Overview- We expected equity markets to pause after they ran higher in Q1. In fact, most of the market did just so: For 2Q Small Cap stocks were -3.1%, Mid-Caps were -3.5%, the Dow Jones Ind Avg was -1.3% and the average stock in the S&P 500 was -2.6%. Remarkably, the Cap Weighted S&P 500 powered higher by another 4.4% in the quarter, with almost all the gains concentrated in the 7 largest tech stocks.

 

Valuation- Our view continues to be that it is difficult to characterize the market as anything but expensive. Given the backdrop of higher rates, inflation and spiraling deficits, it seems that longer-term cap weighted returns, over the next 5 years, will likely not match the robust returns of the last decade. However, the narrowness of the market is now skewing these valuation measures. There are 2 different markets one needs to value now: Large Cap Tech, and everything else. Large Cap tech is as expensive as it has been in several decades:

 

 

 

Overview- We expected equity markets to pause after they ran higher in Q1. In fact, most of the market did just so: For 2Q Small Cap stocks were -3.1%, Mid-Caps were -3.5%, the Dow Jones Ind Avg was -1.3% and the average stock in the S&P 500 was -2.6%. Remarkably, the Cap Weighted S&P 500 powered higher by another 4.4% in the quarter, with almost all the gains concentrated in the 7 largest tech stocks.

 

Valuation- Our view continues to be that it is difficult to characterize the market as anything but expensive. Given the backdrop of higher rates, inflation and spiraling deficits, it seems that longer-term cap weighted returns, over the next 5 years, will likely not match the robust returns of the last decade. However, the narrowness of the market is now skewing these valuation measures. There are 2 different markets one needs to value now: Large Cap Tech, and everything else. Large Cap tech is as expensive as it has been in several decades:

 

 

Further, other than large cap tech, most of the other market components are fairly valued. This leads us to 2 possible conclusions: Scenario 1 is that the economy has achieved a soft landing. Once this becomes more obvious, the rally broadens out and the rest of the market starts to perform much better than it has relative to Large Cap Tech. Perhaps the broader market can even outperform Large Cap Tech in such a scenario. The second possibility is that the historical narrowness of the market is a harbinger of a cyclical peak, and the broader market is topping before Large Cap Tech. In this 2nd scenario it would be only a short time until Large Cap Tech tops as well. We believe a decline in the economy and earnings would necessitate a bearish outcome in Scenario 2. As of now, we cannot say with confidence that this is where we are. So, we favor scenario 1 for now.

 

Large Cap Technology has been the dominant market driver since the market bottomed out in early 2023. 2022 was a year of major outperformance for value while Large Cap Tech severely underperformed. We think at these stretched valuations one should consider the potential for value to start to outperform.  There are three primary factors which tend to drive value outperformance: higher inflation, higher real interest rates, and higher economic growth. The FED may have managed to rein in inflation from the 9% peak, but there are reasons to be concerned that structural factors such as tight labor markets, geopolitical tensions / deglobalization, higher deficits, supply-chain disruptions, the push for green-energy and AI raising commodity prices, which may keep inflation sticky. This would keep real interest rates higher than we have experienced for the last 2 decades. Further, almost every market participant has been surprised that the economy has held up with the higher rates and inverted yield curve we have. If this continues, this also could favor value. It is for these reasons why it seems reasonable to have a balance of growth and value at these valuations for both classes.

 

Economy- We are reiterating our outlook for a “K” economy: a K-shaped recovery occurs when varying parts of the economy recover at different rates. The economic path, when charted together, may diverge and resemble the two arms of the Roman letter “K.” This contrasts an even, uniform recovery across all sectors, industries, or groups of people. In the current instance the bottom half or more of economic participants may be struggling due to A) fiscal stimulus and savings running out:

and B) the cumulative effects of inflation and asset prices making real earnings suffer. However, those at the top that own assets are still thriving. Cracks in the economy are increasing – bankruptcies and delinquencies are climbing, housing is slowing, and the employment situation by some measurements is slowing. However, these are only cracks, and there are other signs of clear strength in income, purchasing managers’ outlooks, etc. Overall, the outlook is still positive, but we are closely monitoring the emerging negatives in this “K” economy.

 

Inflation/Rates- We see some positives emerging in the fixed income market: The last 3 months have shown clear progress on inflation and a case can be made that inflation is slowly moving back down to the Fed’s target of 2%. This may give the Fed cover to cut rates once this year. However, we still aren’t at the 2% goal – most measures are more in the 3% range. Further, a case can be made that longer term rates may be stickier as the deficit is now parked in the 120% area and the government shows little interest or progress in deficit reduction. Looking at the political landscape, in our view, if either current front runner wins the Presidential election, neither one is likely to address cutting the deficit. This may be a problem for longer term rates and the natural rate of interest rates may not go down and may even rise a bit:

Another issue that we are researching is how AI advancements may increase electricity needs. AI data centers have put a high demand on energy. AI is increasing hardware needs and commodities. While the productivity promises of AI are deflationary in the long term, the infrastructure needs may be inflationary in the short term. The cases for both higher and lower rates are compelling, and we are mixed on how this will play out in the near term. Accordingly, we are invested a bit more conservatively in fixed income with a duration bet slightly less than the benchmark. However, we are focused on yield enhanced areas that maximize income, such as the variable rate loans and securitized bonds, which have reduced interest rate exposure.

 

Trend- Most trends are neutral to positive, particularly for Large Cap Tech. Our view continues to be that the market may be a bit jittery in the near term, so we are keeping our beta close to the market with an overweight in defensive areas like call writing ETF’s that have more income production if the market trades sideways. However, we are trying to rotate into more aggressive areas that continue to outperform in the near-term using ETF’s but are keeping a very tight leash on these areas as they could reverse at any time.

 

Sentiment / Seasonality – We can reiterate that sentiment, while getting a little frothy in the short term, isn’t showing the kind of euphoria that is associated with secular highs. However, we are seeing this euphoria in Large Cap Tech…but not in the rest of the market. This bifurcation is worrisome, but we frankly aren’t sure what to make of it (this parallels the Valuation discussion scenarios 1 and 2 above). Seasonality favors the bulls in July, but August and September are coming, and they tend to be weak. Generally, election years tend to end positively. We see a mixed bag in the short term but embrace the possibility for a decent finish to the year with bouts of volatility making a return.

 

Conclusion- 3Q has the possibility of more volatility than 2Q and we think the market could be higher or lower depending on when you look at it during the quarter. However, we do expect a more positive resolution later this year. It’s difficult to paint a significantly negative picture for earnings in the short term, rates seem to be in check, and Trend/Sentiment/Seasonality aren’t overly bearish. Over the longer term, we see valuation and economic challenges, and these factors will likely take coordinated fiscal and monetary actions to resolve.