Something Strange Is Going On

Last year’s miserable stock market performance was paced by huge declines in sectors that had theretofore led the markets higher. The Communications Services, Consumer Discretionary, and Technology sectors fell 40%, 38% and 29%, respectively, last year before consideration of dividends, making them the worst-performing of the eleven S&P 500 sectors. This makes pretty good sense because, generally speaking, the stocks operating within those three industry sectors trade at relatively high price-to-earnings multiples. The high valuation multiples reflect the fact that these companies have better prospects for earnings growth than the economy at large. Investors are willing to pay up for greater growth potential because there could be a big payoff someday down the road. One need only look at a long-term chart of MSFT, TSLA or AAPL to see the near limitless possibilities. 

But relative earnings growth can’t be an investor’s only consideration. Another characteristic of high-growth companies is that their need for cash is greater than lower-growth companies, and that means that capital returns to investors are pushed farther into the future as compared with more mature companies that pay higher dividends, for example. This deferral of capital returns makes higher-growth companies more susceptible to interest-rate increases because the opportunity cost of ownership rises as interest rates rise. If I can now earn 4% in a one-year CD with very little risk – a rate that is up from almost zero as recently as a couple years ago – does it make sense to tie up money in a risky enterprise operating in an uncertain economy with no guarantee of future returns? Probably not as much, especially given that inflation is still running well above that 4% CD rate.   

In the chart below you will see that the rise in interest rates (we show the 2-year and 10-year Treasury yields) last year was met with concerted selling in the three underperforming sectors. You may also notice that during the few short periods when interest-rate increases did relent, so did the selling in those three sectors. Again, this is what we would probably expect to happen. 

But then things got more complicated. During the initial few weeks of 2023, interest rates plummeted as investors saw progress in the fight against inflation. More recently, though, the inflation data has suggested that the Fed has more work to do. Interest rates have spiked back up as a result. The yield on the two-year Treasury, at 4.62%, is now close to last year’s high again. The yield on the 10-year has bounced pretty aggressively as well, though at 3.80% it’s still well below last year’s high of 4.24%. Interestingly, though, the rotation into higher-growth sectors of the stock market has not stopped. The Communications Services, Consumer Discretionary, and Technology sectors are up 14%, 17% and 14%, respectively so far this year. And investors aren’t exactly pouring into the highest quality names in these sectors either. Investors are falling all over each other to add risk again! 

The rally in high-growth stocks in the face of continued interest rate increases is not the only strange signal coming out of the capital markets these days. Another obvious one is that the yield curve remains highly inverted, which is a clear recession indicator, even as stocks are rising and credit spreads on bonds remain very tight, both of which suggest a recession may be avoided. We continue to see inflation breakeven rates at fairly low (if rising again) levels even as incoming data suggest that inflation will remain a problem well into the future. And it seems everyone is worried about inflation but we’re not really seeing those fears reflected in higher commodity prices, especially inflation hedges like gold. I could go on, but suffice it to say that we are in a period of inordinate uncertainty right now. Blindly piling into low quality funds does not strike me as a thoughtful investment strategy, and I would have to think that our friends at the Fed agree.

Hang in there, and resist the temptation to follow the herd off the cliff. There will come a time to embrace a little more risk, but now doesn’t seem like that time!