Wealth Matters Newsletter - July 2023

Artificially Inflated by Artificial Intelligence?

Written by: Mark P. Bernier, CFA, Senior Vice President/Wealth Management Officer

The tech-heavy NASDAQ Composite marked its best performance for the first half of the year since 1983.  The 32.32% return even exceeded returns experienced during the exuberance of the dot-com bubble of the late 1990s.  Commercial applications of artificial intelligence (AI), particularly generative artificial intelligence (AI that can generate content such as text, imagery, audio, or synthetic data), was a driving force behind the rally to date.  The S&P 500 and Dow Jones Industrial Average indexes also delivered strong performance during the first half of 2023 at 16.88% and 4.94%, respectively, but their relative exposure to technology names left them lagging the NASDAQ.  Is this the beginning of another bull market?

The second quarter of 2023 was not all sunshine and rainbows, despite the positive performance of the stock market. Stresses in the banking system that were at the forefront of investors’ psyches at the end of the first quarter were still present and visible during the second quarter.  First Republic Bank, the $229 billion dollar San Francisco-based lender that catered to high-net-worth customers, became the second largest bank failure in U.S. history on May 1, 2023.  First Republic had idiosyncratic risks, much like Silicon Valley Bank and Signature Bank, that were exposed by the U.S. Federal Reserve’s aggressive monetary policy actions.  Indeed, the Fed raised the Fed Funds rate another 0.25% at its May Federal Open Market Committee (FOMC) meeting, before pausing at its June meeting.  While the Fed acknowledged strength and resiliency in the economy, it also recognized that inflation remained elevated and forecast at least two more rate hikes in 2023.  The Fed will be paying close attention to the Senior Loan Officer Opinion Survey throughout the year for signs of contraction in credit availability.  Tightening of credit conditions, in response to banking turmoil earlier in the year, could aid the Fed in its efforts to reduce inflation.  As of this writing, the Fed Funds futures markets are predicting over 87% probability of another quarter-point rate hike at the July FOMC meeting.

Some recent data on the U.S. economy supported the resiliency the Fed noted in their commentary from the June FOMC meeting.  First quarter gross domestic product (GDP) growth was revised up to 2.0% from an initial reading of 1.1%, over 1.3 million new jobs were created year-to-date through May, and orders for durable goods (items meant to last a long time) grew for their third month in a row through May.  However, recent readings on U.S. manufacturing activity showed eight consecutive months of contraction and the service side of the economy showed activity that was just barely expansionary; consumer spending in the U.S. slowed significantly to end the quarter.  Internationally, European manufacturing powerhouse Germany is already in recession and significant weakness in Chinese economic is already being felt by its trade partners around the world.

U.S. corporate earnings releases for the second quarter are set to begin during the second week in July.  According to FactSet Research Systems, Inc., earnings for S&P 500 companies are expected to decline by 6.8% over the prior year.  If this comes to fruition, this will mark the third consecutive quarter of negative earnings growth.  This is one of our primary concerns for the sustainability of the market returns: high valuations.  At the end of the quarter, the forward price/earnings multiple of the S&P 500 was 20.4x, higher than the five and ten-year averages of 18.6x and 17.4x.  This means investors are willing to pay more for stocks relative to the earnings the companies generate now than at any time over the last five and ten years, on average.  With interest rates already at the highest levels we’ve seen in over a decade, and the potential for additional rate hikes this year, the backdrop for sustained stock market strength is questionable.  Additionally, the VIX – a measure anticipated price volatility of the S&P 500 – ended the quarter at 13.59, the lowest levels since January 2020.  Low VIX readings can imply investors complacency and leave markets susceptible to unexpected moves.  Lastly, market breadth – the number of stocks contributing to returns – has narrowed.  The S&P 500 is a market capitalization weighted index: larger companies represent a larger percentage of the overall index.   When the constituents of the S&P 500 are weighted equally, the year-to-date return drops from 16.88% to 7.03%.

Generative AI may very well be a paradigm shift for the global economy, leading to meaningful increases in worker productivity.  If history is any guide, productivity gains from improved technology take time to develop and translate into earnings.  The sizeable gains for segments of the markets this year may reflect the promise of this new technology’s impact, but may have moved a bit too far, too fast.  

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