The More Things Change, the More They Stay the Same

Thoughts on the Current Environment

Third Quarter 2023

by Ralph Segall, CIO

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“If you know what’s going on, you don’t need to know what’s going on to know what’s going on.”

The Money Game, “Adam Smith,” 1968


Reflect for a moment, if you would, on the quote above that graces this edition of Thoughts on the Current Environment. It was written about and during a time of a wild and wooly bull market. There was a great deal of unrest in the country—an unpopular war in Vietnam, social unrest sparked by assassinations, and political instability. Business and consumers were grappling with seemingly intractable inflation. On the floor of the New York Stock Exchange, shares of a steadily declining number of stocks continued to advance but, for most, the bull market had ended. Those that were advancing were referred to as the “Nifty Fifty,” and they were driven by a strong belief that the opportunities for their growth were unlimited and immune to any of the issues affecting the rest of the economy. This belief in the durability of the prospects for the Nifty Fifty would last into 1970, but the reality of fundamental economic forces and interest rates, and their effect on valuations, would ultimately bring these highfliers back to Earth.


Another factor that weighed on markets was investor psychology. As Smith1 put it:

Markets are only a tiny facet of society, but being made by mass psychology, they are a good litmus paper for what is going on. Markets only work when they believe, and this confidence is based on the idea that men can manage their affairs rationally. The longest period of prosperity in the last few hundred years came when everyone believed that the king was on the throne, that the pound was worth a pound, that God was in His Heaven, and that all these things would continue for ever and ever…In the longer run, the actions of all the investors, individual and institutional, professional and nonprofessional, have to be based on the belief that leadership knows what it is doing and that rational men are handling the nation’s business rationally. If that belief fades, then so do the markets.”


History Doesn’t Repeat Itself, but it Rhymes

The relevance of that era to 2023 is not a forced one. We are moving through a similarly tumultuous period, both societal and economic. Politics in this country are as polarized and volatile as possibly any other period in history, short of the period of the Civil War. Global economic changes triggered by the COVID pandemic continue to impact both Main Street and Wall Street. Inflationary pressures, initially triggered by pandemic-related supply chain failures and stimulative monetary policy, have moved from “transitory” to reality. Central bankers around the globe have taken aggressive measures to reign in rising prices. While these measures appear to be working, inflation remains above targeted levels. Interest rates are close to reaching a point at which they will truly begin to bite—when they exceed the Consumer Price Index (CPI) and begin to be positive on a “real” basis—and various sectors of the economy are starting to feel the effect. We note that the yield curve2 remains “inverted”—short term rates are higher than longer dated rates—which has historically been associated with economic downturns.

In previous editions of this newsletter, we have noted many reasons why global economic growth may be facing headwinds going forward. There are numerous reasons for an investor to be cautious. The market results of 2022 were a dramatic reminder that security prices do not move in just one direction. Apparently, however, despite all this uncertainty and societal turmoil, optimism has not been lost. The financial markets in 2023, at least through June 30, have reversed course and produced positive returns. Although the Federal Reserve and other central banks have continued to raise short term rates, fixed income markets, benefiting from higher current yields, have produced positive returns. Stocks, as well, are up 16.17% for the first half of the year. No recession has developed despite the significant number of economists forecasting doom. Employment gains have stayed strong, inflation has come down and the budget crisis has been addressed, at least until 2025. And on top of that lies the development of artificial intelligence (A.I. platforms, such as ChatGPT, promising to transform virtually every aspect of life). So, it turns out, all is well. Or is it?


What is Lurking Just Beneath the Surface, and Why it Matters

In the markets, it pays to remember that often all is not what it seems to be. The stock market, according to the most commonly followed indices, the Russell 3000® Index and the S&P 500® Index3, both considered to be representative of a broad spectrum of publicly traded domestic large and small companies, are up 16.2% and 16.9%, respectively, through June 30, 2023. Delve one layer down, however, and the story is a bit different. Reminiscent of the late ‘60s Nifty Fifty period, an unhealthy concentration in a very few companies has led to positive index returns, while the overall results of the broad market are quite a bit less robust.


Source: FactSet. Year-to-date return through 6/30/23. Past performance cannot guarantee future results. All investments involve risks, including the potential loss of capital. Indexes are unmanaged and do not incur fees. One cannot invest directly in an index.


As the table starkly shows, the favored 10 names in the Russell 3000 Index are doing just fine in the market this year, thank you, while the rest of the market is up modestly. It is indeed the case that the profits of these favored 10 companies are growing better than the rest of the economy, surprising investors with much better-than-expected profitability in the first half of 2023. But it is equally clear that the valuations the market is placing on this tiny subset of companies reflect growth rates into perpetuity that seem a bit unrealistic, in my opinion.


Diversification is one of those rare things in life: a free lunch. Don’t sell it short.


Source: FactSet. Year-to-date data in 2023 is through 6/30/23. All investments involve risks, including the potential loss of capital. One cannot invest directly in an index.


As the chart above shows, the major stock market indices are at the highest concentration levels in history. It’s important to remember that index returns are capitalization weighted. This means that the largest companies have the largest impact on the index returns. As you can imagine, the positive stock returns we are seeing are being dominated by literally 10 companies. The experience of concentrated portfolios is that they work…until they don’t. For the vast bulk of our clients, diversification is a valuable tool over the long run. This is as much the case for institutional clients such as pension funds or endowments as it is for wealth management clients. For portfolios that are now in or approaching distribution, it is not necessary or advisable to take the increased risks that concentration creates. Just to show one small example, our standard practice is to limit the size of any given holding to no more than 5%, measured at market. At June 30, there were two holdings in the Russell 3000 Index whose weight exceeded that. Two issues, which have a weight of only 6.7 basis points4 in the equal-weighted index, constitute 1,130 basis points in the cap-weighted index.

Just like the Nifty Fifty, a small group of companies can dominate in short periods of time. Often these periods are only identified in retrospect. The economic and societal volatility we face currently has created a situation where 10 stocks dominate the markets. Can this last? Of course not, but it can certainly be a powerful force in the meantime. A question that could be reasonably asked is if we can see this now clearly, why we do not own more of those stocks in our portfolios. The answer is simple. We are long-term investors and fiduciaries of capital. History has shown that approaching the markets with a long-term approach works. We may miss short sprints such as we are seeing, but these parabolic-like run-ups ultimately end badly, in my experience. Shrewd analysis, patience and diversification remain the bedrock of our work. To try to play the “Money Game” in the short term is an exercise in divining the psychology of crowds, an exercise at which very few are winners.


We would like to acknowledge the contributions of Michael Chilla, of our Quantitative Research team, for his assistance in the preparation of this edition.


Market Barometer
As of June 30, 2023

Source: FactSet. Past performance cannot guarantee future results. All investments involve risks, including the potential loss of capital. One cannot invest directly in an index.


1“Adam Smith” was a pseudonym for George Goodman, a financial writer and journalist.

2A yield curve is a graphical representation of interest rates on bonds across a range of maturities.

3The Russell 3000 Index is a market capitalization weighted equity index that provides exposure to the entire U.S. stock market. The index tracks the performance of the 3,000 largest U.S.-traded stocks, which represent about 98% of all U.S.-incorporated equity securities. The S&P 500 Index is a market capitalization weighted index that measures the performance of about 500 companies in the U.S. It includes companies across 11 sectors to offer a picture of overall U.S. stock market and the broader economy. One cannot invest directly in an index.

4A “basis point” is 1/100 of 1%, or, 0.0001.

This information is for educational purposes and is not intended to provide, and should not be relied upon for, accounting, legal, tax, insurance, or investment advice. This does not constitute an offer to provide any services, nor a solicitation to purchase securities. The contents are not intended to be advice tailored to any particular person or situation. We believe the information provided is accurate and reliable, but do not warrant it as to completeness or accuracy. This information may include opinions or forecasts, including investment strategies and economic and market conditions; however, there is no guarantee that such opinions or forecasts will prove to be correct, and they also may change without notice. We encourage you to speak with a qualified professional regarding your scenario and the then-current applicable laws and rules.

Different types of investments involve degrees of risk. The future performance of any investment or wealth management strategy, including those recommended by us, may not be profitable or suitable or prove successful. Past performance is not indicative of future results. One cannot invest directly in an index or benchmark, and those do not reflect the deduction of various fees that would diminish results. Any index or benchmark performance figures are for comparison purposes only, and client account holdings will not directly correspond to any such data.

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