Be careful what you wish for might be an apt description for the third quarter. If you had given us (and probably most investors) the chance to sign up for lower inflation with higher economic growth, we would have gladly done so. However, instead of a broad-based rally, most financial assets declined in the third quarter. The primary headwind was concern about higher for longer, as longer-term interest rates, especially those five years and out, moved dramatically higher. The yield on the ten-year treasury bond has only briefly been higher in the last twenty years (see chart below) and has only risen faster on one occasion in the last sixty years (1980-81).
Following the Global Financial Crisis in 2008-2009 through 2021, the Federal Reserve (Fed) largely supported the economy and financial markets with low rates and balance sheet expansion (buying treasuries and mortgages). While the battle to cool the stimulus-fueled economy has been underway since early 2022, the market didn’t seem to fully appreciate that the era of easy money was over until now. With the Fed continuing to talk tough even as inflation has been retreating and with the US economy proving resilient, investors realized that even if the Fed stops hiking in 2023, widely anticipated rate cuts are unlikely anytime soon.
What are the impacts of higher for longer rates?
- Good for savers - cash and bond yields are now competing with stock returns.
- Bad for borrowers - interest rates on new fixed-rate loans and existing floating-rate loans are surging.
- Negative for stock valuations - using a higher discount rate reduces the present value of future earnings.
- Tough on (some) company earnings - even companies that built up cash and borrowed when rates were low will eventually feel the pinch if rates stay high.
- Costly for governments – as most countries took on massive amounts of new debt during the pandemic, higher rates will sting budgets as low-cost debt is rolled over.
- Headwind for economic growth - governments, consumers, and businesses will reduce outlays as they pay more in interest.
As the higher-for-longer scenario becomes the consensus view, it seems to us that the Fed is close to getting what it wished for. The Fed only directly controls short-term rates, while the market determines longer rates. The recent developments indicate that the market is taking the Fed’s mission seriously.
Bigger was better
While asset values were falling everywhere as the third quarter progressed, a look under the hood offers perspective on portfolio performance in 2023. Broadly speaking, yields on bonds and cash are up a lot, meaning bond prices are down, and stocks prices are up a little. The S&P 500 is the exception - it has returned 13.1% year-to-date. The biggest of the big, including the “magnificent seven” - Apple, Microsoft, Alphabet, Amazon, Nvidia, Tesla and Meta - are driving the S&P. They have gained 85% on average while the remaining 493 stocks are collectively flat on the year. Small and foreign stocks also posted meager returns through September.
Periods of top-heavy performance are nothing new. It was the FAANG gang in the 2010s, the tech darlings in the years leading up to 2000 and the Nifty Fifty (think IBM, Kodak, GE, Sears, and Xerox) in the late 1960s. FAANG morphed into the magnificent seven, dropping only Netflix (the recent underperformer of the group) and adding Tesla, Nvidia and Microsoft. But many of the favorites from earlier periods of heavily concentrated returns fell back to earth. The performance hangover for most Nifty Fifty and tech bubble names lasted years and some never recovered - Polaroid and Lucent, for example.
The magnificent seven now account for about 28% of the S&P 500 and 24% of the Russell 3000. Rock Point portfolios hold far less of the behemoth stocks - under 10%. Why not buy more? After all, it seems like we have been banging our heads against a wall by trying to keep pace with an index driven by stocks we (largely) don’t own. Most years (not including 2023, so far), we have held our own, or better, by finding opportunity elsewhere, but that doesn’t answer the question.
We are fundamental investors. We create valuation models that combine inputs such as sales growth and margins to estimate future earnings that are discounted back to the present at an appropriate interest rate. The goal is to find and own businesses that are trading at levels well below our valuation. We find the opposite to be true more often than not – the stock is trading for more than we think it’s worth. If overvaluation persists after a review of our assumptions, we move on to the next idea. In practice, our process is more complicated than that, considering other qualitative and quantitative factors, but creating the model is central to the search for undervalued investments.
Most of the magnificent seven are trading far above our calculated valuations. Taking Nvidia as an example, we would have to project an amazing level of earnings growth extending many years into the future to value the company anywhere near its current price. True, Nvidia could meet or surpass currently high expectations, but as was the case from late 2021 to late 2022 when the stock dropped from about $330 to $110, it can go the other way too.
In contrast, there are companies that could grow as much or more than Nvidia and/or have quality balance sheets with strong cash flows that are trading at bargain basement prices. In the current environment, most investors view these opportunities as “too risky” because they are worried about missing out on the AI revolution or because they wouldn’t touch a stock that has fallen 50% in nine months. We take the other side of that argument – as part of a diversified portfolio, out of favor, low expectations stocks can decrease the risk of performing poorly over the long run. We’ve been through many of these dislocations and if we’ve learned anything, it’s that they tend to last longer than we’d like, and that they also present some of the best opportunities we may see for many years. As is often the case in investing, the hard part is having the patience to see it through.
We are happy to report that we have added two new team members in the last year. Pat Curtis joined us as a Research Analyst from Los Angeles, where he was most recently in-house counsel at an internet advertising company. Dylan Mackie came on board straight from UVM and hit the ground running on our operations and client service team. Please find their full bios on our website.