Mana's 3rd Quarter Economic And Market Update
Asset Class Performance
US Stocks took a pause in the third quarter of 2023 following a strong first half. The Dow Jones Industrial Average slipped 2.1% in Q3, the S&P 500 declined 3.3%, and the Nasdaq Composite lost 3.9%. Global markets had similar performance outcomes, with Emerging Markets down 2.9% and Non-US Equities down 4.1%. Nine of the eleven S&P Sectors posted negative returns in Q3 of 2023. The Energy sector led the way with a 12.2% total return, largely due to rising oil prices; the price of WTI per barrel surged 28.5% in Q3. Communication Services inched 1% higher in Q3. Utilities were deepest in the red for the second straight quarter, finishing down -9.2%. Commodities was the only positive asset class in Q3. Emerging Markets’ -2.8% decline was good enough to be the 2nd best performing asset class on this table, and US Real Estate was the worst with an -8.6% decline.
Extensive research has shown that, if you have a diversified portfolio, a whopping 88% of your experience (the volatility you encounter and the returns you earn) can be traced back to your asset allocation. - Vanguard.
Investment Commentary + Outlook
Economic Conditions
In September, headline inflation reached 3.7% and core inflation stood at 4.1%, both figures falling within the range of 4%. While Inflation has come down significantly since it peaked last June at 9%, it remains a significant distance from the Fed’s 2% target. Below is a chart from JP Morgan highlighting the components of inflation.
Biggest gains: Transportation service costs, including auto repair, auto insurance, and auto leasing.
Biggest declines: Purchases requiring financing have slowed due to rising rates, such as cars and appliances. Shelter prices, including rent, as an overall contributor have declined.
Weakness in the bond market has shifted the expectations for rate hikes in 2023. There’s a delicate balance. At the moment, the markets are adjusting to a ‘higher for longer’ scenario, which puts stress on the overall system. With a higher cost of capital (cost to borrow), businesses and individuals can function less efficiently and levered than previously. This puts greater stress on those businesses and individuals with high leverage. However, on the other side, if we enter a recession, the Fed has historically aggressively cut rates. Depending on the path of inflation, it may or may not be possible to do so.
Valuations in the US Stock Market
The S&P 500 has undergone a significant correction of 7% since late July, particularly affecting tech and cyclical sectors. However, this downturn has rendered valuations 9% cheaper than they were in late July, presenting a potentially favorable entry point for long-term investors. Continuing on what we discussed during our Q2 2023 market update, it's noteworthy that the S&P index's concentration has intensified. The 10 largest stocks have contributed a staggering 97% to the year-to-date return, now accounting for over a third of the entire index.
Data from First Trust highlights one of the biggest drags on performance YTD, but potentially one of the greatest opportunities going forward. Small capitalization stocks, specifically measured by the S&P SmallCap 600® Index, peaked in early November 2021, a significant contrast to large caps, which measured by the S&P 500® Index, only reached their peak on the first trading day of 2022. Since the small caps' peak on November 8, 2021, the S&P SmallCap 600® Index has experienced a substantial 19.0% decline in total return, compared to a milder 6.0% loss for the S&P 500® Index. Moreover, small cap stocks have not only consistently underperformed large caps over the past 21 months but are also trading at one of their most significant discounts to large caps since the tech bubble burst more than 23 years ago. Presently, the S&P SmallCap 600® Index trades at 15.4 times the next 12 months' earnings, while the S&P 500® Index trades at 19.6 times. Small cap stocks tend to suffer larger earnings declines in recessions than market caps, however, this may be priced in to a certain extent, given the current valuation dispersion versus large caps. Additionally, if we do have a shallow recession, small caps should lead their larger peers on the road to recovery. Below is a chart from First Trust showing performance since 1926 of major asset classes, highlighting small caps as long term investment.
Bond Opportunity Set
Current 10-year yields stand at a relatively high 4.6%; there's a likelihood that rates might decline in the future due to slowing growth and potential rate cuts by the Fed, increasing the probability of a recession. Emphasizing the importance of diversification, fixed income has proven its resilience across various market environments.
One particular area we’d like to highlight is municipal bonds. Municipal bonds are bonds offered by municipalities (states & local governments). Sometimes they are for specific projects (e.g. maintain a water line) or sometimes they can be used with greater flexibility. Defaults in municipal bonds have been rare. Per Vanguard: Cumulative default rates for investment-grade municipal bonds total 0.09% over ten-year periods, on average. This compares with 2.17% for the global corporate market—well over twenty times that of municipals according to Moody's data as of December 31, 2021.
Yields on municipal bonds vary by duration, state, and credit worthiness, but JP Morgan reports in their Q4 Guide to the Markets that as of 9/30/2023 average yields are 4.32% and average maturity 13 years. While this seems low compared to a CD, yielding 4.5-5.5% depending on maturity, interest on municipal bonds is tax free federally, and tax free in your state when investing in non-taxable municipals offered by your state of residence. Below is a chart showing the taxable equivalent yield compared to the tax free yield. So instead of comparing 4.32% to 5.5%, you are comparing 8.64% to 5.5% as a taxpayer with a 50% combined federal and state tax rate.*
The opportunity cost of cash
In the current investment landscape, it might appear tempting to hold onto cash, seeking the safety it provides. However, it's crucial to recognize the opportunity cost associated with this approach. By keeping too much in cash, we risk missing out on potentially attractive and superior returns offered by fixed income and global equities. While we can never time the peak, based on market conditions, it does appear that we will achieve peak 6-month Certificate of Deposit (CD) rates over the next year, or perhaps we already have. As a reminder, CDs are an agreement with a bank to lock money for a specific period of time. They are considered safe, because they are fully backed by the guarantee of the US government (up to $250k FDIC insurance). Interest on CDs are taxable both federally and by the state. The below chart shows the 12-month investment performance of 6-month CDs, US aggregate bonds, high yield bonds, and US stocks following the peak 6 month certificate of deposit rate. In all cases, bonds delivered positive returns, and in all but one, stocks delivered positive returns. These returns significantly outpaced 6-month CDs. We think there is a place in the portfolio for CDs (short term cash needs), however, for longer term investing, we continue to believe it is prudent to invest in both stocks and bonds.
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Stephanie Bucko and Cristina Livadary are fee-only financial planners based in Los Angeles, California. Stephanie is the Chief Investment Officer and Cristina is the Chief Executive Officer at Mana Financial Life Design (FLD). Mana FLD provides comprehensive financial planning and investment management services to help clients grow and protect their wealth throughout life’s journey. Mana FLD specializes in advising ambitious professionals who seek financial knowledge and want to implement creative budgeting, savings, proactive planning and powerful investment strategies. As fee-only fiduciaries and independent financial advisors, Stephanie and Cristina never receive commission of any kind. Stephanie and Cristina are legally bound by their certifications to provide unbiased and trustworthy financial advice.