Investment Outlook Summer 2023

By Argent Wealth Management, LLC on July 19, 2023

Bull Market Until Proven Otherwise

Second Quarter Review, Third Quarter Outlook:

Stock market signals are more positive than negative, and the economy remains resilient. Since October 2022, the S&P 500 is up over 20%, and investors have become more optimistic than pessimistic. Therefore, although the weight of the evidence suggests positive equity returns are more likely than negative over the next six months, investors should expect more muted returns (meaning less gain over the next six months than over the last 8 months) if sentiment remains more optimistic than pessimistic. The main longer-term risk to the stock market is that the Fed has, or will, tighten too much, and a recession could be looming later this year or in 2024. This is discussed below.

Trend Charts

Stock markets are forward indicators for the economy. Markets tend to do well (or poorly) before the economic environment improves (or worsens). Therefore, when stock market indices climb above their 200 day and 50 day moving averages it is a positive sign. When those moving averages are upward sloping it is even more positive. When multiple indices, and therefore stocks, are above their 200 day and 50 day moving averages (positive market breadth), it is historically a bull market signal.

Above, the S&P 500 shows a clear pattern of higher highs and higher lows since October 2022. If the bull market continues, which the weight of the evidence suggests, it is likely the S&P 500 will reach new highs.

The MSCI ACWI (All Cap World Index) shows a similar pattern as the S&P 500, and remains well below its all-time high.

The Russell 2000 Index of small cap stocks has struggled more this year than large cap stocks. Prior to SVB’s (Silicon Valley Bank) collapse, small cap stocks were outperforming large cap stocks. SVB, and other regional banks, mostly reside in mid and small cap indices. Moreover, many investors worried that lending to small and medium sized businesses would dry up due to regional bank woes. The worst appears to be in the rear-view mirror for regional banks, and fears have dissipated somewhat. The Russell 2000 has climbed above its 200 day and 50 day moving average, yet this index is ~30% away from its all-time high. This means small caps could have more upside than larger capitalization indices that are closer to all-time highs.

In addition, small cap and non-U.S. stocks look inexpensive compared to the S&P 500. Investors should consider allocations to these asset classes, within their risk tolerance framework, if they don’t have exposure already.

Fear and Greed

Ned Davis Research’s (NDR’s) Crowd Sentiment Poll is a composite of multiple sentiment indicators. Near the recent stock market low in October 2022, this sentiment indicator hit its lowest point since 2009. Investors were highly pessimistic. The adage of “it is best to buy when others are fearful” held true again. Since this indicator hit 37.6, equity markets have climbed upward. So too has this indicator, and recently it climbed into its “Extreme Optimism” zone. However, it is far from the readings investors typically see at bull market peaks.

Economic Indicators

The stock market tends to be a forward indicator but doesn’t always get the story right. Economic data remains uncertain. Inflation is on a downward trajectory, but the pace of that trajectory is unknown.

If inflation remains on a downward trajectory, which investors expect, the Fed can stop raising the FFR (Federal Funds Rate) and may even lower it. Currently, investors expect the Fed to potentially increase the FFR. one more time to 5.25%- 5.5%, then pause, and lower it in 2024.

Up revisions of the FFR would occur on economic strength. In this case, inflation would remain higher than expected. A strong consumer leads to increased demand, which increases prices. Inflation and the economy are linked. Down revisions of the FFR would occur on economic weakness. In this case, inflation would likely come down faster than expected. In either case, the Fed has room to raise or lower the FFR based on economic data. This is not an unhealthy place for the Fed and economy to be. In fact, many believe it is much healthier than zero or near zero interest rates that existed for most of the last 14 years. For example, low long-term mortgage rates, aided by the Fed holding the FFR near zero, helped drive up housing prices dramatically making homes unaffordable for many.

With most investors focused on the Fed, many have lost sight of the fact that the federal government is also a source of stimulus. The change in stimulus year-to-year can have a direct impact on consumers, the economy, and stock markets.

According to NDR’s Real Monetary, Fiscal, and Exchange Rate Policy Index, since January 1974, when overall policy eases it is bullish for stocks. This index is above 8.8. Cost of Living Adjustments (COLA) for social security is part of the reason this index is trending upward. Historically, readings above 8.8 correlate with the Dow Jones Industrial Average rising 16.4% per annum.

Despite all the above evidence, the yield curve is sending a bearish message. An inverted yield curve historically portends a recession most of the time and should not be ignored. However, the yield curve is also a reflection of inflation expectations. Investors expect inflation to be high in the short-term (thus investors demand higher yields on shorter maturities) and come down longer-term. It is unclear how much the yield curve is inverted due to inflation expectations versus recession expectations.

Despite the warning from the yield curve, the employment situation remains robust. There are currently about 1.8x the number of job openings per unemployed.

And consumer balance sheets remain strong relative to history. According to Investopedia, consumer spending consistently accounts for about 70% of the U.S. economy. Despite higher interest rates, consumers are in relatively good shape when it comes to financial obligations, debt service, and mortgage service. Therefore, consumers can withstand higher interest rates and continue to consume.

Conclusion

The economy and consumers remain resilient in the face of higher interest rates. The change in stimulus in 2023 from 2022 is positive. The Fed has room to maneuver upward or downward depending on the trajectory of inflation and the economy, which are linked. Stock market signals indicate we are in a bull market. However, near term sentiment is optimistic so investors should expect more muted, but positive returns over the next six months. If sentiment were to get more pessimistic again, along with a pull-back in stocks, it would likely be a time to look for opportunities. Having said that, the Fed did raise rates to 5% in the fastest tightening cycle in history and that could have unforeseen effects on the economy in the next six months. Investors should remain vigilant. At Argent, we will continue to follow the data and make changes to client portfolios within their risk tolerance framework as appropriate.

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