Market Synopsis – November 2023

Market Synopsis – November 2023

Dec 5, 2023 | 0 comments

Divergence in Equity Markets

As 2023 draws to a close and we reflect on the year that was, one thing that stands out is the resilience of equity markets. The S&P 500 has overcome a global banking crisis, the highest US Federal Reserve (“Fed”) funds rate in 22 years and a widely anticipated recession to deliver an impressive 18.97% return year-to-date. Dig a little deeper though, and one quickly realises that this performance has not been widespread.

Much of the S&P 500’s performance can be attributed to just a few shares, namely the so-called “Magnificent Seven” (Alphabet, Amazon, Apple, Meta, Microsoft, NVIDIA, and Tesla). These seven shares have risen to more than 30% of S&P 500’s total market capitalization. For context, over the last century, the late-1990s is the only other time in the post-war era that the US market has been this concentrated – see Figure 1.

Figure 1 – Nearly unprecedented US equity market concentration

While the tech sector’s major weighting in the market is not new, it was even more pronounced in 2023 as market participants reacted with exuberance to NVIDIA’s first quarter earnings results and the potential boost to the tech sector’s earnings that Artificial Intelligence (“AI”) could generate. Despite this phenomenon being idiosyncratic and unrelated to the business cycle, it was powerful enough to lift the overall equity market. Relative to 7-10 year USD-hedged global government bonds, the MSCI All Country World index outperformed by 12% year-to-date. However, the equal-weight index has essentially moved sideways versus government bonds, which highlights just how sizable the impact of the NVIDIA and AI narrative has been – see Figure 2.

Figure 2 – Without the tech sector global shares would not have outperformed bonds

A Lesson from History

While we do firmly believe in the potential productivity benefits that AI could usher in, we do not view the recent AI driven rally of the “Magnificent Seven” to record valuations as wise. The price-to-earnings multiples of these shares have risen to heights comparable to a similar group of shares from the 1960s, known as “Nifty Fifty” – see Figure 3 and 4.

Source: Bloomberg,

Figure 3 – Tech sector’s rich multiples

Figure 4 – The latest investment craze is the Magnificent Seven

The Nifty Fifty was comprised of the shares of companies that were considered the best and fastest growing, so good that many investors thought that nothing bad could ever happen to them. Sentiment surrounding these shares was uniformly positive, and as a result many portfolio managers found safety in numbers. So much so that at the time a common adage was “you cannot be fired for buying IBM” the era’s quintessential growth company.

Except that if you did buy these shares in 1972 and held them until 1974, you would have realised losses of more than 90%. A baffling outcome for unwitting investors who owned pieces of the best companies in America. Perceived quality, as it turns out, does not guarantee a successful investment or safety of capital.

The problems started in 1973 when an OPEC oil embargo created a global recession that then led to the S&P 500 tumbling 47%. Many of the “Nifty Fifty”, for which it had been thought that “no price was too high”, did far worse, falling from peak P/E multiples ranging from 60 to 90 to multiples in the single digits. As a result, investors lost almost all their money in the shares of companies that “everyone knew” were great.

For us, this 50-year-old example serves as a reminder of what can happen when one invests in the most popular businesses while ignoring their extreme valuations. Logically, you are unlikely to find any of these shares in our funds for as long as they trade at these hefty prices.

A Quick Recession Check

Is a recession still likely, and if so, why is it taking so long? The answer to the former lies in the level of the Fed funds rate. Interest rates are considered restrictive once the effective Fed funds rate (3-month T-Bill) has risen above nominal GDP growth, at which point the real Fed funds rate is positive. This is illustrated in Figure 5 below, where rates are currently high and positive in real terms. Therefore, the level of interest rates in the US can be considered restrictive.

Figure 5 – US monetary policy is tight

Historically tight monetary policy typically precedes a recession, and this time is unlikely to be any different. The only way a recession could potentially be avoided is if the Fed returns interest rates to neutral or even easy territory. However, this would require larger rate cuts than investors are currently pricing in and thus is probably unlikely.

From a timing perspective we expect the onset of a recession to only take place in the second half of 2024. Why the second half? Well, labour demand is currently dropping and yet a sharp increase in unemployment has not been observed. This is because there is still an excess of job vacancies, measured by the jobs-workers gap, which still needs to be absorbed. At the rate that the jobs-workers gap is currently shrinking, job openings will likely normalise by mid-2024, at which point unemployment will rise and a recession will take hold.

A False Start to The Bond Market Rally

With bond yields falling from their highs of 4.98% on the 19th of October to 4.24% now, some may feel that the bond rally is already underway. However, if we look back to the 2006-2007 period as depicted in Figure 6, we can see how 10-year treasury yields peaked in line with the last Fed rate hike in 2006. After which yields remained rangebound while the Fed kept the policy rate unchanged. The 10-year yield only began its recessionary decline just before the first Fed rate cut occurred.

Assuming this relationship still holds, the recent pullback in yields is unlikely to be a marker that the bond rally has begun. We believe that will only occur in the coming year, in line with the expected rate cuts in 2024, as the Fed attempts to avoid a recession or because one has already begun. In either case, expect bond prices to rise.

Figure 6 – 2007 may be a roadmap for US 10-year yields

Investment takeaways

The remarkable 18.97% year-to-date return delivered by the S&P 500 belies the true economic situation playing out. One in which tight monetary policy is becoming a drag on the US economy and businesses alike, as broadcast by the performance of equally-weighted equity indices. Furthermore, the misaligned performance of S&P 500 against the macroeconomic backdrop highlights the very real danger that a group of shares can pose when they become too popular. Just like the “Nifty Fifty” has already taught us, investors must avoid getting caught up in investment crazes that disregard valuation fundamentals. Rather, we believe long duration bonds offer compelling risk return characteristics. Especially given that the bond market rally has not truly started, for that, one will need to wait until the Fed begins to cut rates.

Are you interested in finding out more about how value investing can help you avoid investment crazes? Connect with Integrity Asset Management and let us help you navigate your investing journey.

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Source: Bloomberg, 30 November 2023