Equity Outlook: Beware the Narrow Market

Beware the Narrow Market

With the S&P 500 up nearly 17% year-to-date through June 30, 2023, one might assume that we are in the midst of a broad rally underpinned by a healthy and growing economy. However, stock market gains have been unusually narrow so far this year. In fact, through the end of May 2023, just seven companies – each of which benefited from recent excitement around artificial intelligence (AI) – had driven all the gains in the market. Excluding those companies, as of 5/31, the S&P 500 was down year-to-date, and there are many crosscurrents in the economy that are creating significant uncertainty:

  1. Inflation is clearly easing, but it remains double the Fed’s target
  2. Unemployment is near multi-decade lows, which means jobs are plentiful, but tight employment may contribute to elevated inflation and thus higher interest rates
  3. The overall economy continues to grow, but we see indications of severe stress in key sectors

The question going forward is whether we are in the midst of a “soft landing”— in which case the recent market gains will almost certainly broaden out — or if we are facing a “hard landing” whereby the narrow market capitulates. Regardless, we believe that the best course of action for equity allocations is to own a concentrated portfolio of Quality Growth companies that generate significant free cash flow and growing dividends to help protect against downside risk while still participating in potential market upside.

Less than Meets the Eye

On the surface, it appears that the economy is as healthy as ever, with risks rapidly receding after a bout of rampant inflation in 2021 and 2022. For instance, the most recent report from the Bureau of Labor Statistics reported year-over-year headline inflation at 4.0% as of May 2023, down from 8.6% in May 2022. Unemployment of 3.7% as of May 2023 reflects a very tight labor market near multi-decade lows. And real GDP growth in the first quarter of 2023 came in at a tepid, but respectable, 1.3% year-over-year.