Treading water in turbulent seas.
Not much has changed since our last update three months ago, which is a positive, given that there is no shortage of concerns influencing the markets. Inflation, although high, is gradually coming down, measured on a year-over-year basis. The Fed has signaled that short-term interest rates might have reached their peak but are likely to remain elevated for an extended period. These factors present challenges for consumers, the economy, and, consequently, the stock market. Nevertheless, the U.S. economy and corporate profits have shown impressive resilience, leaving stocks largely unchanged this quarter.
The S&P 500 Index experienced a modest decline of 3% this quarter, including dividends. However, the year-to-date return of 13% is quite strong in the context of historical returns. Global stocks, as represented by MSCI’s All Country Worldwide ex-U.S. Index, also saw a 3.7% decline this quarter but have managed a year-to-date return of nearly 6%.
As we noted in our previous update, certain unique factors have been affecting stock performance this year. While the S&P 500 has had a strong showing year-to-date, the full picture is more complex. Surprisingly, 47% of the index’s constituent stocks have declined this year, and only a small fraction—29%—have outperformed the market. There are two primary reasons that account for these discrepancies.
Firstly, the S&P 500 is market-capitalization-weighted, which means larger companies exert a more significant influence on the index’s overall performance. In contrast, indices like the Dow Jones are price-weighted. Secondly, the largest companies in the S&P 500 have been the top performers this year, skewing the aggregate numbers. For example, the top ten companies in the S&P 500 have seen an average return of 69% year-to-date, far outpacing the broader market, but delivered a 1% return in the third quarter. On an equal-weighted basis, the S&P 500 Index is up only 4% year-to-date, and the median stock return, including dividends, is only up 2%!
With stock prices largely unchanged versus one quarter ago, we remind readers of the main reasons U.S. stocks have remained robust in 2023. One is the surprising resilience of the macroeconomy despite rising interest rates. Contrary to widespread expectations for this year, we have not entered a recession, and corporate earnings have remained robust. This favorable turn of events has contributed to improved market sentiment. Secondly, valuations have also played a role. At the start of the year, market multiples were subdued due to anticipated economic weakening and rising interest rates. However, as sentiment improved and interest rates appeared to be nearing their peak, valuations expanded. Lastly, the exceptional performance of a few large-cap stocks has disproportionately driven the index higher. NVIDIA, Meta Platforms (formerly Facebook), and Apple have posted year-to-date returns of 198%, 150%, and 32%, respectively, contributing significantly to the S&P 500’s strong performance.
Our outlook largely aligns with our stance three months ago, albeit with added caution. Forward earnings estimates for 2024 and 2025 are encouraging, and the S&P 500 price-to-earnings (P/E) ratio based on 2024 expected EPS is 18x, which, while slightly elevated compared to historical standards, is not alarming.
However, it’s prudent to consider the downside. If earnings in 2024 decline by 15-20%, the implied S&P 500’s forward valuation would be 24x, which would surely result in a sharp decline in stock prices. Though not our base case, this scenario remains within the realm of possibility, given the aforementioned risks.
In summary, the market’s journey through 2023 has been akin to climbing a steep, precarious hill. While many obstacles lie ahead, there are also reasons for optimism. Diligent asset allocation and staying invested appear to be the wisest courses of action in this environment. At Howland Capital, our focus remains on two key areas: effective cash flow planning and disciplined asset allocation. Despite the uncertain landscape, our long-term view remains positive.