Current Investment Outlook

Markets were strong in the first half of 2023, with both the S&P 500 and the NASDAQ rising well above their fourth quarter lows. The Dow Jones Industrial Average rose 4.9% in the first half, with the S&P 500 Index up 16.9% and the NASDAQ up a resounding 32.3%, as growth led and "safe stocks" lagged. While each market could reverse at any time, all of these averages are now in a confirmed bull market by having risen more than 20%. The first three quarters of 2022 painfully recorded the worst decline since the Financial Crisis of 2007/2008 and the so-called Tech Bubble of 2000. But, as you recall from our quarterly letters, we reversed our bullish stance over thirteen years at the beginning of 2022 and became more positive again at mid-year. Our negative call was perfectly timed, but the bullish turn was a little early. Although we were premature, our view gave us time to prepare for the sort of market we have seen in the first half of 2023. The market continues to face many challenges, including a healthy valuation and very narrow leadership. But, it keeps climbing its wall of worry, even in the face of a steeply inverted yield curve, one of the more reliable negative indicators. We remain cautious and observant, but we think stocks have room to rise at least somewhat higher from here.

Due to the severity of the Financial Crisis, consensus has been negative much or even most of the time since 2008. Caution was justified when the Fed raised rates too rapidly in late 2019, when COVID hit, and when the market discovered that it was going to have to deal with runaway inflation. In each case, however, the market has shown its resiliency and recovered. As we outlined in January, 2022, our one exception to a fifteen-year bullish view was when we saw that valuations had become excessive in late 2021. The decline was immediate and severe, and market psychology turned extremely negative, leading us to turn positive again on market prospects in July. As described above, that view was early, but correct.

Today, the market has a lot to worry about. It has been troubled about corporate earnings expectations, stock valuations, major geopolitical risks, poor fiscal and monetary policy, still high inflation, and excessive amounts of debt. Over the past decade, monetary and fiscal policy has been excessively expansive. The Federal Reserve has increased its balance sheet from $1 trillion to $9 trillion, and our government has spent another $5 trillion to stimulate the economy since the Pandemic. These funds have been created out of thin air and that is wildly inflationary. Regardless of earnings prospects and other developments, this is a burden the market must carry forward for years to come.

From 2008 through 2016, the Federal Reserve was trying to undue the Financial Crisis, and it did so by giving away free money. For a few years, they tried to reverse their Quantitative Easing program, but at the end of 2019, the market signaled that the Fed was squeezing too hard. When COVID hit a few months later, they went right back to their easy money policy. This approach persisted until the end of 2021. When they saw inflation beginning to run out of control, the Fed reversed course again, raising interest rates in early 2022 at the fastest pace in fifty years. The Fed waited too long with low interest rates and then found that they were in a position where they had to increase rates rapidly. Most foreign Central Banks followed suit. Today, the Fed expects to increase rates at least one or two more times, and pause a long time before cutting rates again.

Our Federal government spends too much money and borrows too much money. Without considering entitlements, our Federal debt outstanding is $32 trillion, equal to 97% of GDP. With entitlements, the picture is even worse, especially in relation to GDP. At the same time, the risk of corporate bankruptcies has risen and bad debt may be the next shoe to drop. There is some $5 trillion in questionable debt: $2 trillion in junk debt and $3 trillion in leveraged loans and private debt. Add to this the problem another $1 trillion in commercial loans to re-price or at risk. We already have the highest level of bankruptcies since 2009.

The latest measure of inflation was 3.0% for the Consumer Price Index, down from a peak of 9% but still above the 2% target. The latest reading reflects a collapse in natural gas prices following an unusually warm winter. Interest rates have declined, reflecting the improved inflation outlook, with the ten-year Treasury at 3.4% versus the Fed Funds rate of 4.8%. Mortgage rates have dropped to 6.8%, down from 7.4%, and on their way to an estimated 5% later this year.

Economists can't decide if our economy is going to slip into recession - or even if it may already have had a recession. And, if there is a recession, they can't decide if there will be a hard landing, or a soft landing, or a rolling recession across a number of different sectors. Real GDP grew 1.6% in the first quarter and is expected to rise 2% in the second quarter, with a 1.3% gain for 2023 and a 1.6% increase for 2024. Unemployment remains low at 3.5%, with 9 million job openings unfilled. The consumer balance sheet of investments and housing value is up to $167 trillion today from $85 trillion in 2007, with debt service over this period down from 13.2% of disposable personal income to 9.8%. Consumer confidence reached its highest level since May, 2022 and new home sales increased by 12.2%. The economy is healthy, but not strong.

There has been a great deal of discussion in recent months about Artificial Intelligence (AI). This has been an area of attention in the scientific world for decades, but it seems to be on a threshold of sorts for achieving practical applications. We find there are many ways to invest in AI suppliers, and we expect that wise use of its strengths can radically increase productivity. Once again, it is a new and exciting world.

The war in Ukraine continues as Russia bombs just about everything in sight. The U.S. and NATO pledge billions, but Ukraine is running short of ammunition - and we are too! China, North Korea, and Iran seem to rattle sabers on an everyday basis. President Biden shows advancing signs of age and often seems confused. His rival Donald Trump may return to challenge him next year. Both men face daunting legal challenges. We may not know where we are going politically, but we are going there fast!

Following declines in the second and third quarters, earnings for the S&P 500 are expected to rise in the fourth quarter and decline slightly for full year 2023 to $220 and rise to $230-245 in 2024. That would place the price-earnings (PE) multiple at about 18 times. The high-end consumer amassed savings during the pandemic and is in very good shape. In sharp contrast, the middle and low-end consumer is struggling with declining real wages, the pain of high inflation, and expanded use of credit card debt. Until a significant reversal in July, the market leadership has been dominated by a few stocks, including the so-called "magnificent seven." Narrow leadership is generally a risky circumstance for the market, but the recent broadening out is encouraging.

The stock market touched important lows in May, June, October, and December. Its behavior since those lows is entirely consistent with climbing a wall of worry. And, there is much to be worried about! But, good companies find a way to work through challenging environments, and this is what we see happening today. This is a perfect time to look for value in the stock market. There is no way to guarantee that the market won't go lower, but its valuation is not inconsistent with the prospects that we see for healthy earnings growth in many sectors.

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