Bob’s Journal for 6/8/23

The Stock Indexes Are Misleading Investors

The S&P 500 is up 12.11% so far in 2023, but many investors didn’t earn those returns because only a few stocks contributed to the index’s gains.

In the month of May, the S&P 500 had a 0.25% return. But the 10 largest stocks in the index had a return of 9.11%. The other 490 stocks lost 4.11%.

Almost all the positive returns in the index in May were in technology stocks with some consumer discretionary and communications services stocks joining in. All the other sectors in the S&P 500 had negative returns in May.

The 10 largest stocks in the index as measured by market capitalization are Apple, Microsoft, Alphabet, Amazon.com, Berkshire Hathaway, NVIDIA, Meta Platforms and Tesla. The only one of those with a negative return in May was Berkshire Hathaway with a loss of 2.27%.

All the others, except Apple and Microsoft, had double-digit-percentage returns for the month.

Here’s another way to look at it. An exchange-traded fund (ETF) that gives equal weight to the stocks in the S&P 500 (instead of the usual capitalization weighting) is up 1.91% so far in 2023 and is down 1.48% during the last 12 months. The ETF is iShares S&P 500 Equal Weight (RSP).

An ETF that invests in the standard capitalization-weighted S&P 500 Index (SPY) is up 12.11% so far in 2023 and 5.81% over 12 months.

Some analysts say this is the largest gap between the returns of the capitalization-weighted and equal-weighted indexes going back to at least 1990.

Currently, the technology sector is more than 28% of the index, near a record high.

The 10 largest positions are 30% of the index, also near a record. Apple is 7.50% of the index, and Microsoft is 6.96%.

It is normal for a relatively small number of stocks to account for a meaningful portion of the S&P 500 and dominate its returns and volatility.

But in 2023, the number of stocks with positive returns has gotten smaller and smaller. Also, a larger and larger percentage of the index is concentrated in a small number of the largest capitalization stocks.

Another warning sign is that less than 50% of stocks in the index are above their 200-day moving averages.

Some analysts say that the 10 largest stocks that are leading the market soon will lift returns for most of the rest of the index.

But traditionally when the number of stocks with positive returns declines, negative returns follow for the entire index. This is known as weak, or narrow, breadth by market technicians.

There’s no way to know what might trigger a stumble in the leaders and bring down the market index. But a review of history indicates stock prices are very precarious and fragile at this point.

Guaranteed Income is a Big Hit with Retirees

People who have guaranteed lifetime income in retirement like it a lot and are interested in buying more, according to a recent survey sponsored by the American Council of Life Insurers.

Guaranteed lifetime income through annuities has been a tough sell to Americans, at least until recently. But it appears that once people have some guaranteed lifetime income, they see the benefits and would like more.

They learn they can spend more freely and don’t worry about fluctuations in the investment markets. Inflation is their main concern.

In the survey, about 26% of respondents already owned annuities. Of them, 86% said they were somewhat or very interested in buying more.

Of the survey participants who didn’t already have annuities, most said they wanted annuities.

Perhaps one factor behind the high interest in annuities is that the survey didn’t use the word annuity. Instead, it asked respondents if they would like a guaranteed income product that pays out like a pension by providing periodic payments during retirement.

Of course, another factor is that prices of both stocks and bonds declined in 2022. Negative returns in the markets always make safety and guaranteed income more appealing.

What Sustains Profit Margins?

Business profit margins surged after the financial crisis. They’ve been well above average and near record levels since about 2012.

High profit margins have been one factor pushing stock prices and valuations higher. I’ve said for a while that profit margins are unlikely to remain near record levels, and the potential for a decline in margins is a risk for investors in U.S. stocks.

Some recent research dives into the reasons profit margins increased and remained high.

James Montier, of GMO, has said for more than 10 years that profit margins are due to decline. Recently, he reported on his research into why his 2012 forecast of declining profit margins hasn’t been fulfilled.

Corporate investment is, of course, a factor that drives profit margins higher, as long as the investments are wise and increase profitability.

But Montier concluded that the federal government’s fiscal deficits are the main reason for the high and sustained profit margins since 2009.

Government spending increases household income, and that allows people to spend more on goods and services. The government also contracts directly with businesses, increasing their revenues and profits.

Since the financial crisis, federal budget deficits have exceeded 6% of gross domestic product (GDP), well above the historic level of about 3%.

If federal spending and deficits don’t decline, profit margins might remain at recent levels.

But Montier says that even if deficits and profit margins stay at recent levels, that doesn’t guarantee stock returns in the next 10 years will replicate those of the last 10 years.

Stock valuations rose along with profit margins and would have to keep climbing for stock prices to continue rising.

Montier estimates that if profit margins and valuations stabilize at recent levels, stock investors in the United States can expect annualized returns of about 3% over the next 10 years.

But valuations already are at elevated levels based on the expectations of low interest rates, rising profit margins and other factors. They’re more likely to decline than to stabilize.

If valuations fall below their recent historic highs, investors will experience negative returns over the next 10 years, even if profit margins stay high.

The Data

The manufacturing sector contracted in May, according to two reports.

The ISM Manufacturing Index declined to 46.9 in May from 47.1 in April.

The PMI Manufacturing Index fell to 48.4 in May. It was 50.2 in April.

The ISM Services Index declined to 50.3 in May from 51.9 in April.

The PMI Services Index increased to 54.9 in May from 53.6 in April. That pushed the PMI Composite Index higher to 54.3 from 53.4 in April.

Any reading below 50 in those indexes indicates a contraction in the sector.

Factory orders were 0.4% higher in April after increasing 0.6% in March. But most of April’s increase was in transportation and defense. After excluding those sectors, factory orders declined 0.4%.

Last week’s Employment Situation reports for May were mixed but generally indicated a strong labor market that’s beginning to weaken.

The unemployment rate jumped to 3.7% from 3.4% in April.

But payrolls increased by a strong 339,000, up from 294,000 in April.

Average hourly earnings increased 0.3% in May, compared to 0.4% in April. Over 12 months, earnings increased 4.3%, slightly lower than 4.4% as of April.

Average weekly hours worked also fell slightly to 34.3 in May from 34.4 in April.

Productivity declined in the first quarter by 2.1% compared to a 1.6% increase in the last quarter of 2022. Hourly compensation increased by 2.1% in the first quarter.

A combination of reduced productivity and higher compensation caused unit labor costs to increase 4.2% in the final estimate for the first quarter. That’s historically high but lower than the initial estimate of 6.3%.

Over 12 months, unit labor costs increased 3.8%, down from 4.9% as of the fourth quarter.

Private sector jobs growth remained strong in May, according to the ADP Employment Report. ADP estimated that 278,000 private sector jobs were created in May, lower than the downwardly revised 291,000 in April.

The report also found compensation is increasing at a lower rate than in the recent past but still is higher than pre-pandemic levels.

The number of job openings jumped in April to 10.103 million from 9.745 in March, according to the JOLTS (Job Openings and Labor Turnover Survey) report. Job openings had declined for three consecutive months.

The number of people quitting jobs declined to 3.79 million, the lowest level since March 2021 and well below the peak of 4.5 million in November 2021.

New unemployment claims increased by 2,000 to 232,000 in the latest week.

Continuing claims, which lag a week behind new claims, increased to 1.795 million from 1.789 million.

The Markets

The S&P 500 rose 1.87% for the week ended with Tuesday’s close. The Dow Jones Industrial Average gained 1.71%. The Russell 2000 increased 5.02%. The All-Country World Index (excluding U.S. stocks) added 2.48%. Emerging market equities advanced 3.45%.

Long-term treasuries gained 0.56% for the week. Investment-grade bonds increased 0.34%. Treasury Inflation-Protected Securities (TIPS) lost 0.02%. High-yield bonds rose 0.88%.

In the currency arena, the U.S. dollar gained 0.18%.

Energy-based commodities increased 2.70%. Broader-based commodities rose 2.28%. Gold advanced 0.16%.

Bob’s News & Updates

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