I wanted to update you on the stock market and our outlook. Currently, the S&P 500 is up over 9% in 2023. Indeed, we’ve experienced an excellent rebound from the bear market low in October 2022. However, looking at what is driving the returns is essential to help determine what the future may hold.
Let’s look at two different ways to get to the same number. Different from the S&P 500, the St. Louis Cardinals have not had a great start to 2023. The batting average for the nine players with the most at-bats is .255, ranging from .289 for Paul Goldschmidt to Willson Contreras’ .219. What might be encouraging is that the hits are not dependent on a few players; the range is relatively tight.
Another way to get to a .255 team batting average is to have one player batting 1.000 and the rest batting .161 each. If that one player batting 1.000 starts to slump or gets hurt, that team is in trouble. The hypothetical batting average is an example of bad breadth in stock market terminology. This same logic applies to stock market returns. Historically, market rallies relying on the outperformance of a narrow set of stocks are not the best foundation for future gains.
Below is a comparison of two ways to examine the S&P 500 Index. For those who don’t know, the index currently comprises 504 stocks weighted by their market capitalization or size (number of shares multiplied by price). Twenty-three cents of every dollar you invest in an S&P 500 index fund goes to the top five companies, and the other 499 splits the rest.
While these five stocks have a history of outperforming the S&P 500, the current outperformance warrants caution. The reason is, historically, in the early stages of a bull market, the breadth of gains is broad-based. As you can see from the table above, if all those same stocks in the S&P are weighted equally, the return is negative year to date and over the last twelve months.
The graph below compares the current market to the 2008 bear market. We are looking out as far from the 2009 bottom as we are from the October 2022 low. As you can see, all parts of the market participated in the gains from the 2009 market low; the lines are moving up in tandem. In contrast, investors are still avoiding the riskier parts of the stock market, as represented by the Russell 2000 (the green line), and the average stock (the maroon line) in the S&P has recently taken a downturn even though the index (the blue line) has taken a leg up.
This is the same pattern we witnessed starting in the second half of 2021; investors sought the safety of the biggest companies until even those were no longer attractive. Since the late 1920s, almost every major bear market and correction was preceded by this same situation. In fact, as it pertains to the S&P 500 there were only two instances since 1940 when breadth divergences were overcome without significant drawdowns – in 1988 and in 1994/1995. Compared to the more than three dozen negative divergences overall, these outliers represent a very low probability bet that breadth will ultimately not matter.
As we’ve mentioned in prior letters, there are aspects of the stock market we use to confirm the returns.
This helps not to get caught up in FOMO, fear of missing out. We take the weight of that evidence to guide our outlook. There are still quite a few pieces of the puzzle missing to lead us to believe the bear market ended in October. The good news is that we now have an alternative to earn a decent return by collecting the income generated by bonds or money market funds. This is a welcome relief after last year’s rapid rise in interest rates left us with very few places to hide.
Should the health of the market improve, we will be in touch. As always, don’t hesitate to reach out if you wish to discuss this further.