index consists of 500 stocks chosen for market size, liquidity, and industry group representation. It is a market-value weighted index (stock price times number of shares outstanding), with each stock’s weight in the Index proportionate to its market value.
The Nasdaq Composite Index is a market cap-weighted index, representing the value of all stocks listed on the Nasdaq Stock Market. The composition of the Nasdaq Composite is a mix of long-established companies that have been on the exchange since inception, to IPO newcomers, companies that grew from OTC exchanges or switched from other exchanges.
The Dow Jones Industrial Average is a price-weighted average of 30 blue-chip stocks that are generally the leaders in their industry. It has been a widely followed indicator of the stock market since October 1, 1928.