Market Navigator – April 2023 edition

Monthly letter

Resilient or complacent?

That is the market question. Our answer is yes, to both.

The market has been resilient -if an investor had been given the news concerning the banking crisis ahead of time, the debate would have likely been less about whether stocks would be up or down in the aftermath, but instead how far down.

Instead, the popular averages powered forward, with the S&P 500 up 3.7% and the tech-heavy NASDAQ gaining almost 7% in March, to close out a strong first quarter.

What’s behind this resilience?

• The bullish view is the banking challenges have a silver lining in that it likely pulls the end of the Federal Reserve’s (Fed) tightening cycle forward and helps to further ease inflation.
• Investor sentiment and positioning was also relatively defensive heading into the month. This means investors were braced for bad news, and, therefore, less selling was needed when the bad news arrived.
• ·Mega cap growth stocks, which have the greatest influence on the market, popped. The five largest stocks in the S&P 500 (Apple, Microsoft, Alphabet, Amazon, and NVIDIA) gained an average of just over 14% in March versus an average decline of 0.7% for the rest of the 495 stocks in the index.

That said, mega cap growth stocks have grown increasingly expensive—the tech sector is trading near the highest premium to the S&P 500 of the past 20 years, and we are seeing fraying below the surface.

Mid-, small-, and micro-cap stocks were down between roughly 3% and 9% in March and only 36% of stocks within the S&P 500 are outperforming the broader index over the past three months.

Importantly, as much as there is excitement about the market’s rebound this year, if one zooms out, the S&P 500 finished March close to where it was at the beginning of December and within the confines of its five-month trading range of roughly 3800 to 4200.

Indeed, markets have been vacillating between bouts of pessimism and optimism as the debate continues between a hard and soft economic landing, sticky versus easing inflation, and tightening versus easing Fed policy.

We see complacency setting in

While keeping an open mind, the weight of the evidence in our work suggests a less favorable risk/reward.

On the positive side of the ledger, strong technical price trends and depressed sentiment remain market assets, and the Fed should be less of a headwind moving forward.

The so-called pain trade, which would be most likely to catch the most investors flat-footed, is for the markets to break to the upside of the trading range. This would likely lead to technical buying as fear of missing out on the rally kicks in.

Yet, the macro and fundamental picture is less supportive. Our view is the market is pricing in a lot of good news, with little room for error.  

• Our House View—even before the banking challenges—was that recession risks remained elevated in the back half of this year as the fastest Fed tightening cycle of a generation, which only started last March, continues to filter through the system.
• Bank lending trends, which had already become tighter, are likely to become even more restrictive following recent financial events.
• Despite these elevated macro risks, the S&P 500’s valuation has rebounded to 18.1x.
• Even if we apply a forward P/E of 18.5x, the highest valuation level of the past decade outside of the pandemic to (arguably optimistic) consensus forward earnings, that would bring the S&P 500 to 4215, or less than 3% above the March closing level.
• For stocks to sustain a much higher level from here, beyond a temporary technical overshoot, one of two optimistic assumptions need to be made overshoot, one of two optimistic assumptions need to be made: 

1.) Investors award a premium stock valuation level that has only occurred twice over the past 30 years, during the tech bubble and the pandemic overshoot.

2.) Earnings in the back half of the year are stronger than even what currently appear to be optimistic consensus estimates.

While both outcomes are possible, we see elevated market risks.

Notably, there is a growing disconnect between consensus earnings projections, which see S&P 500 profits rebounding to a record in the second half, versus a consensus of economists looking for a material economic slowdown.

Although the potential of a Fed pivot is also supporting stocks, we don’t view this as a panacea. One only needs to look back to 2001 or 2008 to see that a shift in Fed policy alone is not always enough to stop an economy on a downward trajectory or start a new bull market.

Bottom line and positioning

Stocks have been relatively resilient in the face of many obstacles, and technical and sentiment remain supportive of the market. However, our view is the market is now baking in a lot of good news and leaving little margin for error.

Therefore, we stay defensive. We maintain an overweight to fixed income relative to equities, with a focus on high quality bonds. We also keep a slight overweight to cash. Within equities, we maintain our long-standing U.S. and large cap bias, which tends to outperform global.

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