By Ben Norris, CFA, Securities Research Analyst, Associate Vice President
The first quarter 2023 earnings season began last week with major banks like J.P. Morgan ($JPM), Wells Fargo ($WFC), and Citigroup ($C). Ahead of what is expected to be a disappointing earnings season, stocks saw one of their strongest pre-earnings surges in more than a decade. The S&P 500 (SPX) is up nearly 6% over the last month despite mixed economic data and lingering turmoil in the banking sector. I remain skeptical of the ongoing rally given consensus expectations for aggregate SPX earnings to decline 5% to 6% in both the first and second quarters. As I’ve noted in the past, stock prices tend to follow earnings. At the same time, a rising interest rate environment tends to lead to lower valuation multiples on stocks. A combination of declining earnings and lower valuations shouldn’t add up to a surging stock market. The sectors leading the market higher are especially puzzling. The Communication Services and Information Technology sectors have both rallied more than 20% year-to-date despite being “long-duration” sectors. Conventional wisdom says that stocks in these sectors should be under pressure because many of the individual companies that populate the sectors derive a large portion of their implied value from future profits, and higher interest rates make those future profits less valuable.
While the market has been led higher by large-cap growth stocks year-to-date, last week saw a resurgence from cyclical and value stocks. The Dow Jones Industrial Average (DJIA) gained 1.2%, beating out both SPX and The NASDAQ Composite (COMP), which gained 0.8% and 0.3%, respectively. Small-cap stocks, which have lagged most other asset classes in 2023, were the best performers last week with the Russell 2000 gaining 1.5%. Still, COMP is up nearly 16% while DJIA has managed to gain just 2.8%. Highlighting the divergence between growth and value so far in 2023, the Russell 1000 Growth (an index of large-cap growth stocks) has gained 14.3% for the year while the Russell 1000 Value (an index of large-cap value stocks) has returned just 2.3%. While it isn’t unusual for there to be a large divergence between the performance of growth and value stocks, many had expected value to continue its strong performance that began in 2022 given the interest rate environment and where we appear to be in the economic cycle.
Digging deeper, what is truly driving the strong year-to-date performance of the Communication Services and Information Technology sectors is the performance of a few very large companies. Apple ($AAPL), Microsoft ($MSFT), Alphabet ($GOOG), and Meta Platforms ($META) have each outperformed the broader market so far in 2023, all at least doubling the performance of SPX. Notably, Meta Platforms (formerly Facebook) has rocketed more than 80% higher after lagging last year. These stocks make up a large portion of most major indices and have contributed to the year-to-date gains seen so far. Looking at this phenomenon another way, an index tracking the largest 50 companies in SPX has gained 13.7% year-to-date vs. SPX’s 7.8% gain. Without the contribution of these large companies, COMP and SPX would each be up less than 5%. So why are these large companies faring so well versus their smaller counterparts? Over the last few years, the companies noted above have begun to function as “defensive” stocks when market uncertainty increases. Their large size and strong balance sheets are attractive to investors in uncertain environments. These companies are the new staples – stocks that investors can look to when they want to decrease risk in their portfolios. However, as each of these stocks have seen price gains this year, their earnings have not seen similar increases, and their valuations have gotten less attractive. I think we will see a return to earnings and valuations having some significance later this year as the economy cools and these stocks will give back some of their gains.
Uncertainty and volatility tend to go hand in hand when it comes to markets. That hasn’t been the case this year. I would argue that uncertainty has remained elevated over the last several months. Investors don’t believe what the Federal Reserve has said when it comes to future monetary policy (the bond market is pricing in 0.50% in rate cuts in the second half of 2023 while the Fed claims no cuts) and the threat of a recession looms large. Each report on inflation, employment, or economic activity feels like it could send markets into a tailspin. Still, the CBOE Volatility Index (VIX), which is often cited as a broad measure of stock market volatility, has settled at its lowest level in 15 months. In contrast, bond volatility has remained elevated as investors try to predict the Fed’s next policy moves. It is unusual to see such a large divergence between stock and bond market volatility, which leads me to believe that either stock market volatility will increase, or bond volatility will decrease in the coming months. My guess is that the former is more likely.
Economic data have been a mixed bag over the last month. Readings on the Consumer Price Index (CPI) and the Producer Price Index (PPI) came in lower-than-expected last week. CPI saw a 5% year-over-year increase in March compared to the 6% increase recorded the month prior. Similarly, PPI increased just 2.7% in March, well below recent readings. In fact, the March 2022 reading of PPI saw a 11.7% increase. The Fed’s aggressive policy moves are beginning to have a real effect on various parts of the economy. U.S. retail sales, a measure of consumer activity, was down 1% in March, a notable deterioration from February and a sign that consumers are beginning to feel pressure. In contrast, April’s reading of Consumer Sentiment saw an unexpected improvement despite employment figures showing that more Americans are filing for unemployment benefits. Industrial production and capacity utilization show that the goods side of the economy is doing relatively well but indicators focused on the services economy continue to languish. Further complicating the economic picture, minutes from the Fed’s March policy meeting were interpreted as hawkish. Within the data, it is implied that the economy will experience a mild recession later this year. The Fed has maintained that they have more work to do in their war on inflation but so far investors aren’t buying what the Fed is selling.
The coming week has a heavy slate of speakers from the Fed before they begin their mandatory quiet period. Wednesday will see the release of the Fed’s Beige Book – a broad look at economic conditions in the U.S. The U.S. leading economic indicators will be released on Thursday and is expected to see a decline. We will round out the week with manufacturing and services PMI.
| Date | Report | Previous | Consensus |
| Monday 4/17/2023 | Home Builder Confidence Index | 44 | 45 |
| Tuesday 4/18/2023 | Housing Starts | 1.45M | 1.4M |
| Building Permits | 1.52M | 1.45M | |
| Wednesday 4/19/2023 | Fed Beige Book | ||
| Thursday 4/20/2023 | Initial Jobless Claims | 239,000 | 244,000 |
| Continuing Jobless Claims | 1.81M | — | |
| U.S. Leading Economic Indicators | -0.3% | -0.7% | |
| Existing Home Sales | 4.58M | 4.48M | |
| Friday 4/21/2023 | Flash U.S. Services PMI | 52.6 | 51.5 |
| Flash U.S. Manufacturing PMI | 49.2 | 49.0 |
Links to previously published commentaries can be found at benjaminfedwards.com/Latest Investment Insights/Weekly Market Commentary/Market