Large Technology Stocks Lead a Reversal in Market Trends
As we review the first half of 2023, simply speaking, it’s hard not to be pleased by stock and bond market returns. Taking a few additonal moments to consider the sentiment entering the year after negative returns in 2022, including the expectations of both economic and corporate earnings recessions, (not to mention the unanticipated regional banking crisis and debt ceiling negotiations!), we can easily move from anxious to pleased to relieved. Generally, economic and corporate earnings data have been better than expected – let’s dig deeper into the details to identify the key takeaways.
As we often see, there were vast differences in equity returns when peeled back by region, country, sector, and company. You may look at a particular index and wonder why your portfolio is earning more or less. Gains were concentrated at the top of the US market: the 10 largest companies comprise 31% of the S&P 500. While it’s not surprising that the largest companies make up a signifcant portion of an index that weights companies by market cap, it is unusual to have most of the top names be growth companies, exposing purely passive investors to risks they may not be aware of.
For example, the companies in the Information Technology (IT) sector (mostly growth companies) have a weighting of 28% of the S&P 500 Index but accounted for nearly 62% of the index’s year-to-date return. In other words, if we remove IT companies from the S&P 500 Index, YTD return decreases from 17% to 6.5%. This includes Nvidia, which rode the excitement of recent AI advancements to a 190% first half return. Outsized returns from large tech companies like Nvidia, Microsoft and Apple, drove the NASDAQ Index up 32% YTD (compared with -33% in 2022!).
Zooming out further, these large U.S. tech-focused companies have been the clear winners over the past ~15 years. Does this mean the trend will continue? After all, Apple just made headlines for being the first company to be valued over $3 trillion. Though it’s tempting to assume their dominance will continue, history has shown that today’s winners aren’t necessarily the winners of tomorrow. Evidence-based investing data shows smaller, relatively cheaper priced, and more profitable stocks have a statistically significant likelihood of higher returns over the long run.
Picture yourself as an investor that was deciding to allocate money to either technology-focused growth companies (represented by the NASDAQ Index) or small cap value companies (represented by the Fama/French U.S. Small Value Research Index) over the past 28+ years. The dot com bubble of the late 1990s drove 40% annualized returns for tech for five years until the bubble burst. From then to the Global Financial Crisis in 2008, tech returns were negative while small value was respectably 8%+.
Then we had the recent ~15-year period where it has seemed tech was the only game in town, outperforming small value by 6% annualized. Staying disciplined and committed to a strategy that underperformed during such an extended stretch isn’t easy! Even glancing at the returns for each index and time period, and doing some simple addition, it’s reasonable to assume that many people would choose to own the NASDAQ Index. But when returns are compounded over a true long-term period, small value has outperformed tech. Here’s a simple table and growth of wealth chart that summarize the results:
Sources for table & chart: Dimensional Fund Advisors, NASDAQ, CRSP databases for returns & market capitalization. Time period: 1/1/1995-5/31/2023. Past performance is not a guarantee of future results. Indices are not available for direct investment. See additional disclosure information below.
In addition, the earnings for these large tech companies haven’t caught up to their high valuations. Said another way, the market is pricing in lofty expectations, but decades of research shows that the price you pay for future earnings matters. This is why we put more focus on assets with cheaper valuations relative to their future cash flows, tilting the odds in our favor.
This discipline is not easy to maintain, but we believe it’s crucial to managing risk and delivering solid investment returns.
Earlier we mentioned key lessons, and we want to reiterate evergreen principles that we believe are important to bear in mind:
Diversification is essential to minimizing the risk of large losses.
Everyone wants more of what’s worked recently, but we don’t recommend driving your car by looking only through the rear-view mirror.
Discipline is rewarded over time when applied to an evidence-based, thoughtful investment approach.
Higher valuations decrease the odds of higher returns. Lower valuations offer more attractive buying opportunities.
Markets are cyclical and trends can change on a dime…timing is not an effective strategy.
There is never a shortage of events to worry about in the markets…but if all the risks priced in fail to fully materialize, returns can easily surprise to the upside (as they have YTD).
Economic resilience has been surprising so far. With global central banks continuing to tighten monetary policy (and the lag it takes having not fully set in) and the corresponding tightening lending conditions by banks, we expect a continued slowdown of economic activity for the remainder of 2023. Whether or not we can avoid recession for the rest of the year is anyone’s guess, but regardless of what happens, maintaining a prudent, disciplined asset allocation unaffected by short-term trends remains the best strategy.
We hope this message helps summarize recent drivers of short-term market returns while not losing sight of the lessons and factors that have been shown to drive positive investment experiences for investors over the long-term. Please don’t hesitate to reach out to your Wealth Management Team with any questions or updates on your personal situation.
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Index returns reflect all items of income, gain and loss and the reinvestment of dividends and other income. For WWP Important Disclosures and Index Descriptions: www.waypointwp.com/index-descriptions
The purpose of this content is to provide general information and does not constitute investment advice nor is it an offer or solicitation for the sale or purchase of any securities. The information represents the views of WWP at a specific point in time and is based on information believed to be reliable. No representation or warranty is made concerning the accuracy of any data compiled herein. In addition, there can be no guarantee that any projection, forecast or opinion in this material will be realized. Any statement nonfactual in nature constitutes only current opinion which is subject to change. Any reference to a security listed herein does not constitute a recommendation to buy, sell or hold such security. Past performance is no guarantee of future results. The historical returns of any securities and/or sectors mentioned are not necessarily indicative of their future performance. Any tax and estate planning information offered by WWP is general in nature. It is provided for informational purposes only and should not be construed as legal or tax advice. Always consult an attorney or tax professional regarding your specific legal or tax situation.
Investment Advisory Services offered through Waypoint Wealth Partners (WWP), a Registered Investment Adviser with the U.S. Securities & Exchange Commission. Registration does not imply a certain level of skill or training.
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