After three consecutive quarters of positive returns, stocks were unable to keep the streak alive and edged slightly lower in the third quarter. Most of the negative performance occurred in September, which was the worst month for the stock market this year. Bond returns were also negative this quarter, while liquid alternatives provided a welcoming boost to returns.
TECH RALLY SLOWS
Returns in the first half of the year were dominated by a handful of well-known, mega-cap technology stocks, which contributed to large-cap stocks’ vast outperformance over small-cap and international stocks. This trend reversed somewhat in the third quarter as returns were generally similar across asset classes. Emerging Markets had the best performance among stocks for the quarter with a loss of “only” 2.9%, while small-cap stocks fared the worst with a decline of 4.9%.
The return distribution between various factors and sectors was also not so wide in the third quarter. For the four factors we track (value, momentum, high quality, and low volatility), the domestic stock returns were within a few percentage points of each other. Quality continued to be the strongest performing factor, outpacing both the benchmark and the other three factors for the third consecutive quarter. Sector returns were also more narrowly distributed between each other compared to the first half of the year when technology, consumer discretionary, and communication services stocks greatly outperformed the rest of the market by a wide margin. Most sectors were modestly negative for the quarter, with the main outlier being energy stocks, which returned over 12% thanks to a $20 increase in crude oil prices.
The concentration of the top ten stocks in the US is currently at a level not experienced since the late 1800s, comprising more than 30% of the S&P 500. While this amount of concentration risk alone is concerning, the high valuation levels of these companies is cause for additional concern. The average Price/Earnings ratio for these ten companies is almost twice as high as the average for the overall S&P 500, which is significantly above its long-term average. Some of these companies, such as Amazon and NVIDIA, have P/Es over 100x. History has shown that when we have this combination of stocks that are highly concentrated and highly valued, the outcome for undiversified investors is usually poor. This was true in the aftermath of the Nifty Fifty stock era in the 1970s, the Dot-Com Bubble bursting in the early 2000s, and even as recently as the downturn in tech stocks in 2022, when the Magnificent 7 lost about 40% on average and unprofitable tech stocks fell even further. When these downturns occurred in the past, having a diversified portfolio helped to provide downside protection. Factor investing also outperformed in these market environments. So, while diversification has looked pretty foolish so far this year, being unduly concentrated in any one industry is a very risky approach.
3rd Quarter 2023 Asset Class Returns
Interest rates rose again this quarter, but this time it was long-term interest rates that rose substantially while short-term rates were stable. The 10-year Treasury yield jumped from 3.8% to start the quarter all the way up to 4.6% to end the quarter and inched even higher to above 4.8% in the days after quarter end. Meanwhile, the front end of the yield curve barely budged, as the 2-year Treasury yield moved from 4.9% to only slightly above 5% at the end of the quarter. This is the opposite of what we experienced in previous quarters when the front end of the yield curve shot up as the Fed aggressively hiked interest rates, but longer-term rates held steady.
The Fed raised the Federal Funds rate by 0.25% during the quarter, a slowdown from prior periods. However, the notion that they may need to keep rates higher for longer to mitigate inflationary pressures is starting to permeate the bond market, and likely was part of the reason longer term rates rose so much during the quarter.
The rise in yields continued to put pressure on bond returns, as the Bloomberg Aggregate Bond Index was down -3.2% for the quarter. However, short duration bonds were able to avoid some of the negative price impact and posted a small positive return. Bond investors may feel further pain in the near term if rates continue to rise, but current yields offer expected long-term returns that we have not seen for over a decade.
While the bond market has posted lackluster returns over the past three years as interest rates rose, alternative investments have helped provide healthy returns that have been largely uncorrelated with stock market returns. The third quarter saw a continuation of this trend. Style premia rose by nearly 13% in the third quarter alone, bringing year-to-date performance up to 19.4% and three-year annualized returns to an impressive 23.5%. Catastrophe bonds continued to deliver positive returns as industry losses for reinsurers have been mild this hurricane season. Other liquid alternative strategies have also managed to outperform the aggregate bond market year-to-date. Investors who were able to endure the subpar returns of some of these strategies in the late 2010s have now seen the benefits of alternative investments. They don’t outperform all the time, but they offer significant diversification benefits and have helped buffer portfolios when both stocks and bonds have been down.
Overall, the third quarter wasn’t a great one for investors. Returns for stocks are still strong year-to-date, but the tide feels like it is turning and leadership within the stock market may be changing. Diversification, which hurt returns early this year, will likely become increasingly important. The days of tech stocks heading straight up seem numbered.