Accuvest Outlook: Cautious in the Near Term
Equity markets have surged by double digits year to date as economic growth and corporate earnings have proven more resilient than expected, and the drawdown of excess savings, resilient asset prices, and a strong labor market have supported consumer spending. Markets are also anticipating that lower headline & core inflation as well as challenges faced by US regional banks will draw the Federal Reserve into interest rate cuts at the end of this year. Additionally, enthusiasm around the transformative power of AI has been a powerful catalyst. However, as we move into 2H 2023, we are questioning whether this strong rally is sustainable. We have become increasingly cautious towards equities.
One of the most glaring concerns that we see in equity markets is concentration risk. This is particularly true for the major market cap weighted indexes in the U.S. The S&P 500’s 2023 rally has been driven primarily by the 7 US mega-cap growth stocks—Apple, Microsoft, Nvidia, Amazon, Meta, Tesla, and Alphabet. As of June 14th, they have risen by an average of 86% amid optimism about the impact of AI on their long-term prospects. These seven stocks alone now constitute 28% of the S&P 500 and account for 80% of the gains in the S&P 500 so far this year.
In addition to the concentration risk, we are cautious towards the major market cap weighted indexes because these 7 companies have historically high valuations. These companies skew the major indexes to worryingly expensive levels. The 12-month forward P/E for the S&P 493 (i.e., excluding the 7 mega-caps) is 15x, a little lower than the 20-year historical median of 15.8x. Add the 7 stocks back in and the S&P 500’s P/E rises to 19.4x. We are skeptical that these valuations are sustainable in the near term given what we believe will be a challenging economic environment going into the end of the year. From a valuation perspective, international markets are far more attractive.
Source: Goldman Sachs
We are also concerned that the stock market has failed to adequately price-in the possibility that the Federal Reserve will keep interest rates higher for longer. At the June FOMC (Federal Open Market Committee) meeting, Chair Jerome Powell made it clear that the Fed is not necessarily done with tightening and could increase rates by another 50 basis points to ensure that inflation is contained. However, the market appears to be interpreting the Fed’s policy forecast as a “bluff”. As implied by Fed Funds futures, investors anticipate that the Fed will only hike rates one more time this year (a 25-basis point increase) and the first interest rate cut will occur in December of this year (see chart). This disconnect between a hawkish Fed and a bullish market gives us cause for concern.
Source: Bloomberg
We also believe that the equity market has been too quick to discount economic reflation and an immediate rebound in corporate profit growth as we are seeing very weak leading economic indicators. For example, the ISM Manufacturing Purchasing Managers Index is at 46.9 and the ISM Manufacturing Report on Business New Orders Index is at 42.6 (a reading below 50 indicates contraction while a reading above 50 indicates expansion). This data suggests that the economy has a way to go before it troughs.
Finally, we believe caution is warranted given that investor sentiment is increasingly one-sided. The VIX (Volatility Index) is at its lowest levels since early 2020 and the AAII (American Association of Individual Investors) Bulls-Bears survey is registering more bulls than bears than at any time since 2021. From a contrarian perspective, this bullish sentiment has historically proven to be a reliable sell signal.
Portfolio Positioning
While we are cautious on equities in the near term, we retain an equal weighting to the asset class. We prefer to manage risk via hedging rather than moving to cash or rotating to less volatile assets. Buffer ETFs are our preferred hedging vehicle as they allow us to retain exposure to equity upside while providing protection on the downside. Remaining invested and maintaining strategic asset allocations are critical to achieving long-term investing goals. At the same time, prudent risk management and volatility reduction is needed in the short term. Large drawdowns can negatively impact immediate financial needs and goals. In today’s highly uncertain environment, we believe that Buffer ETFs are an excellent way to satisfy both of these objectives.
We are moderately underweight fixed income. While we believe inflation has peaked, it remains high, thereby eroding real returns. We are limiting volatility and interest rate risk by allocating to short and intermediate-term maturities. We are taking advantage of higher yields and steepness at the shorter end of the yield curve through a held-to-maturity laddered bond strategy. By laddering target-term bond fund maturities into the future and allowing them to mature at par, the portfolio is locking in today’s attractive yields and delivering predictable income while mitigating interest rate risk.
In alternatives we own a very small satellite position in the Bitwise 10 Crypto Index Fund (BITW). BITW currently has a -56% discount to NAV. We believe that positive expected returns, low correlations and the ability for the discount to narrow make BITW an ideal vehicle to gain exposure to the crypto space. Elsewhere, we have recently exited our position Gold (GLD). Gold has served as an effective defensive real asset this year and we have benefitted from its low correlation and inflation protection. However, recent negative price action has led us to exit our position and rotate into JPMorgan’s Ultra-Short Income ETF (JPST). JPST allows us to take advantage of the attractive yields at the short end of the curve.
Performance Review Q2 2023
Equities
Our equity portfolio modestly underperformed the All-Country World Index (ACWI) in Q2. With the S&P 500 outperforming global equities on the quarter, our dedicated U.S. exposure, which includes U.S. Equity Buffer ETFs (BFEB and BAUG), helped relative returns. Both BFEB and BAUG are well below their caps, each with well over 10% upside potential before the end of the outcome period. On the negative side, as Emerging Markets underperformed on the quarter, our position in the Innovator Emerging Markets Power Buffer (EAPR) underperformed the All Country World Index (ACWI).
Fixed Income
Our short-duration Fixed Income portfolio outperformed the longer duration benchmark, the Bloomberg US Aggregate Bond Index (AGG) on the quarter. Our position in the Emerging Market Sovereign Debt Closed-End Fund (EDD) performed well and was a large contributor. Not only has Emerging Market Debt been a very resilient sector of the fixed income market year-to-date, but a narrowing of the discount to NAV (Net Asset Value) has boosted returns. With the yield curve becoming even more inverted over the quarter, our position in the Interest Rate Volatility and Inflation Hedge ETF (IVOL) detracted from returns.
Alternatives
Gold (GLD) was a detractor from performance in Q2 2023. Gold has served as an effective defensive real asset throughout the year but has recently shown weakness, leading us to exit our position. Our small position in the Bitwise 10 Crypto Index (BITW) helped relative returns.
Contributors to relative performance
· US Equity Buffer ETFs (BFEB and BAUG)
· Emerging Market Domestic Debt Closed-End Fund (EDD)
Detractors from relative performance
· Interest Rate Volatility and Inflation Hedge (IVOL)
· Gold (GLD)
Overweight
· Crypto
Equal Weight
· Equities
Underweight
· Fixed Income
Disclosures: This information was produced by, and the opinions expressed are those of Accuvest as of the date of writing and are subject to change. Any research is based on Accuvest’s proprietary research and analysis of global markets and investing. The information and/or analysis presented have been compiled or arrived at from sources believed to be reliable, however, Accuvest does not make any representation of their accuracy or completeness and does not accept liability for any loss arising from the use hereof. Some internally generated information may be considered theoretical in nature and is subject to inherent limitations associated therein. Any sectors or allocations referenced may or may not be represented in portfolios of clients of Accuvest, and do not represent all of the securities purchased, sold, or recommended for client accounts.
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