The Real Story about Q1’s Big Stock GainsBy datatrekresearch in Blog
After a strong Q1 for US/global equities, how should investors think about portfolio composition for Q2 and the rest of 2023? If this is the beginning of a new bull market, then it makes sense to keep equity allocations stable or even increase them. On the other hand, if Q1 was just a head fake, then taking profits here is prudent.
Three points on this thorny question:
#1: Keep in mind that Q1’s equity market performance was concentrated in a very small group of names:
- The S&P 500’s Q1 price return of +7.0% was entirely driven by US Big Tech. The percentage point contributions were as follows: Apple (1.8 points), Nvidia (1.4 pts), Microsoft (1.2 pts), Tesla (0.9 pts), Meta/Facebook (0.8 pts), Alphabet/Google (0.6 pts), and Amazon (0.6 pts). The total here is 7.3 points, which means the S&P 500 would have been down 0.3% in Q1 without them.
- MSCI Europe was up 10.3% for Q1 in dollar terms, but 9.0% in local currency. On top of a strong euro, European equities were also helped by Financials (1.1 percentage point contribution), ASML (0.5 pts), LVMH (0.5 pts), Novo Nordisk (0.4 pts) and SAP (0.3 pts). Without currency, Financials, and these 4 names, MSCI Europe’s Q1 gain would have been 6.2 percent (40 pct less than the headline number).
- MSCI Emerging Markets was up 4.1% in Q1. Over half of that gain was due to Asian Big Tech. The point contributions: Taiwan Semi (1.5 pts), Tencent (0.7 pts), Alibaba (0.3 pts). The total is 2.5 points of that 4.1% gain, or 61 percent.
Comment: Q1’s global equity market gains were concentrated in a handful of stocks and also driven by a weaker dollar. US large cap investors would be down on the year without US Big Tech, and dollar-based investors would have much smaller gains were it not for European Financials, a few large cap names, and a weaker greenback. Narrow market leadership is rarely a good sign about overall market health.
#2: Markets are pricing in a series of Federal Reserve rate cuts in the second half of 2023 despite explicit guidance from the US central bank that this is not their gameplan:
- The latest FOMC Summary of Economic Projections, out just last month, shows that the committee believes Fed Funds will end the year at 5.1%.
- Fed Funds Futures currently put the highest odds on Fed Funds ending the year at either 4.25 – 4.50% (35% probability), 4.50 – 4.75% (26%) or 4.00 – 4.25% (23%).
Comment: Markets have run out well ahead of the Fed in terms of expected future monetary policy. They may be proven correct, but only if the US economy cools sufficiently to reduce inflation. Which brings us to our third point ...
#3: Contrast the market’s view of future interest rates (lower, due to an economic slowdown) with Wall Street analysts’ S&P 500 earnings estimates (going to new record highs by Q3 2023). The following FactSet chart shows the Street’s expectations for Q1 2023 – Q1 2024 index earnings per share (light blue bars) and compares them to Q2 2021 – Q4 2022 actual results:
Comment: It is hard to square the market’s view on rates with analysts’ views on earnings, and the latter is the only thing making the S&P 500 look reasonably priced here. The S&P 500 is at 4,100. If the Street’s 2023 numbers are correct ($220/share), then the index trades for 18.6x current year earnings. If the Street is wrong, and the index can only earn $51/share per quarter (the Q1 2023 estimate), then the S&P is trading for 20.0x earnings. We can certainly justify an 18.6x multiple if the Fed is about to cut rates and earnings will shortly make new highs. But a 20.0x multiple seems too high if rates are not coming down and earnings are merely stable the rest of the year.
Takeaway: April tends to be a good month for stocks, so we suggest considering any market strength this month as an opportunity to reposition portfolios, reducing equity exposure and adding shorter term bonds in their place. This is not a “bearish” call as much as it is a “let’s be careful” call.
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CME FedWatch Tool: https://www.cmegroup.com/markets/interest-rates/cme-fedwatch-tool.html
Latest FOMC Summary of Economic Projections: https://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20230322.pdf