Published on July 18, 2023

The S&P 500 has generated double digit returns so far in 2023, but the gains have been narrowly focused. Heading into the second half, we will be watching to see whether the rally broadens or the market capitulates.

Beware the Narrow Market

With the S&P 500 up nearly 17% year-to-date through June 30, 2023, one might assume that we are in the midst of a broad rally underpinned by a healthy and growing economy. However, stock market gains have been unusually narrow so far this year. In fact, through the end of May 2023, just seven companies – each of which benefited from recent excitement around artificial intelligence (AI) – had driven all the gains in the market. Excluding those companies, as of 5/31, the S&P 500 was down year-to-date, and there are many crosscurrents in the economy that are creating significant uncertainty:

  1. Inflation is clearly easing, but it remains double the Fed’s target
  2. Unemployment is near multi-decade lows, which means jobs are plentiful, but tight employment may contribute to elevated inflation and thus higher interest rates
  3. The overall economy continues to grow, but we see indications of severe stress in key sectors

The question going forward is whether we are in the midst of a “soft landing”— in which case the recent market gains will almost certainly broaden out — or if we are facing a “hard landing” whereby the narrow market capitulates. Regardless, we believe that the best course of action for equity allocations is to own a concentrated portfolio of Quality Growth companies that generate significant free cash flow and growing dividends to help protect against downside risk while still participating in potential market upside.

Less than Meets the Eye

On the surface, it appears that the economy is as healthy as ever, with risks rapidly receding after a bout of rampant inflation in 2021 and 2022. For instance, the most recent report from the Bureau of Labor Statistics reported year-over-year headline inflation at 4.0% as of May 2023, down from 8.6% in May 2022. Unemployment of 3.7% as of May 2023 reflects a very tight labor market near multi-decade lows. And real GDP growth in the first quarter of 2023 came in at a tepid, but respectable, 1.3% year-over-year.

However, scratch the surface and the picture is a little less clear. While inflation has certainly come off the 2022 highs, it remains double the Fed’s 2% inflation target. This has forced the Federal Reserve to hike its key interest rate to over 5% and signal that it may further raise rates in 2023. And while low unemployment is a welcome boon for workers and supports wage gains, the tight labor market has been a key support to stubbornly high inflation and thus persistently high interest rates. These elevated interest rates have played an influential role in a rash of regional bank failures, leading to tightening credit conditions across the economy. We have also seen a marked increase in bankruptcies of troubled retailers and office real estate properties as liquidity has dried up (in fact, the running joke in real estate circles is that Class B office values are now measured by land value less demolition costs). As for corporate earnings, these are on track to be down 2.1% year-over-year for the first quarter of 2023. In addition, key metrics from companies we carefully track indicate that low-income consumers are facing significant economic stress, while middle income consumers are increasingly reliant on credit card debt.

The Magnificent Seven

Overall we think risks remain elevated for the economy. So why is the S&P 500 up so much this year? As mentioned above, a big part of the answer lies in a very narrow market supported by a small handful of large technology companies that have rallied significantly. Shares in Nvidia, Meta (Facebook), and Tesla have rallied well over 100% so far this year, and Apple is up over 40% — we do not hold any of these companies in our core equity or income portfolios. Microsoft, Alphabet (Google), and Amazon, all of which we own in size, have been bid up as well.

In fact, excluding these seven companies, which have been dubbed the “Magnificent Seven,” the S&P 500 was down year-to-date as of 5/31/23. These firms now account for about 30% of the index and have generated the largest year-to-date outperformance for the cap-weighted index vs. the equal-weighted index on record.

All is Not Lost

While we are cautious about the near term, it is important to remain level-headed. The economy appears to be slowing, but with low unemployment and inflation grinding lower — albeit at a gradual pace — it is possible that we are in the midst of a “soft landing,” whereby the economy slows without crashing into a recession.

Interestingly, in roughly the last week and a half of June, the rally has broadened to include a larger swathe of the market. If this trend persists, it could indeed reflect a soft landing.

And counterintuitively, the fact that a recession is so widely expected may actually drive companies to take actions that reduce recession risk. The Conference Board recently noted a 99% chance of recession in the next twelve months. Bloomberg has even called this “the most-anticipated downturn ever.” With such broad anticipation of a recession, companies have laid off workers and significantly slowed hiring, which may actually create a release valve for tight employment and thus help alleviate inflation, potentially enabling the Fed to back off on future interest rate hikes. The fact that unemployment has crept up to 3.7% vs. a low of 3.4% may reflect a gradually loosening labor market in the context of a growing economy.

Regardless of where the market is headed, we view a defensive quality tilt within equities as the prudent course of action: If the market rally broadens out, remaining invested should reward investors; and if the rally ends, owning quality assets should help mitigate downside risk.

Do Not Chase the Market

As always, we think it is dangerous to simply chase the companies that are driving the latest stock market gains. Rather, more than ever we believe that investing in a concentrated portfolio of Quality Growth companies represents the right course of action. Quality Growth companies have durable competitive advantages that allow pricing power and/or market share gains, enabling growth in earnings and free cash flow through most environments, including through inflationary periods. And Quality Growth companies are often well capitalized, usually pay growing cash dividends, have good management, and benefit from secular tailwinds. Investing in a concentrated portfolio of these companies at attractive valuations and having a long-term view should enable solid participation in market rallies while protecting against market turmoil.

We have also found that this narrow market has created dislocations in great businesses that we believe are temporarily out of favor, and we are actively taking advantage of sell-offs in the share prices of individual companies. As the economy stabilizes and eventually grows at a healthier pace, we anticipate broader participation in market gains and a recognition of the value of many of the Quality Growth companies we hold.

Please reach out should you have questions.

John Osterweis

Founder, Chairman & Co-Chief Investment Officer – Core Equity

Core Equity Composite (as of 3/31/24)

In our Core Equity accounts Osterweis has the discretion to decrease or increase equity exposure in an effort to reduce risk.

  QTD YTD 1 YR 3 YR 5 YR 7 YR 10 YR 15 YR 20 YR INCEP
(1/1/1993)
Core Equity Composite (gross) 9.85% 9.85% 27.09% 6.83% 12.83% 11.58% 9.40% 12.56% 9.54% 11.49%
Core Equity Composite (net) 9.59 9.59 25.85 5.80 11.74 10.49 8.32 11.46 8.44 10.34
S&P 500 Index 10.56 10.56 29.88 11.49 15.05 14.09 12.96 15.63 10.15 10.42
Swipe Table for Full Data

Past performance does not guarantee future results.

Rates of return for periods greater than one year are annualized. The information given for these composites is historic and should not be taken as an indication of future performance. Performance returns are presented both before and after the deduction of advisory fees. Account returns are calculated using a time-weighted return method. Account returns reflect the reinvestment of dividends and other income and the deduction of brokerage fees and other commissions, if any, but do not reflect the deduction of certain other expenses such as custodial fees. Monthly composite returns are calculated by weighting account returns by beginning market value. Net returns reflect the deduction of actual advisory fees, which may vary between accounts due to portfolio size, client type, or other factors. From 1/1/2021 onward, net returns also reflect mutual fund fee waivers in certain periods.

The Standard & Poor’s 500 Index (S&P 500) is an unmanaged index and is widely regarded as the standard for measuring U.S. stock market performance. This index does not incur expenses and is not available for investment. Index returns reflect the reinvestment of dividends. The S&P 500 Index data are provided for comparison of the composite’s performance to the performance of the stock market in general. The S&P 500 Index performance is not, however, directly comparable to the composites’ performance because accounts in the composites generally invest by using a portfolio of 30-40 stocks and the S&P 500 Index is an unmanaged index that is widely regarded as the standard for measuring U.S. stock market performance.

The fee schedule is as follows: 1.25% on the first $10 million, 1.00% on the next $15 million up to $25 million, and 0.75% in excess of $25 million. A discounted, institutional rate is available.

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The Core Equity Composite includes all fee-paying separately managed accounts that are predominantly invested in equity securities, and for which OCM has the discretion to increase and decrease equity exposure in an effort to reduce risk. The non-equity portion of the account may be invested in cash equivalents, fixed income securities, or mutual funds. Individual account performance will vary from the composite performance due to differences in individual holdings, cash flows, etc.

References to specific companies, market sectors, or investment themes herein do not constitute recommendations to buy or sell any particular securities.

There can be no assurance that any specific security, strategy, or product referenced directly or indirectly in this commentary will be profitable in the future or suitable for your financial circumstances. Due to various factors, including changes to market conditions and/or applicable laws, this content may no longer reflect our current advice or opinion. You should not assume any discussion or information contained herein serves as the receipt of, or as a substitute for, personalized investment advice from Osterweis Capital Management.

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This commentary contains the current opinions of the author as of the date above, which are subject to change at any time. This commentary has been distributed for informational purposes only and is not a recommendation or offer of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed.

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The S&P 500 Index is an unmanaged index that is widely regarded as the standard for measuring large-cap U.S. stock market performance. The S&P 500 Equal Weight Index is an unmanaged index composed of the stocks held in the S&P 500 Index using an equal-weighted approach instead of market cap-weighted.

Cash flow measures the cash generating capability of a company by adding non-cash charges (e.g., depreciation) and interest expense to pretax income.

Free cash flow represents the cash that a company is able to generate after laying out the money required to maintain and expand the company’s asset base. Free cash flow is important because it allows a company to pursue opportunities that enhance shareholder value.

A yield curve is a graph that plots bond yields vs. maturities, at a set point in time, assuming the bonds have equal credit quality. In the U.S., the yield curve generally refers to that of Treasuries.