The first half of the year has been strong for investors. The S&P 500 is up 14.51% for the year (data from Morningstar) as of this writing. Investors have cheered falling inflation and looked forward to the end of the Federal Reserve rate hiking cycle. Additionally, economic data has continued to come in ahead of expectations (as measured by the Citi Economic Surprise Index) and corporate earnings have exceeded analysts’ estimates.
Our process tells us the market backdrop is not quite as strong as it appears. Stock market gains have been concentrated in a relatively small number of large companies. The Dow Jones Industrial Average is up just 2.97% for the year, and the equal-weighted S&P 500 is up just 5.01%. 5 of the 11 sectors in the market are negative for the year (all data from Morningstar). Markets are strongest when participation is broad – i.e., when a large number and wide variety of companies are advancing – and weakest when participation is narrow. The market advance has been narrow for most of this year.
Fundamentally, we still see risk to the economy. The Conference Board’s Leading Economic Index is at levels that have historically led to a recession. Bank lending has slowed considerably, and the money supply has contracted over the past year. Typically, this leads to economic weakness.
For the above reasons, we recently reduced risk in client portfolios. The market may continue higher in the short term. But the weight of the evidence suggests that the market will present a more attractive entry point in the coming quarters. That said, it is not appropriate to be overly negative or to bet on a significant decline right away. There are still opportunities in individual companies; our process seeks to find those opportunities. The market is still digesting the COVID-related monetary interventions and the large increase in interest rates; it may take several more quarters before it is fully sorted out. But our contention is that a strong bull market awaits us on the other side.
