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The Download: 4Q 2023

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2024: A year of imbalances?

What a difference a year makes. In 2023, capital markets defied the dire predictions of 2022, and stock prices rose significantly. The economy continued to diesel ahead, and inflation dissipated.  What’s not to like?

As a risk-first investment manager, at times like these, we feel inclined to remind investors of the other side of the investing coin; while risk may appear dormant, it is certainly not dead. It is after periods of good performance that investors have more money, want more return, and invest more heavily. And investors mostly just invest more in whatever performed best last year. So, while we look forward with hopeful optimism, there are imbalances present in the marketplace that are hard to ignore.

U.S. equity market concentration

The Magnificent 7, the Mega 8, or simply the top 10 stocks in the S&P 500 – however you define them – led the U.S. stock market higher last year. And by a stunningly wide margin. The Magnificent 7 gained almost 80% last year, while the other 493 stocks in the S&P 500 gained a respectable, but far back second place of 15%. Telsa, Meta, Microsoft, Apple, Amazon, Alphabet, and Nvidia dominated the media and investors’ attention. It seems as if no other investments exist. These seven stocks are quintessentially the stocks of the day.


Source: YCharts. U.S. Value Stocks: Russell 1000 Value, U.S. Small Cap Stocks: S&P 600. Top 7 stocks: Apple, Microsoft, NVIDIA, Google, META, Tesla. Weight of Top 10 Stocks: JP Morgan Guide to the Markets and are based on the 10 largest index constituents at the beginning of each month.

Is this type of market concentration unprecedented? Not quite. Similar circumstances occurred during the Tech Boom in the late 1990s. During that euphoric time, fewer and fewer stocks garnered most investors’ attention. The names were different, but the effect was the same. Investors felt like they were missing out and were drawn to chase the performance of hot stocks or strategies of the day. For those of you who weren’t around back then, predictably the NASDAQ eventually lost 70% of its value during the Tech Wreck. Today, the concentration in the S&P 500 is higher than the peaks reached in 1999.

At that time, very few stocks dominated the media and investors’ attention, and grand swaths of securities were left behind. Interestingly, when the Tech Wreck hit, most other capital markets that were left behind flourished. The imbalance was corrected, and this correction of capital lasted over a decade, as the S&P 500 and tech-heavy NASDAQ trailed the returns of most other equity asset classes.


Source: YCharts. Emerging Markets = MSCI Emerging Markets Index, U.S. Large Cap = S&P 500 Index, U.S. Small Cap = S&P 600 Index. Developed xU.S. = MSCI EAFE Index, U.S. Aggregate Bonds = Bloomberg U.S. Aggregate Bond Index.

Today, this very same imbalance exists. The market cap of the Magnificent 7 stocks is almost $12 trillion dollars.¹ To put that in perspective, that is about three times the size of the Gross Domestic Product (GDP) of Germany.² Just seven stocks represent 30% of the S&P 500 Index. For those indexes that don’t include these seven stocks, their performance and valuations have languished, leaving large swaths of the market undervalued by traditional measures. We are certainly not expecting the Magnificent 7 to crash, far from it, as these seven stocks are solid businesses. It is more the case that we would expect market performance to broaden out.

The takeaway

To take advantage of a concentration imbalance, look to other assets such as small-cap stocks, international stocks, and emerging markets stocks to outperform the large-cap tech-heavy U.S. indexes. Frontier strategies hold reduced exposures to U.S. large-cap stocks.

Bond market concentration

Just as the U.S. stock market appears hyper-focused on just seven stocks, the bond market appears specifically focused as well. The mind of the bond market appears convinced that interest rates are going to drop.  In 2023, investors bought heavily into intermediate to long-term treasury bonds. On the surface, this seems like a logical “bet”, as inflation has dissipated, and the Fed has announced that they are expecting to cut the Fed Funds Rate by 0.75% in 2024. However, Fed rate cuts do not always linearly translate to interest rates in the marketplace falling.

Today, the current yield on the benchmark 10-year treasury bond is about 4%, and the Federal Funds Rate is 5.5%.  If the Fed lowers the Fed Funds Rate by the expected 0.75% in 2024, that will still leave short-term rates above the current 10-year treasury yield of 4%. This implies that the “market” is likely expecting the Fed to cut by more than 0.75% this year. In other words, the expected Fed rate cuts, and more cuts, are already priced in the treasury market.  Ironically, though, historically, when the Fed cuts interest rates, the yield curve eventually returns to its normal upward-sloping shape, which means that the 10-year treasury yield may actually be pressured upward from 4%.

While many investors have focused their bond positioning on lower yielding and higher duration bonds, there appears to be higher expected return and lower risk opportunities in short-term actively managed bond funds.


Source: Frontier. Reflects current holdings as of December 31, 2023.

The takeaway

To take advantage of an imbalance in the bond market, look to those bonds that offer higher yields and less duration.  Currently, Frontier strategies hold several bond funds that offer close to twice the yield of the U.S. Aggregate Bond Index while taking a fraction of the duration risk.

The Fed imbalance

It appears to be a foregone conclusion that the Fed will cut rates by at least 0.75% in 2024. But, what if they can’t?

Historically, the Fed has only been able to materially cut the Fed Funds Rate when there has been an economic or asset price disruption.  Without disruption, lowering interest rates can reignite inflation. Landing the Fed Funds Rate appears to be a narrow trajectory. If too much too fast, then we could see a resurgence in inflation. Too little and higher for longer may disrupt asset prices and the economy. Either way, the Fed will probably move in a measured manner, and likely at a slower rate than investors would like.

This leaves the imbalance of an inverted yield curve for longer. For the Fed to cut the Fed Funds Rate in earnest, asset prices or the economy may need to be corrected. Believe it or not, the longer the Fed Funds Rate remains above the market rates of interest, the worse it is for the economy. First of all, higher interest rates, in general, start to eat into borrowing costs, slowing lending, consumer spending, capital expenditures, and investing. Secondly, higher short-term interest rates put pressure on the banking sector as savings rates are approaching lending rates.  Finally, the longer interest rates stay higher, the more refinancing costs become a deterrent to growth. Thus, an inverted yield curve for longer has a cost.


Source: YCharts. Data as of September 30, 2023

It is also true that, coincidentally or fundamentally, most market disruptions have occurred when the yield curve has been inverted, asset prices were richly priced, and when the economy had been strong. All of these conditions are apparent today. Viewing the chart above, every time when there has been a gap between the Fed Funds Rate and the inverted yield curve, there has been a market disruption.



The takeaway

The Fed may have a tough time cutting interest rates significantly here. Cutting interest rates without an economic or asset price disruption can lead to future inflation pressures. It might take longer than investors are speculating for the Fed to land interest rates.

The longer interest rates stay elevated and the longer the yield curve stays inverted, the more damage interest rates can inflict on the economy and asset prices. Higher for longer and inverted for longer can lead to surprise risk events. Frontier strategies remain positioned in a below benchmark risk posture and are broadly diversified with tilts towards high expected return asset classes.

Less risk and greater diversification are our roadmap for 2024.

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