FTDS - Third Quarter 2023 - CIO Overview
2023-09-22 01:10:00 ET
Summary
- One could use the word anomaly for Q3 of the stock market. S&P 500 performance for the first two months of the quarter was driven by the “magnificent seven” large-cap tech-oriented stocks.
- In my opinion, the issue of concentration versus diversification is currently pronounced.
- In our US Equity ETF portfolio, we are underweighting the tech sector. And we are strategically overweight the US aerospace and defense sector.
One could use the word anomaly for Q3 of the stock market. S&P 500 performance for the first two months of the quarter was driven by the “magnificent seven” large-cap tech-oriented stocks.
About half of the year-to-date performance of the S&P Index was driven by these seven stocks. The other 493 stocks’ combined performance was about half of the index.
In the US Equity ETF portfolio, we hold RSP , the equal-weighted S&P 500 ETF. It underperformed the cap-weighted SPY . Same 500 stocks; just two ways to position them. Both ETFs have long histories and liquid trading.
The performance difference is due to the heavy tech sector concentration in the cap-weighted index. We have a risk management diversification bias in the US Equity ETF portfolio when it comes to the portion in broad-based ETFs. That’s why we hold RSP and not SPY.
In my opinion, the issue of concentration versus diversification is currently pronounced. I’ve written and spoken about it, so let’s add two other public voices to the conversation.
In mid-September, Torsten Slok, PhD, Chief Economist & Partner at Apollo Global Management, put it this way in a public note: “The ten largest companies in the S&P 500 make up 34% of the index, and these ten mega-cap companies have an average P/E ratio of 50.”
Also, Wes Crill, PhD, Senior Investment Director, and Vice President of Dimensional Fund Advisors, added this in his public note (hat tip to Chad Burns for sending it to me):
“The top seven contributors to the US market - Apple, Microsoft, Alphabet, Amazon, Nvidia, Tesla, and Meta - have returned a collective 66.3%, accounting for a sizable portion of the Russell 3000 Index’s more than six percentage point outperformance versus the MSCI All Country World ex USA Index. Without these seven stocks, the Russell 3000 return falls from 20.3% to 10.8%, which would lag the non-US index with or without its top seven contributors. Of course, market concentration cuts both ways: benefiting in some periods (like this year) and detracting in others. One of the big selling points for global diversification is reducing your portfolio’s concentration, helping to mitigate the ups and downs from a handful of stocks. For example, the 25 largest US stocks account for about 38% of the Russell 3000 Index but just 23% of the globally diversified MSCI All Country World IMI Index.”
A few readers may recall that 23 years ago, when the NASDAQ bubble had not yet burst, I wrote about the extreme concentration of tech sector risk at the time.
That paper, titled “Will the NASDAQ selloff become a crash?” was published on April 1, 2000, 23 ½ years ago. The paper discussed why the overvalued concentration in the tech sector was likely to burst.
In our US Equity ETF portfolio, we are underweighting the tech sector. And we are strategically overweight the US aerospace and defense sector. Clients can see this in the private note on their reports.
I believe the defense sector will be very busy for years to come. The recent Putin-Kim summit is an indication why. As a citizen, I would prefer a peaceful world. But we don’t have it, and our adversaries are increasingly dangerous to America, in my opinion.
We are watching the political turmoil in Washington and the nasty fight over the US budget. It’s not likely to get better. Political dysfunction erodes investor confidence, so you see a cash (or cash equivalent) reserve in the portfolio. With opportunity, we can deploy that at any time.
Let’s segue to bonds and another anomaly. The political culture war in the US, the debt ceiling fight, and now the budget fight are taking a toll on America’s credit standing in the world, in my opinion.
Many keep saying that all is fine and the US will never default. Maybe so, but the world doesn’t seem to trust us as much as it used to.
Let’s examine some evidence that supports me making that statement. Our inference is that there is causality between what you’re about to see in the charts below and the politics of confrontation over America’s credit.
I cannot prove the causality and can only demonstrate the coincidence. But I cannot find any other evidence of causality. So here goes.
The first chart below shows the credit default swap pricing on the US government. This is the 10-year instrument. Notice where it was on January first.
Notice the spiking up to May and then the retrenchment after the “Biden-McCarthy deal.” Then notice the new spiking back to the old peak levels after the small group of confrontationists in the House caused the Biden-McCarthy deal to unravel.
The takeaway is that the world’s bond investors don’t trust us as much as they formerly did and are demanding a higher amount of credit default insurance protection against a US default.
(That would include a late payment, which would be an item of default even if it were subsequently cured.) We’ve written about this and remind our readers of our July 30 paper on the debt ceiling.
Here’s the link: “ The Cost of Debt Ceiling Crisis .” Let me thank my colleagues Shaun Burgess and Tom Patterson for their help with this graphic.
The second piece of evidence is the credit spread between the direct US government Treasury yield curve and the US federal agency yield curve. Note that the federal agencies have also been downgraded by rating agencies, just as the US Treasury has been.
The federal agency spread at the 30-year maturity is now (September 15) about 80 basis points, according to Bloomberg data. On January 1 of this year, that spread was about 45 basis points.
Note that there is only a one or two basis-point spread at the one-year maturity. We infer that the market is saying, “We’re not worried about getting paid in the next year, but we are increasingly worried about the commitment of the United States as we look farther out into the future.” Again thanks to colleagues Dan Himelberger And Tom Patterson for this graphic.
For reference, here is the same agency-Treasury spread on January 1 of this year. You can observe how the spread has widened as the political debt ceiling and budget fight damage has occurred, and how it has impacted the creditworthiness of the United States in the eyes of the world.
A consequence of the higher longer-term federal agency interest rate spread is that it impacts home mortgage rates in the United States. The federal agencies of Fannie Mae, Freddie Mac, FHA, and GNMA are the largest combined mortgage operators in the world.
If they must pay more for their money, and they borrow from sources worldwide, then they must ultimately impose a higher mortgage interest rate for the lending to the new home buyer in America.
So, in my opinion, the impact of the political dysfunction in Washington is ultimately being paid for by an additional $30–$40–$50 a month in added mortgage payments by new-home buyers in the United States.
Those buyers don’t realize they will be paying more than they would otherwise be required to pay because of congressional dysfunctional politics. If they did, we believe the public reaction would be strong enough to change this systemic flaw in our national politics.
I’m not sanguine about the politics of our country. We have a little over a year to go before the 2024 national election. I think the nation’s politics will increasingly influence market behavior now that the primary process in both the Democrat and Republican parties is intensifying.
Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.
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Third Quarter 2023 - CIO Overview