March Madness

Market Update for the Quarter Ending
March 31, 2023

Sometimes it’s best to expect the unexpected. Fans of this year’s NCAA tournament, often referred to as “March Madness”, were treated to an unexpected set of outcomes throughout the tournament. The top teams, identified as “1 seeds”, were all knocked out prior to the final four. In fact, this was the first Final Four since 1979 with no team seeded better than a 4 seed, and little known Florida Atlantic University, a 9 seed, became the lowest-ever seed to make the Final Four. In the end, 4-seeded University of Connecticut prevailed, and brackets were busted everywhere.

Much like the NCAA tournament, investors often experience unexpected outcomes. The American Association of Individual Investors (AAII) Sentiment Survey provides insight into investor opinions and forecasts for the next 6 months. The survey has compiled data going back to 1987 and has proven to be one of the most reliable indicators of investor sentiment. “Sentiment” is the general mood of investors toward equities. However, the fascinating aspect of the survey is that it has proven to be a contrarian indicator – meaning that when the herd is positioned one way, it’s best to be positioned in the opposite way. Historically, when investors are bullish (optimistic), below-average equity returns tend to follow, and when investors are bearish (pessimistic), above-average equity returns generally follow.

The historical average for investors has been 31.0% bearish, 37.5% bullish and 31.5% neutral. Near the end of the first quarter, 45.6% of investors were bearish, 22.5% were bullish and 31.9% were neutral. The difference between bullish and bearish investors was -23.1%, down slightly from -29.2% earlier in March, but amongst the most pessimistic readings of the last 6 months. The spread was -43.1% near the equity bottom in September 2022 and +7.1% at the year-end 2021 equity peak.

Why are investors so pessimistic? Economists are widely predicting an economic slowdown and possible recession within the next 12 months, and recent distress in the banking sector only increases those odds. Inflation is still too high. The Fed has substantially hiked interest rates over the last year and it’s unclear when it will stop and pause. Politics at home could drive the debt ceiling debate too far. Geopolitical risks remain elevated due to the war in Ukraine and simmering tensions between the U.S. and China.

There is a large punch list of worries for investors. But, these worries have been in plain view and financial markets have digested these concerns for many months in most cases. Equities remain close to 20% below their January 2022 peak and reflect a great amount of uncertainty. The S&P 500 is not cheap, but fairly priced at 18x forward earnings. This is considerably cheaper than the nearly 24x valuation in late 2020 and 21x in late 2021. A basket of large, high quality technology stocks has supported the index in recent months. However, beneath the surface, the S&P 600 and S&P 400 (Small and Mid-sized domestic companies) valuation remains considerably cheaper at 13x forward earnings – both near the cheapest levels of the last 20 years. Therefore, much of the negative headlines are reflected in equity prices already.

Banking on stability

The newest development was the banking distress that began around the second week of March. Our March newsletter covered the details of the Silicon Valley Bank (SVB) collapse, but the key element is that this should not be a systemic banking issue moving forward. All banks will have losses within their securities portfolios due to the fact that interest rates have risen during the last 12 months. But, approximately 90% of deposits at SVB were not FDIC insured and a concentration in speculative venture capital and immature technology companies posed a unique set of risks. Moreover, interest rates are on the decline, with the 10-year treasury down to 3.49% at 3/31/23, from 4.08% in early March and 4.23% back in October 2022. Finally, the Fed’s new Bank Term Funding Program was initiated to provide temporary liquidity to banks by accepting underwater U.S. Treasuries as collateral for funding.

The biggest factor going forward may be tighter bank lending conditions. Less access to capital for individuals and businesses could pull forward that expected recession, but also help the Fed’s inflation battle and enable the Fed to slow or pause future rate hikes.

Financial markets rebound across the board

The trend higher in both equities and bonds off the October lows continued through the first quarter. The S&P 500 increased 7.5%, but was led by a select group of mega-tech companies that pulled the index higher. The Russell 2000 Small Company Index increased 2.7% and was more severely impacted in March by the stress in the banking sector. Smaller-sized “regional” banks bore the brunt of the pain, but anything associated with financials, including insurance and wealth management were punished.

As was the case in the fourth quarter, developed international markets continued to post the highest returns of the major indices, with the MSCI EAFE Index up 8.5%. Performance was boosted by a declining dollar, which peaked at a near 20-year high in September. Emerging markets, as measured by the MSCI Emerging Markets Index, returned 4.0%. The China reopening story should be a theme that plays out throughout 2023.

After posting the worst 9-month stretch ever and bottoming out in October due to inflation and rising interest rates, the U.S. Aggregate Bond Index has turned a corner as inflation has cooled. The index gained 2.9% during the first quarter. While the Fed may actually increase the overnight fed funds rate 1-2 more times before pausing, longer-term rates have declined since October. Declining interest rates push bond prices higher. Moreover, yields are considerably higher than 12-15 months ago, allowing for more cushion should rates rise once again.

Global Asset Allocation Strategy

The strategy remains slightly overweight equities after adding to risk assets at the October market lows. Specifically, extra exposure resides in domestic small and mid-sized companies, which trade near the lowest valuations of the last 20 years. Smaller companies can carry more risk, but this is mitigated by the fact that valuations are low, coupled with the fact that we focus on owning higher quality companies. Close to 25% of companies within the Russell 2000 Small Company Index are unprofitable. However, we center our core small and mid-sized domestic exposure around the S&P 400 Mid-Sized Company Index and the S&P 600 Small Company Index that have strict profitability and quality requirements. Just over a third of equity exposure lies within the small/mid capitalization space.

We have mostly let international equity profits run since October. We feel that the declining U.S. Dollar should continue to act as a tailwind to investments overseas. Furthermore, parts of Europe may already be in a recession and could see faster growth soon. We also like the China reopening story, despite the challenging geopolitical risks and looming demographic challenges down the line.

Bonds are back in a big way. We exited the bond alternatives that were so beneficial last year; first in October at peak rates and then again in December. We also extended duration with the belief that interest rates were likely near peak levels and set to level off or decline in coming years. Although it may be tempting to sit in money market mutual funds yielding close to 4.7%, bonds should beat this rate of return if interest rates remain steady or decline over the next 12-24 months. Bond portfolios currently yield between 5.5% and 6.0%, depending on the specific portfolio and bond allocation. Bonds remain high quality, as it makes little sense to “reach’ for extra yield with low-quality junk bonds. The compensation for low quality bonds just isn’t sufficient with credit spreads still tight.

Focused Equity Strategy

The first quarter witnessed substantial volatility, as equities rallied in January, then fell in late February and early March on the collapse of Silicon Valley Bank, before rallying again through the end of the quarter. A small group of big technology companies led the way, along with some previously beaten down stocks that rebounded strongly. Investors favored higher quality stocks with strong cash flows and revenue growth, along with more speculative beaten down names that rallied off of extreme lows.

The financial sector was down -5.5% as measured by the S&P Financial Select Fund (XLF), with the sell-off concentrated in regional banks and a handful of companies deemed to be exposed. Most accounts have eight financial holdings, primarily positioned in the largest, highest quality banking, capital markets and insurance companies.

In January, we trimmed AbbVie (ABBV) and added Arista Networks (ANET) in most accounts. While we feel AbbVie is a high-quality pharmaceutical company, we felt its valuation did not warrant the position size it had grown to. Arista Networks (ANET) is a well-managed networking equipment company that is experiencing strong growth and is taking market share. It complements our Cisco (CSCO) position, as it is a competitor and both companies serve a growing and important market segment. At the same time, we also disposed of two very small holdings, Viatris and Kyndryl, which were spinouts of Pfizer and IBM, respectively.

In March, we sold our position in Boeing (BA), trimmed Fairfax Financial (FRFHF), and added 3M (MMM). Boeing’s prospects have changed radically since we purchased it, due to the crashes of two 737-Max planes in 2018-2019, and subsequent groundings of that product line. Then there were problems with the 777 plane and a halt in production. While we waited for a recovery in the stock price, we reached the opinion that the company’s valuation is impaired and decided to exit the position.

Fairfax was trimmed primary due to our belief that the valuation did not justify the position size it had grown into. We still believe Fairfax, based in Canada, is a well-managed and diversified global insurance company.
3M is a large, diversified manufacturer whose stock had been punished due to litigation over Combat Arms earplugs used by the military. Unrelatedly, the company has decided to exit PFAS manufacturing by the end of 2025, which modestly reduces profit forecasts. We believe the liability is quantifiable, given the history of this kind of litigation, and the stock represents an attractive risk-reward at these levels.

Equity performance may not correlate with the general economy

The current economic picture is stronger than most realize, but we expect economic growth, employment and corporate earnings to slow in coming quarters. The odds of a “soft economic landing” or mild/moderate recession are higher due to the after-shocks of the Fed’s recent rate hikes combined with the likelihood of tighter lending conditions. But, this does not mean that equities will fall apart and break below the lows experienced last October.

During economic slowdowns of the last 70 years, equity markets have bottomed first, followed by economic growth (GDP), then payrolls, and finally, corporate earnings. Equities have bottomed on average eleven months prior to earnings bottoming. Thus, when the headlines appear bleak and trending the wrong way, equities tend to look ahead to the recovery.

U.S. equities fell nearly 30% from the peak into October, with some technology and lower quality companies and sectors declining over 50%. While equities have partially recovered, we expect to be range bound and choppy until some uncertainty is lifted. Looking ahead, a decline in the U.S. Dollar, interest rates and inflation that have been major headwinds to the economy and financial markets should all become tailwinds. It is important to maintain equity exposure in uncertain times because the initial equity recovery that is usually less anticipated tends to be quite strong.

As always, please reach out with questions. We would be happy to discuss the current headlines and portfolio positioning in greater detail at any time!