TIAA recently sent two written communications worth a mention here.
- TIAA recently sold TIAA Bank, which is/ was, the custodian of IRA accounts in custody at TIAA. Soon TIAA IRA accounts will be transferred to TIAA Trust. We see no need for concern about this change.
- Effective September, TIAA is limiting to $150,000 the amount of TIAA Real Estate that a single investor can own. That limit was actually put in place around 2012, but TIAA left open a loophole that firms like PIM have used to implement much bigger allocations. The recent announcement closes the loophole. This situation puts PIM in a tough spot. Our fiduciary duty is to our clients, certainly not to TIAA. By closing the loophole and assigning an arbitrary deadline, TIAA is forcing PIM to make allocation decisions in an unnatural manner. For now, just know that this is under careful consideration and that we will communicate our thinking in greater detail in the coming weeks.
The purpose of our writing is to educate and inform. Most often the approach is proactive. We have an idea or concept in mind that we believe you might find interesting. This narrative is a bit more reactive, seeking to address a question which may have crossed your mind recently. “The markets seem to be doing okay, but my performance is a bit modest. Why?” Completely legitimate question. The short answer is that the conservative positioning we adopted last year, which was effective in minimizing losses relative to market indexes, was maintained for most of the first half of the current year. We discussed this in prior written communications. We specified why remaining conservative was prudent and acknowledged that the cost of maintaining a conservative investment outlook would be a lower level of participation if markets advanced. Markets have advanced, and they have not, depending on how you understand what’s going on this year.
Rationale for Conservative Allocations
We present a detailed explanation of the following data points later in this document.
- US GDP: slowed from 2.6% to 2.0% (revised from 1.3% on 6/29).
- Housing Affordability: as low today as just prior to the 2008-9 financial crisis.
- ISM New Order Index: as low as March of 2020 (COVID).
- Profits: 2% decline in Q1 (much better than the street expected, but negative nonetheless).
- Jobless Claims: moved 20% above the annual low in December 2022.
- Yield Curve: as inverted now as it was in 1980; the 3-month versus 10-year treasury has been this far inverted 8 times since 1962, each and every time preceding a recession.
First, let us dispense with the fixed income portion of client portfolios. All fixed income investments in Schwab accounts are beating their benchmark year-to-date. Fixed income investments at TIAA and Fidelity are also performing well. Little need to further discuss the performance of this portion of portfolios, other than to say we are overweight bonds and cash, and a great many PIM clients have moderate to conservative allocations in normal economic conditions. Because the total return of fixed income portfolios is typically comprised mostly of interest payments made throughout the year, performance is gradual and not complete until year end.
Market leadership is a phrase that refers to which sectors/ segments of the equity market are doing well. The breadth of market leadership matters. Are most companies doing well, growing earnings, experiencing stock price appreciation? Generally, the greater the breadth of market leadership, the healthier the market. This year, market leadership has been extraordinarily narrow, though improving in recent weeks.
Equal Weighting versus Market Capitalization Weighting
Following naturally from the comments above about market leadership, an equal-weighted index allocates capital equally to each stock within the index. A cap-weighted index devotes capital to each stock based upon the size of the company relative to the index.
The S&P 500 is the default proxy for “the (large cap) stock market” in the U.S. and is a cap-weighted index. As of June 30th, the largest seven companies in the S&P 500 accounted for 27.57% of the index. The Magnificent Seven are, by index weighting: Apple 7.69%, Microsoft 6.79%, Google/ Alphabet combined share classes 3.61%, Amazon 2.8%, Nvidia 1.9%, Tesla 1.89% and Facebook/ Meta 1.7%. This level of concentration has been witnessed twice in the past 25 years, in the lead up to the tech bubble of 2000 and in the early days of the COVID recovery.
The ticker symbol of the most commonly traded S&P 500 exchange-traded fund is SPY. The ticker symbol RSP is the Invesco S&P 500 Equal Weight Index. As of June 30th, SPY was up 16.79% for the year. RSP was up 6.93% for the year. If you remove the performance of Apple, Microsoft, Amazon, Nvidia, Google, Tesla and Facebook, the S&P 500 is up 3.7% for the year, with all of the positive performance of these 493 companies coming in the last week of the quarter.
Growth Versus Value
The S&P 500 is comprised of both growth and value stocks. The Russell 1000 Growth and Russell 1000 Value are the relevant indices. Vanguard ticker symbols VONG (R1000 Growth) and VONV (R1000 Value) track these benchmarks.
Value stocks tend to be more defensive, as was in evidence last year. In 2022, VONG was down 29.18%. VONV was down 7.66%. This year, returns have flipped. As of June 30th, VONG is up 28.31% and VONV is up 3.92%. While we have moved away from the dedicated large cap value exposure we employed last year, we did maintain value positions throughout most of the first half of the year.
Active Versus Passive Investing
The “Active vs. Passive Debate” has been raging within the investment management industry for ages. By active management, we do not mean self-directed versus hiring an investment professional. Active means actively managed mutual funds (or Separate Accounts, or Hedge Funds, etc). Passive means unmanaged/ passively managed index funds/ ETFs. The passive school of thought contends that active management cannot outperform indexing consistently. The active school of thought contends the opposite and includes risk management as a key component. Strict proponents of either approach are often quite dogmatic and defend their positions with religious zeal. We understand the virtues of both and use both active (mutual funds) and passive (Index) investments in client portfolios.
With respect to domestic large cap equity investments, the passive indexers are winning this year. When 96% of the total return of the S&P 500 is concentrated in the largest 7 companies, and the remaining 493 have aggregate performance of 3.7%, how might anyone beat this index? Well, you either own these companies only, or a fund or index that is over-weight these stocks, or you own the index itself and realize index returns. In other words, it is impossible for a diversified portfolio to outperform under these conditions. Not only is it a challenge mathematically, but it is also a challenge legally. The SEC’s diversification rule does not permit a mutual fund to concentrate client assets into so few stocks. Thankfully, such concentration of performance is exceedingly rare.
U.S. Small Cap Stocks
The domestic stock market is more than just the S&P 500. U.S. small cap stocks are always part of a diversified portfolio. Indeed, since 2010, U.S. small cap has been the leading asset class four times. U.S. large cap was the leading asset class three times. Bonds, emerging markets equities, real estate, and cash round out the list of leading asset classes over the 13-year period from 2010-2022.
This year, through June 30th, U.S. small cap stocks (Ticker: IWM), were up 7.40%. However, all of that return came in the first week of June. The index was essentially flat for the first five months of the year.
In the past we have owned positions in the emerging markets and non-U.S. small cap sectors. We vacated these positions last year. We felt there was too much uncertainty in these asset classes. Somehow, both are up between 5-6% year-to-date. Non-U.S. large cap is up 10% for the year. The international mutual fund we owned in Schwab accounts throughout all of 2022 finished the year in the 1st percentile of performance within its Morningstar category. In other words, just about nothing we could have owned did better. This year, the fund was up 7.71%, but trailing its index, through the first six months before recently being replaced.
Ending where we started, the purpose of this narrative is to educate, specifically to provide context about the unique nature of capital markets in the first half of 2023 and relate these dynamics to your portfolios. The bottom line is that things are generally fine. We might have delivered higher investment returns if we had returned to normal allocations and concentrated equity investments in narrowly focused tech/ growth stocks, or simply owned the index and nothing else in the large cap space. The data presented next in long, detailed form, did not support such an approach.
Deep Dive into the Data
Our January commentary explored three possibilities for the economy and markets this year. We labeled these the good, the neutral and the bad. Quoting ourselves directly from the neutral scenario: “Careful examination of the Leading Economic Indicators gauge appears to reveal a slowing economy, yes, but one that is simply normalizing after COVID, rather than moving towards a recession. This is exactly what the economy needs to bring down inflation and represents the “soft landing” scenario. However, it’s a fine line between slow-down and recession.”
We did not believe that the neutral scenario was most likely. Yet this turned out to be the most accurate descriptor of the first six months of the year. During this period, U.S. economic growth (GDP) slowed from 2.6 to 2.0 and inflation (CPI) has fallen from 6.5 to 4.1 on a year over year basis. Yet, the S&P 500 has advanced by 16.79% and fear of any further economic slowdown seems to have dissipated. We believe that the economy is closer to the fine line between recession and soft landing than current market prices suggest.
The HOPE Cycle (Housing, Orders, Profits and Employment) is a classic framework for gauging economic health. Every business cycle is different, but the framework is a useful way to organize data in a consistent time-tested fashion.
Housing and its related industries drive 15-20% of economic activity in the US. The housing sector is very sensitive to interest rates and consumer sentiment. Due to these factors, it’s a classic leading indicator. Housing affordability (a measure of incomes, mortgage rates and home prices) is as poor today as just prior to the 2008-9 financial crisis. However, home prices nationally remain stable overall, due to a limited supply of existing homes for sale. New home construction levels are improving, suggesting confidence in the sector that accounts for 20% of overall home sales. Home builders have lowered prices modestly and are offering teaser rates on loans issued through their mortgage subsidiaries to address affordability issues. Yet it is volume that drives economic activity and volumes of existing homes sales (4.3 million) are not too far above their housing crisis lows of 3.8 million units sold annually. It's hard to see this market becoming a tailwind for the economy without mortgage rates falling from the current ~7% to around 4%.
New orders are a key driver of business expectations. If business owners have a strong order book, they are more likely to seek additional employees, increase wages and overtime and buy additional supplies. We use the ISM New Order Index due to its long history. The current ISM reading is 42.6, which ties the COVID low from March of 2020. Going back to 1948, a reading this low has resulted in a recession each time, without exception.
First quarter corporate earnings were significantly better than expected. The street was looking for a 7% decline year over year; corporations delivered a 2% decline. Negative earnings are never a good thing, but finance is a relative game. The street was expecting a very poor quarter and received just a poor quarter. We’ll get a better window into profit in a few weeks as firms report second quarter results.
One of the insights from earnings calls was that companies reported a surprising level of pricing power, which supports profit levels. Many firms noted that they have been able to increase prices faster than their own production costs. It’s as if consumers are accustomed to inflation and are accepting ever higher prices. The result is firms making more money even as they sell fewer products. This is unusual and the reverse of the multi-decade trend. While high profit margins may be a reality for some firms now, it’s notable that areas focusing on the bottom end of the income ladder reported weak numbers.
Dollar General, a firm that should do well in a weakening economy, missed earnings and fell 15%. Unable to push higher prices, the fall in sales volume caused overall profits to decline. We have a running list of retailers who have missed profits or lowered guidance: Walmart, Best Buy, Advance Auto Parts, Foot Locker, Home Depot, Lowe's, Tractor Supply, Dollar Tree, Dollar General, Target and Ross Stores. Recall that 70% of economic activity is driven by the consumer. The conclusion here is that consumers at the middle and lower end of the income ladder are cutting back spending on discretionary items. It’s unclear if this spending caution from these consumers will extend to other income groups. The outcome will likely depend on the next factor.
The best leading indicator for the employment market is initial jobless claims, a measure of the number of people filing for unemployment insurance for the first time. Data is released on a weekly basis. In December of 2022, jobless claims increased to 20% above the annual low. Historically, this level of change in jobless claims has triggered a rise in unemployment of roughly 1.5% within six months (data going back to 1969). This time, the unemployment rate, six months out, has increased by all of 0.3%.
Another leading employment indicator is the average weekly hours for all employees. This statistic has been in a steady decline for nearly two years and is now at a level rarely seen outside of recessions. This counterintuitive dynamic, where hours worked is falling while employment remains strong has been labeled “Labor Hoarding”, by the financial press. Employers, fresh off paying signing bonuses to rebuild staffing levels after COVID, are keeping employees on the books despite not having enough work to keep these employees busy full-time. Resolving this imbalance will require either a faster growing economy or layoffs. The current situation is untenable.
The main difference between today’s economy and what 70 years of market data suggests we should be experiencing is the massive amount of pandemic stimulus that was pumped into the economy. Consumers have “excess savings”, a rough figure that is found by subtracting income (including government transfers) from aggregate spending. This excess savings, in theory, allows consumers to spend above their means in the short run, which obviously supports corporate profit margins.
This party won’t last forever though. No one knows the exact timeframe, but it is thought that excess savings has been spent by the bottom income quintile of households and will be spent by the middle and top by the end of the year. The resumption of student loan payments, which have been suspended for three years, will certainly speed the process.
The Yield Curve
We’ve written a great deal about the yield curve of U.S. Treasury securities. To refresh, the yield curve is a representation of the cost of loans for the benchmark borrower (US Government) over various time frames ranging from one month to 30 years. Long-term loans should have a higher interest rate than short-term loans to account for the impact of inflation and investment risk. The yield curve inverts when longer term U.S. Treasuries yield less than short term. If longer term loans don’t command higher income for the lender, there’s little or no incentive for financial firms to make such loans. Without the availability of credit, the pace of the economy will slow or even contract.
A specific measure of the curve that has received a great deal of attention recently is the 3-month Treasury relative to the 10-year Treasury. A lot can go wrong in ten years, so a 10-year Treasury should yield more than a 3-month Treasury to account for these risks. When it doesn’t, something is wrong with the economy.
Since 1962, the 3-month to 10-year Treasury curve has inverted eight times; this is the ninth. Each of the first eight times, a recession followed, with no false positives. This statistic is undefeated as a recession forecaster. The last time the yield curve was this inverted was 1980.
The indicators just discussed have historically been reliable predictors of recession. This time, so far, not yet. Employment remains stronger than history says it should be, profits are falling but remain higher than expected, the housing market is weak, but new homes are selling surprisingly well. The U.S. economy is bending but hasn’t broken.
There are three ways to measure investment returns: 1) absolute return, 2) relative return, 3) risk-adjusted return. During 2022, absolute return on PIM portfolios was less than zero across the board, but relative return was strong, by degrees, depending on individual risk profile. This year, absolute returns are positive, again with magnitude dependent upon risk profile, but relative return on the equity side is lagging. This is for two reasons. We maintained value positions for much of the first half of the year, which underperformed relative to growth, and market leadership is so narrow that a fully diversified portfolio almost can’t outperform the cap-weighted benchmark. The fixed income portion of portfolios is, so far, performing in line with expectations.
The data suggests that continued caution is warranted, yet the market seems oblivious. Data released during the last week of the second quarter suggests that the economy is growing faster than initial estimates and that the Fed has more work to do in bringing inflation down to acceptable levels.
Estimates for earnings on the S&P 500 have been negative since last summer, falling 7% on a forward basis. At the same time, high quality bonds are yielding their highest rates in 15 years. Institutional investors remain skeptical of expanding growth rates in the face of the highest interest rate environment in over 20 years. Pension funds and large endowments remain underweight equities.
Moving forward, we will monitor developments diligently and will make adjustments as we deem appropriate.
Summer, in western Washington, starts on July 5th, they say. Which means we have arrived at the time of year we all strive for throughout winter and spring. From all of us at Personal Investment Management, best wishes for a glorious summer filled with friends, family, and outdoor adventures.
If you have questions about this communication or anything else, please contact your PIM financial advisor at your convenience.