Divergence Continues

Market divergence

I’ve written a few times about the divergence in equity markets this year, and that divergence continues. In the U.S. the S&P 500 gave back a chunk of its YTD gains since July but is still up +9.35% as of October 31st.

Meanwhile, an equal weight index of the S&P 500 has turned negative, at -0.26% over the same period. Equal weighting (EW) reduces the skew in returns of 2023 caused by a handful of large-cap tech stocks (the Magnificent 7).

Some may criticize EW as “make-believe” (and they have a point), but the same reality is observable in other “real-world” market indices. For example, the widely followed (and original) U.S. stock market index, the Dow Jones Industrial Average (DJIA), is down – 3.84% for the year.

The DJIA is made up of the 30 largest “blue chip” stocks in the U.S., mostly global conglomerates. And while there are some tech stocks in the index, the only Magnificent 7 that makes the list is Apple. Removing AAPL would result in an even lower YTD return. But even without make-believe adjustments, the DJIA shows real-world results less skewed by large-cap tech.

SPY vs RSP vs DIA

Market implications

The divergence in market returns implies a couple of issues. First, the YTD rally in U.S. stocks is not as strong as it appears on the surface. EW and DJIA returns reveal investors are not buying into the average stock. Rather they are crowding into a small handful of names they see as safe bets, and betting that a small number of winners will keep winning. That does not reflect broad and strong bullish sentiment.

Second, the divergence reflects a high level of uncertainty priced into markets. In other words, if sentiment was widely bullish, we would expect to see higher and more consistent returns across stocks. Instead, we have a dichotomy where a few stocks are doing exceptionally well, while most are struggling to find direction. Unlike in 2021 when market sentiment was clearly positive, and in 2022 when it was clearly negative, market sentiment in 2023 remains clearly undecided.

Macro perspective

No surprise, the divergence in markets reflects similar uncertainties lingering in the economy. While economic conditions were convincingly negative at year-end 2022, they have fluctuated up and down throughout 2023, perplexing economists and investors alike.

For example, consumer sentiment is a closely watched economic indicator in the U.S. because consumption is the largest component of American GDP. Simply stated, how consumers feel about their finances and the economy influences how much they are willing to spend (consume).

The University of Michigan runs the most widely followed index on consumer sentiment. Historically, sentiment is positive when the Consumer Sentiment Index is above 80, not positive below that level, and recession typically follows readings below 70.

UoM Consumer Sentiment Index

The October reading came in at 63.8. Save for a brief window in 2021, fueled by COVID government stimulus, sentiment has been below 80 since the 2020 pandemic. Furthermore, most of the period since 2022 has been below 70.

A deeper look reveals why consumer sentiment may be so gloomy. After a short-lived spike from government stimulus, personal savings have drawn down at a rapid pace post-COVID and are near the lowest levels in more than two decades.

U.S. Personal Savings Rate

Meanwhile, consumer debt has ballooned over the same period. An alarming statistic is debts like credit card balances have grown faster than debts like mortgage balances. That matters because credit card debt is not “good” debt. It’s unsecured, has higher interest rates, and is often used to subsidize unproductive consumption versus productive investment. Against that backdrop, it’s no wonder why consumer sentiment is also not good.

Total Consumer Debt

However, like with markets, economic indicators are also showing divergence. A simple way to see this is with an aggregate economic index like the OECD’s Composite Leading Indicator (CLI) which combines a range of data into a single measure. After falling throughout 2022 and into Q1 2023, the U.S. CLI registered 6 straight improvements since March 2023.

OECD U.S. Composite Leading Indicator

While not all underlying measures are seeing improvement (e.g. consumer sentiment), the overall big picture is of marginally improving economic conditions. Admittedly, that is not outstanding good news. But still, we can say current conditions look better than they did at the start of the year.

Reaching, we could also say it looks more likely the U.S. has achieved the soft landing that appeared unattainable last year. At the very least, we can say the likelihood of a near-term recession is less than the 100% predicted last year.

Investing implications

Uncertainty is part and parcel of investing. So, in that sense, we could say conditions are not unusual and are getting back to business as usual. If that is the case and the U.S. avoids a recession, then we can expect the progression of the next expansionary cycle. As that unfolds, we’d also expect markets to respond accordingly with risk assets (like stocks) advancing more broadly than they have.

Of course, the nature of uncertainty is we don’t know what will happen next and anything is possible. What ultimately comes next only time and data will tell. To that end, if the data on economic and market conditions continue to improve, then we will continue to increase our allocation to risk assets. Fortunately, we should have ample time to do that because expansionary cycles typically last for years, the most recent lasted for over a decade.

Our next move, in that case, would be to adjust from our current modest underweight risk position to a market or neutral weight position. In time, and as the data justify, we could move to an overweight position. Keep in mind this process works the same in both directions. In other words, if conditions unexpectedly deteriorate, we would be equally ready and willing to derisk. Unfortunately, we do not know which direction the next step will be, but we are watching, waiting, and ready to move.

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Victor K. Lai, CFA