June 22, 2023
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June 2023 Market Commentary
June Market Update 2023
As we pass the halfway mark for calendar 2023, it’s worth reviewing where we are in terms of the economy and how the market is reacting thus far. Coming into 2023 the consensus of economic forecasts was projecting a slowing economy and possibly a recession, with earnings expectations much too high. Strategists were calling for a revision downward for earnings across the board and markets braced for a significant drop in consumer and industrial spending, credit losses, and bankruptcies as the US and Canadian economies absorb 500 bps of rate hikes by spring of 2023.
The first quarter surprised with better than expected earnings and nominal GDP in the US around 6% and in Canada 3.1%. As we near the end of the second quarter in two weeks, this trend continues, with Q2 earnings stabilizing near Q1 levels, and last week analysts increased Q2 to Q4 earnings estimates by the most since the start of the year. This implies we may now be experiencing trough earnings for the year, and the greatly anticipated and feared market selloff may already be behind us in October of 2022. In Canada, likewise we are seeing good jobs numbers and GDP trends, modest wage growth and a housing market that is bouncing off recent lows and heading higher once again. This clearly has caught the eye of the Bank of Canada governor who this week raised the prime interest rate to 4.75%, surprising most and no doubt reflecting a renewed effort to slow the Canadian economy and control still too high inflation.
Last week’s US jobs report told us that the US economy created 339,000 new jobs in May, much higher than expected. This is 0.2% increase in the total workforce. Data back to 1980 tells us that when new jobs are being created at this pace, a recession is pushed out 6 to 12 months. In other words, in no case since 1980 has the US economy slipped into a recession any sooner than that after a jobs report similar to what we saw last week. Since the Canadian economy tends to follow the US lead, we can expect our economy to fair similarly.
The US VIX, or fear index, has now fallen to 14, the lowest since February 19th, 2020. As much as the economic and market conditions remain unusual, the VIX is signalling that market volatility may be normalizing.
US and Canadian corporate bond spreads are sitting at their 12-month averages. That tells us that the bond market is not concerned about future earnings and cash flows. This is also what market valuations are telling us, with the S&P500 index now trading above 19x earnings for 2023.
This all sounds very reassuring, and yet investors have yet to embrace the good news. Fund flows continues to show retail investors are continuing to sell equity funds, as they have all year, in favour of bonds and cash Even bond fund flows were negative last week, likely over worries about the US debt ceiling impasse and the subsequent need to issue large amounts of US Treasuries now that the debt ceiling has been raised, implying higher yields to attract buyers and lower prices for bonds. This, of course, is a contrarian indicator and historically marks good entry points for stock investors.
Institutional investors have also been very bearish all year, and only in mid May has their sentiment shifted more positively. Data from State Street’s Institutional Investor Risk Appetite Indicator, newly updated to May 31rst, shows how big money is positioned in terms of money flows into less or more risky financial assets. The index has shown steady declining trend in risk assets since the end of 2022, reaching a multi-year low in May, and just turning more bullish on higher risk assets in the last two weeks. We therefore have the makings of a further rally in US and Canadian equities since risk sentiment appears to be bottoming and is now starting to rise.
As analysts revise higher their earnings estimates for the rest of the year, could this mean we are on the cusp of a more broad market rally in the coming months? So far this year the TSX is up less than 3% and the S&P500 is up 11%. But the gains in the US markets have come entirely from a rally in mega-cap technology names (Amazon, Meta, Google, Apple, Nvidia, Tesla and Microsoft), which now comprise 26% of the market weighted index. However, the equal weighted index is up only 1.8% this year, only turning positive for the year last week. This shows that the persistent rally in large cap stocks this year has not been as much about hope for better than expected earnings for the market as a whole, as it is about big cap tech’s cost-cutting driven earnings power and all the recent buzz about artificial intelligence. That said, perhaps markets are beginning to come around to the idea that corporate earnings will be better than expected over the balance of the year. The macro data mentioned above is no doubt driving this change in sentiment.
The true sign that market sentiment has changed will be when we see this year’s rally broaden to include names other than just a handful of mega cap technology and IA related names. Watch for a recovery in industrials, financials and cyclicals as a signal that we have truly turned the corner. In the meantime, there appears to be more upside remaining in large cap growth and technology stocks, many of which still trade significantly below their 2021 highs. In fact, the Nasdaq100 index, holder of most of the big technology names in the US market, needs to rise another 25% before reaching it’s prior high in 2021. The fuel driving this rebound will have to come from the more bullish institutional investors who have mostly shunned these names all year, as well as from retail investors who have mostly sat out the recent recovery in growth names, and who will at some point, be forced to join the rally or be left behind.
Finally, a few thoughts about the out-performance of the Nasdaq index, up over 12% so far this year, after losing 33% in 2022, and mega-cap tech names in the S&P500 up 27% so far this year. Firstly, Nasdaq has to rise 25% in order to get back to it’s all-time high of November 2021, as I mentioned above. The rally is at least partially predicated on the promise of novel artificial intelligence developments. That said, generative AI still has a long way to go to prove itself additive to tech stock valuations in the near term.
Secondly, the Nasdaq almost always rallies in the year following a down year. After the 13 down years over the last 5 decades (except for 2022) the NAS posted positive returns 10 out of 13 times. The average upside is +19.2%. Of the 10 positive years, the average upside is 33.7%, while the three down years averaged -29.2%.The only times the NAS posted back-to-back negative annual returns were in 1974 (recession amid the oil crisis) and in 2001/2002 (bursting of the dot-com bubble and the aftermath of the 911 terrorist attacks).
Thirdly, almost no big tech names have set a new record high this year. Although Nvidia, Microsoft and Apple have, Meta, Amazon and Tesla are significantly below their prior all-time highs.
Fourthly, after the NAS composite registers an outsized gain in January like this year, it tends to finish the year very strongly, often with the best results coming in the 4th quarter. The NAS gained 10.7% in January. The index gained over 8.9% in January, 8 other times, and went on to post a positive gain for the year, 6 of 8 times. The two losing years were -5.2% in 1987 and -21.1% in 2001 (geopolitical shock from the 911 attacks). The average return for strong January years is +29.8%, and excluding the two down years, the average is +44.2%.
Fifthly, for those concerned that generative AI buzz is fueling a tech stock bubble, history says to look for the Nasdaq to almost double in a calendar year before worrying those gains could lead to a subsequent crash. Data from the US Federal Reserve since 1970 indicates major declines in the NAS have only occurred after calendar year gains in excess of 60%, which has happened only 5 times. The YTD NAS gain of 12% shows we are very far from anything resembling a tech bubble.
As always, if you would like to talk about anything mentioned in this letter, or would like to review your portfolio in light of the more recent developments, please call or email me. We would be happy to arrange an in-person meeting (or via telephone or virtual) to review your portfolio, or discuss any matter related to your financial well-being.
Gordon Forsey Advisory Group:
Gordon Forsey P.Eng., MBA, CIM, FCSI
Portfolio Manager, Sr. Wealth Advisor
Tel: 902-420-6203
Andreas Demone BBA
Client Associate
Tel: 902-420-9624
Terri MacPhail
Client Associate
Tel: 902-420-8263
Source of data, statistics and historical information provided by US Federal Reserve, Reuters, S&P, CIBC Economics, State Street Inc, and DataTrek.
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Gordon Forsey is an Investment Advisor with CIBC Wood Gundy in Halifax. He and his clients may own securities mentioned in this column. The views of Gordon Forsey do not necessarily reflect those of CIBC World Markets Inc.