Every piece has a place that determines where you start
If a piece is missing from where the parts should meet
It distorts the whole picture and the puzzle can’t be complete – Anonymous
For investors focused primarily upon the behavior of the financial markets the first quarter seemed to offer a relatively normal recovery from a difficult 2022. Both bonds and stocks rose in value, so it wasn’t difficult to feel a sense of relief as last year’s 15% losses for 60/40 stock bond investors provided the welcome relief of 3 ¼ % profits. The onset of the new year offered the hope of something a bit better than that though as January represented close to the entirety of the quarter’s gains with February drawing down some portion of those profits and March restoring the greater amount of them with the S&P 500 rising 7.50% for the quarter and 3.7% for the month. The fixed income markets mirrored the equity markets by rising in January, falling in February and rising again in March. While a cursory glance of the equity markets might not reveal much in the way of the dramatic, a closer examination of the market exposes something a great deal more interesting.
The first hint of something interesting lying beneath the surface of the returns of the indices is by observing the dramatic variance in the returns of the indices themselves. The Dow Jones Industrial Average was up less than 1% but the Nasdaq Composite was up 17%. Of the eleven sectors of the S&P four, Utilities, Health Care, Energy and Financials, were negative. Three, Information Technology, Communication Services and Consumer Discretionary, were positive by double digits. Digging a bit deeper still one would discover that Information Technologies’ 21.6% return and its two largest companies, Microsoft and Apple, with a combined weighting of 44% of that sector and whose returns of 20% and 27%, representing 48% of that sector’s return, aren’t very far distant from one another. The truth that the stock market is back to riding on the returns of the “mega cap” technology companies is revealed by investigating the returns of the other two sectors. Second place Communication Services is dominated by the 38% weighting of Meta (Face Book) and Alphabet (Google) with respective returns for the quarter of those two companies of 76% and 17 ½%, explaining 76% of that sector’s return of 21%. Third place Consumer Cyclicals’ combined weighting in Amazon and Tesla is 34% and with returns of 23% and 68%, are responsible for 78% of that sector’s performance of 16%. So, we’re left confronting the reality of an entire index being dominated by the performance of six companies, representing 19% of the capitalization of the index, providing 69% of the S&P 500’s 7 ½% return for the quarter.
The onset of April brings showers, but it has also brought investors the welcome relief of the prospect of a Fed declaring victory over inflation and ending its rate rising cycle. In a world where debt is three times the size of the global economy, we’re well past the point of paying down the debt so we’re left with the need to refinance it by borrowing new money to issue new debt to replace the “old” debt as it matures. For the “treadmill” to continue to turn over the world depends upon the availability of collateral; the requirement for an asset to support the existence of the loan. The availability of that collateral is referred to as liquidity and since 2022, central banks, ostensibly concerned about levels of inflation, have caused global liquidity conditions to be a receding tide, leading to the inevitability of something in the global financial system breaking and indeed, the likely cause of the market declines in 2022. The current inverted yield curve, in which longer maturity securities pay lower rates of interest than those of shorter maturities, is an indicator of a lack of system liquidity. In March we had two banks in the United States requiring support to avoid the possibility of a larger problem in the banking system. Interestingly though, the onset of “the banking crisis” led to a recovery in the stock market as the S&P, whose year to date return had fallen to less than 1% on March 13th, added 6 ½% to that number by month’s end.
The future would now seem to be able to be seen with a bit more clarity. Until mid-month investors were caught up in a confusing mix of good economic news being bad financial market news due to the belief that the Fed wanted slower rates of economic growth in its quest for a lower rate of inflation. While the Fed denied that its response to “the banking crisis” at mid-month represented any sort of retreat from its policy, the reality of its response is likely to be characterized by a restoration of the pro-liquidity actions of its policy from the onset of the pandemic in early 2020 through 2021, as demonstrated by a dramatic narrowing of the yield spread between two year and ten year treasury rates from nearly 1% at the onset of the month to close to ½% at the month’s end. So, if we’re back to inhabiting a world in which good economic news is also good financial market news what should investors expect over the next several months?
The reality of a world characterized by very high levels of debt means that the provision of an adequate level of liquidity is the single most important determinant of the outlook for the stock market. As its insufficiency explains the negative returns delivered by the 2022 stock market, so is its restoration likely to be the source of the positive returns experienced by investors in 2023. Remember, debt is a global and not just a domestic phenomenon and with global capital flows of $170 TRILLION and the value of the US stock market $44 trillion a 5% change in the former represents a 20% change in the latter.
Mark H. Tekamp; April 10, 2023