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As we enter our company’s 36th year, we are very mindful of the significant changes in the investment world compared to the 30-year period from 1989-2019. That prior period was characterized by strong enabling of technology as the entire world was wired with broadband and real time networks made it easier to run global supply chains. A lot of US manufacturing was outsourced to low-cost countries, primarily China, which became part of the World Trade Organization. Globalization was rising and was a significant disinflationary force. Companies were shareholder driven with a primary goal of maximizing shareholder returns. Just-in-time manufacturing and other efficiency-enhancing measures were prioritized. And for 40 years, interest rates and inflation were on a strong downward trend. From 2009 – 2021 the Federal Reserve kept short term rates at essentially zero percent. Now the environment of easy monetary policy is ended.
With Covid, many of these secular trends began to reverse. There are increasing barriers to cross border data flow to protect privacy and national security. The US and China are decoupling, and globalization is no longer viewed as a positive. Companies are more concerned about just-in-case rather than just-in-time. Supply chains that were focused on efficiency are now more concerned about resiliency, and onshoring and near-shoring are becoming more prevalent. Increasingly, CEOs are being told, “Don’t just maximize shareholder value – think about more of your stakeholders.” And, of course, interest rates and inflation have been rising from historically low levels.
In the post-COVID era, stock valuations, inflation, and interest rates are all higher. Demographic trends (aging populations and fewer workers), decarbonization, and deglobalization are all inflationary. Equities historically have been the highest-returning asset class over the long term, and we see nothing to alter that precedent. However, higher stock valuations plus higher interest rates mean less return from markets broadly. While falling interest rates and easy monetary policy led to strong gains in the broad stock market, we now see more dispersion in earnings estimates, valuations, and stock returns. We believe stock selection will be rewarded as investors prioritize company fundamentals. Free cash flow will become increasingly important. So will dividends. Innovation has provided innumerable benefits over the decades and has been increasing. Technology will benefit. Anything that reduces unit labor costs will take on increasing importance.
The first half of 2023 was a good period for stock market indices, less so for many individual stocks and sectors. The S& P 500 rose 16% in the first half of 2023, its best first half since 2019 and at a 52-week high. The bottom seven performing sectors are up only 1.0% on average with 223 of the S&P 500 having negative YTD returns. Apple, Microsoft and five other tech giants (the “magnificent seven”) have returned an average of over 50% this year accounting for virtually all the market’s positive performance.
On a positive note, the stock market has gained over 10% in the first half of the year 28 times since 1929. In 21 of those years, the advance continued throughout the second half with an average second half increase of 6%. 1929 was the only one of those years to finish the year in negative territory.
Economically, the biggest theme in recent months has been “where’s the recession?”. The average American is employed and still enjoying the savings accumulated during the pandemic. Resilient consumption and employment conditions have stalled a recession. While investors have hunkered down in cash, as shown by the extraordinary flows into money market funds, this also suggests record levels of sidelined cash that could eventually make its way into the economy and markets. Past episodes of peak money fund flow have historically been followed by strong returns from equities.
Markets are said to climb walls of worry, and one thing that hasn’t changed throughout our company’s history is that there are always many things to worry about. There are always potential drawdowns and negative developments that could occur. It is precisely those worries that create investment opportunities.