There is a lot of excitement regarding how the S&P 500 has performed so far. Although, for many economists and market strategists that don’t buy the recent gains, it’s how the year finishes that counts. In this most recent letter, We’ll review what has happened so far, and what we think needs to happen so the market can continue to go up in the 2^nd half of the year.

Need-to-Know Topics

• The 1st half’s performance was unexpected by many but was limited to only a few areas. We’ll discuss what should happen to have a good 2^nd half also.
• Inflation & employment continue to moderate to normal levels.
• Will the Federal Reserve continue to increase rates?
• Earnings season is upon us.
• Where are the opportunities for the 2^nd half of the year?

1^st Half Performance

The S&P 500 index has defied all odds this year much to the surprise of most market strategists. Since the end of last year, most market strategists predicted muted returns in the S&P 500 for 2023, as they forecasted the economy would be in a mild recession by the summertime. Fortunately for all of us, the strategists have been wrong thus far. As of June 30^th, the S&P 500 is up a whopping 16% for the year. However, not all asset classes have participated to the same degree as the overall S&P 500. Bonds did not perform as analysts originally expected due to a stronger-than-expected economy, and not all S&P 500 sectors fully participated in the performance either. This has led to a wide difference in performance between the S&P 500 sectors and the S&P 500 overall.

Inflation & Rate Hikes

Inflation, as measured by the Consumer Price Index, peaked in June of 2022 and has been steadily declining since then, much of the decline has coincided with the Federal Reserve’s rate hiking program, which began in March 2022.

For stocks to continue to make gains in the 2^nd half of the year, inflation should continue to moderate toward the Federal Reserve’s target of 2% annually, so the Federal Reserve can maintain the Fed Funds rate at or near current levels. Currently, the Federal Reserve has estimated they may increase rates 2 more times this year; however, many high-profile investors have cast doubts that they will actually do it because they think inflation seems to be moderating just fine at current Fed Funds Rate levels.

The Federal Reserve still has a tightrope to walk between raising the Fed Funds Rate and losses on banks' balance sheets. The higher the Fed raises rates, the more losses banks have on long-term Treasury bonds they purchased when rates were at record lows. Furthermore, higher Fed Funds Rates will entice banking customers to remove money from their lower-yielding savings accounts and deposit them in higher-yielding money market accounts, sometimes paying 2 or 3 times the interest than savings and deposit accounts. These transfers would put further unwanted pressure on banks.

Tale of Two Markets

There has been an increasing divergence between the mega-cap growth stocks, like NVIDIA, Meta, Tesla, Amazon, etc., and everyone else in the S&P 500 since the regional banking issues in March.

The S&P 500, maybe the most widely used benchmark for the stock market in the U.S., is a market capitalization (market cap) weighted index. Meaning, it takes all 505 companies in the S&P 500 (yes, there are 505 companies in the S&P 500) and divides them up based on the total value of all outstanding shares of each company; the higher the market cap is, the bigger the company is. As an example, Apple has 15.73 billion shares outstanding and it is trading at $187.35 per share, at the time of this writing. To figure out Apple’s market cap, we would multiply 15.73 billion shares by $187.35, and get a total market cap of approximately $2.95 trillion.

One of the issues with using a market cap-weighted index to track overall market performance is that the larger companies’ performance can overshadow what is going on with the rest of the S&P 500. Apple and Microsoft make up almost 15% of the S&P 500, alone. If they are up for the day, it’s very difficult for the index to be down – even if most of the remaining companies in the index may be down that day.

Another issue, which leads to my point in this section, is the S&P 500 is dominated by the Technology sector. The Tech sector now makes up almost 30% of the S&P 500. The next biggest sector is the Healthcare sector at almost 14%. Furthermore, the Technology sector doesn’t even include major companies like Meta, Amazon, Netflix, and more. If you were to add in all companies that we may think of as Tech companies, it may take the Technology sector up to 50% of the S&P 500. So, basically owning an S&P 500 index fund is akin to owning a Tech concentrated fund. We’re not saying that’s good or bad, however a reminder of the increased volatility of being overly exposed to Technology stocks should be made.

One of the ways that we can keep track of the overall health of the stock market and remove the noise of many of the bigger companies, and the Technology sector, is to look at the Invesco S&P 500 Equal Weight ETF (RSP) (this is not an endorsement of RSP). The RSP evenly divides all the companies in the S&P 500 rather than divided by market cap. This means that Apple has the same weighting in the index as Fortrea Holdings, the smallest company in the S&P 500.

There were two newsworthy events that happened in March. The first was the regional banking issues resulting in the unraveling of Silicon Valley Bank, et al, and the second event was the launch of ChatGPT and the Artificial Intelligence (AI) whirlwind that has since followed. You don’t have to be an elite chartist to notice the divergence on the chart we illustrated above. When the news broke of the banking issues in early March, both indexes turned lower. However, when ChatGPT was launched, the two lines came apart and haven’t looked back.

This massive divergence between the two indexes happened due to companies like NVIDIA, Microsoft, Meta, Google, Amazon, and basically any other company that may benefit from anything related to AI, being purchased in droves, while more “traditional” companies like United Healthcare, Johnson & Johnson, and Caterpillar were left behind. Industrial sector companies, like Caterpillar, were not in favor because investors believed the regional banking issues would put a crimp in lending and therefore speed up an already looming recession.

Thankfully, strong employment and economic data have put those fears to rest somewhat, for now. The month of June was a strong month for traditionally economically sensitive areas like the Industrials and Materials sectors. For the stock market to continue making gains in the 2^nd half of the year, performance needs to be spread out among different sectors of the S&P 500, not just Technology.

Employment

The employment situation looks to be trending in the right direction: the Unemployment Rate has come off it's multi-decade low, the Labor Force Participation Rate is trending higher, and the Job Openings and Labor Turnover Survey (JOLTS) numbers are trending lower, as well. For the Federal Reserve to stop hiking rates, they will have to continue to see the employment situation moderate.

The Labor Force Participation Rate is currently sitting at 62.6%; it will hopefully keep trending toward the 2020 high of 63.4%, or even better, the high reached in the late 90s of about 67%. This would mean that more people in prime working years would be employed. It also provides more tax revenue to the government, leads to higher productivity, and there is also evidence that a higher labor force participation rate can lead to less crime. Something everyone can get behind, I’m sure.

Job Openings are still extraordinarily high and need to continue to trend lower to the long-term average of around 7 million people. They are currently sitting at around 9.8 million job openings. Why are high job openings bad? High job openings show a labor shortage. When there is a labor shortage, employers will entice potential employees with higher wages, which may lead to higher inflation. Higher inflation may lead to even higher wages… Do you see where I’m going with this?

Believe it or not, there is such a thing as a balanced and healthy labor market. The Federal Reserve is dead set on getting the economy there, but the only real weapon they have is raising or lowering the Fed Funds Rate as necessary. For the stock market to continue making gains in the 2^nd half of the year, the employment situation should continue to moderate without causing excess layoffs.

Here Comes Another Earnings Season

Earnings season for the 2^nd quarter of S&P 500 companies will begin this week. The 1^st quarter’s earnings result surprised analysts to the upside, and we suspect most analysts have the same expectation for the 2^nd quarter. If companies don’t deliver positive results for the quarter, and more importantly, positive future estimates, investors will not hesitate to sell stocks so they can take profits from the strong 1^st half performance.

Company analysts are expecting earnings to begin growing again, possibly as soon as the 3^rd quarter, as the S&P 500 had negative earnings growth last quarter and is expected to have negative growth for the 2^nd quarter results, also. We are currently in one of the weakest seasons of the year in regard to the S&P 500 performance. A major reason for that is the volume of trades on the exchanges is low due to vacations. It doesn’t take much news to set selling trades in motion, so we’ll be watching earnings results very closely for good deals.

Opportunities

Compared to some other sectors of the S&P 500, we think the Industrial sector is undervalued. There are many tailwinds that may push the industrial sector higher in the 2^nd half of the year. Federal money from the CHIPS Act and the Inflation Reduction Act has barely started to filter through the Industrial sector. Both Democrats and Republicans are pushing to bring important manufacturing back to the U.S. (known as onshoring), and for that to happen, factories need to be built and outfitted with the latest in industrial technology.

We also see opportunities in intermediate-term and long-term U.S. Treasury bonds. It’s hard to argue against the idea that the Fed is close to the finish line regarding interest rate hikes. To that end, U.S. Treasury bond valuations are currently attractive due to the Federal Reserve eventually cutting the Fed Funds rate in the future. It may take a little patience as no one truly knows when they will cut rates, but the Fed will have to cut rates sooner or later. Even if the economy does not enter a recession, it will have a difficult time growing with rates in the mid-5 %. Thankfully, the aggregate bond market is currently paying around 4.22% in interest (based on the 30-day SEC yield of AGG), so there is a positive benefit to waiting for the potential future appreciation.

Finally, we also see some opportunities in the Communications sector. This is an oddball sector. It contains companies like Google, Meta, and Netflix which are great growth companies, but it also includes companies like Verizon and AT&T. Don’t get me wrong, Verizon and AT&T are also very good companies; however, they can hardly be considered growth companies. Much of the revenues in the Communications sector are derived from advertising. That is the main source of revenue for Meta and Google, for instance. Valuations in companies like that are not as high as their Technology sector counterparts like Microsoft but have much to gain from AI aiding in targeted advertising.

We really hope this commentary has helped put some things in perspective. It is our aim to keep you educated on what is going on within the economy and the market. We believe a better understanding leads to a better outcome! Have a great rest of July!

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All investing involves risk including loss of principal. No strategy assures success or protects against loss.

The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that the strategies promoted will be successful.