From a macro point of view, the U.S. market indexes have generated flat to negative returns for almost the past three years, with large rallies and drops producing no returns for investors outside a select group of technology stocks. Thousands of stocks have flat to negative returns year to date, and over the past 12 months, indicating a less than robust market environment. Your average asset allocation or 60/40 portfolio is doing even worse due to large negative returns on the bond side. Something I predicted was going to happen exactly two years ago in a blog update I wrote.
Our analysis suggests that the equity markets have been in a bear market since the end of 2021, and October's market activity has reinforced this trend. Something I warned about back in May of 2022. The performance of a small number of mega-cap growth stocks has masked weakness elsewhere in the market. For instance, the returns in both the S&P 500 and Nasdaq were driven by the same seven stocks, which are being referred to as The Magnificent 7. This implies that most other stocks, sectors, and industries, including utilities, real estate, industrials, small caps, mid-caps, dividend-value stocks, and even the equal-weight S&P 500 index, have been in the red for the year. On average, stocks have been flat or down for the year.
Longer duration treasuries, which typically provide a risk hedge to equities, continued to struggle in October, exacerbating the challenge for investors seeking to manage their portfolios. This may change if and when the U.S. enters a recession as longer-duration treasury yields start dropping.
However, the latter half of the month saw a shift back toward defensive equities, suggesting a shift in sentiment. The general perception that the Fed might have completed its interest-rate hikes but will maintain them at higher levels for a longer time might encourage investors to think more about the longer-term economic implications of tighter monetary conditions. We continue to monitor geopolitical events in the Middle East closely. Nonetheless, stocks and bonds have taken the conflict in stride so far, except for some short-term volatility in the energy market.
Given our belief that this year's U.S. equity market performance appears to be more of a bear market rally than a new bull market, we have remained committed to defensive positioning and risk management. Throughout the year, our equity allocations have typically oscillated between neutral and defensive, but we have never gone fully risk-on. Core inflation appears to be sticky for longer, so we have incorporated some inflation protection in the form of energy, commodities, and gold. We are still holding significant amounts of money markets and short-term Treasuries. With T-bill yields still north of 5%, cash is no longer trash and provides an opportunity to obtain a high risk-free return on our money while using it as a risk management tool.
Around this time of year, investors usually anticipate Santa Claus rallies. While this is always a possibility, we remain wary of overall economic conditions and suggest remaining alert and cautious. We have observed that weakening consumer demand has been a common theme in Q3 earnings reports. Over the past year, retailers have reported this, which could indicate that consumers are fatigued and feeling the consequences of high inflation and high-interest rates. These conditions are unlikely to dissipate soon and may tip the scales toward a recession as we head into 2024.
The Fed, together with its allies at the Treasury, recognizes that the economy is on shaky ground. While fighting inflation remains the priority, they also understand that an election year is around the corner. The preference could be to support the economy over the next 12 months through quasi-easing policies.
The Fed's preferred scenario would be a gradual economic slowdown while avoiding an increase in asset prices, which would raise inflation pressures. We recognize that such an approach to managing the economy is unlikely to achieve the intended effect since there is no such thing as a free lunch. Our current base case, as previously stated, is a continuing rolling bear market that will occasionally produce large rallies but one where cash over longer periods should outperform. We will continue to stay neutral, owning some equities with a barbell of cash and treasuries.
For us to increase equity positioning across strategies we would need to see more stocks participating to the upside something that has not happened in 3 years.
Year-to-date returns for S&P500, Nasdaq100, Dow Jones Ind Avg, Small Cap Index.
Notice the percentage of stocks outperforming the S&P 500 index is at it lowest point since 1998. Similarities with the great tech bubble of 2000.
Figure 1: Data provided by S&P Global https://www.spglobal.com/spdji/en/documents/performance-reports/dashboard-us-sector.pdf