Perspective :

The Download: 4Q 2023

< Back

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.

JUST SEVEN STOCKS DROVE MOST OF THE RETURN IN U.S. INDEXES IN 2023

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.

PERFORMANCE OF ASSET CLASSES BEFORE AND AFTER THE TECH WRECK

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.

LESS RISK, MORE RETURN. SHORT TERM YIELD-ORIENTED 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.

FED FUNDS VS. INVERTED YIELD CURVE

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.

FED TIGHTENING AND YIELD CURVE INVERSIONS ARE DESTABILIZING

FED TIGHTENING AND YIELD CURVE INVERSIONS ARE DESTABILIZING

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.

Download PDF

Past performance is no guarantee of future returns. The performance discussed represents total returns that include income, realized and unrealized gains, and losses. Nothing presented herein is or is intended to constitute investment advice or recommendations to buy or sell any type of securities, and no investment decision should be made based solely on the information provided herein. There is a risk of loss from an investment in securities, including the risk of loss of principal. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will be profitable or suitable for an investor’s financial situation or risk tolerance. Diversification and asset allocation do not ensure a profit or protect against a loss. All performance results should be considered in light of the market and economic conditions that prevailed at the time those results were generated. Before investing, consider investment objectives, risks, fees, and expenses. Frontier may modify its process, opinions, and assumptions at any time without notice as data is analyzed.

Envestnet licenses models from Frontier that are used in investment advisory programs sponsored by Registered Investment Advisers. In such programs, Envestnet acts as the discretionary manager for client accounts in the programs. In many cases, Envestnet manages and implements the models as received from the model provider. The performance information included herein is intended to provide you with a general understanding of how the model has performed when managed by Frontier. However, such performance information is likely to be different from the actual performance you would experience should Envestnet make changes to the models or place trades at different times, and also depending on when your account is incepted and when you make contributions and withdrawals.

Information provided herein reflects Frontier’s views as of the date of this newsletter and can change at any time without notice. Frontier obtained some of the information provided herein from third-party sources believed to be reliable, but it is not guaranteed, and Frontier does not warrant or guarantee the accuracy or completeness of such information. The use of such sources does not constitute an endorsement. Frontier’s use of external articles should in no way be considered a validation. The views and opinions of these authors are theirs alone. Readers access the links or websites at their own risk. Frontier is not responsible for any adverse outcomes from references provided and cannot guarantee their safety. Frontier does not have a position on the contents of these articles. Frontier does not have an affiliation with any author, company or security noted within. Frontier reserves the right to remove these links at any time without notice.

Exclusive reliance on the information herein is not advised. This information is not intended as a recommendation to invest in any particular asset class or strategy or as a promise of future performance. References to future returns are not promises or even estimates of actual returns a client portfolio may achieve. Assumptions, opinions, and estimates are provided for illustrative purposes only. They should not be relied upon as recommendations to buy or sell any securities, commodities, treasuries, or financial instruments of any kind. This material has been prepared for information purposes only and is not intended to provide, and should not be relied on for, accounting, legal, investment, or tax advice. Frontier does not directly use economic data as a part of its investment process.

Any forward-looking statements or forecasts are based on assumptions and actual results are expected to vary from any such statements or forecasts. No reliance should be placed on any such statements or forecasts when making any investment decision. The estimates, including expected returns and downside risk, throughout are calculated monthly by Frontier and will change from month to month depending upon factors, including market movements, over which Frontier has no control. They are only one factor among many considered in Frontier’s investment process and are provided solely to offer insight into Frontier’s current views on long-term future asset class returns. They are not intended as guarantees of future returns and should not be relied upon in making investment decisions.

Hypothetical expected returns have certain limitations, are discussed for illustrative purposes only and it should not be assumed that actual results will match the hypothetical expected returns referred to. Unlike actual performance, hypothetical expected returns do not represent actual trading and since trades have not been executed, the results shown may have under or overcompensated for the impact, if any, of certain unforeseen market factors. Hypothetical expected returns, whether back tested or forecasted, have many inherent limitations and no representation is being made that any account will or is likely to achieve the results expected. In fact, there are frequently material differences between hypothetical expected results and actual results achieved. One of the limitations of hypothetical expected results is that they do not take into account that material market factors may have impacted the adviser’s decision-making process if the firm were actually trading clients’ accounts. Also, when calculating the hypothetical expected returns, the adviser has the ability to change certain assumptions and criteria in order to reflect better returns. There are numerous other factors related to the markets in general or to the implementation of any specific investment strategy that cannot be fully accounted for in the preparation of hypothetical expected results, all of which can adversely affect actual trading and performance. Importantly, it should not be assumed that investors who actually invest in this strategy will have positive returns or returns that equal either the hypothetical expected results expected. In addition, performance can and does vary between individuals.

In reviewing the performance information presented here, we recommend that you consider both the returns generated and the level of risk that was assumed in generating those results. We believe that performance information cannot be properly assessed without understanding the amount of risk that was taken in delivering that performance.

Frontier provides model strategies to various investment advisory firms and does not manage those models on a discretionary basis. The performance and holdings of model strategies may vary from strategies managed by Frontier.

Inflation is the decline of purchasing power of a given currency over time. A quantitative estimate of the rate at which the decline in purchasing power occurs can be reflected in the increase of an average price level of a basket of selected goods and services in an economy over some period of time. The rise in the general level of prices often expressed as a percentage, means that a unit of currency effectively buys less than it did in prior periods.

© Morningstar 2024. All rights reserved. Use of this content requires expert knowledge. It is to be used by specialist institutions only. The information contained herein: (1) is proprietary to Morningstar and/or its content providers; (2) may not be copied, adapted, or distributed; and (3) is not warranted to be accurate, complete, or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information, except where such damages or losses cannot be limited or excluded by law in your jurisdiction. Past financial performance is no guarantee of future results.

It is generally not possible to invest directly in an index. Exposure to an asset class or trading strategy or other category represented by an index is only available through third-party investable instruments (if any) based on that index.

Frontier Asset Management, LLC is a Registered Investment Advisor. Frontier’s ADV Brochure and Form CRS are available at no charge by request at info@frontierasset.com or 307.673.5675 and are available on our website frontierasset.com. They contain important disclosures and should be read carefully.

ASSET CLASS INDEX INDEX DESCRIPTION
U.S. Large Cap Equity S&P 500 / Nasdaq Composite Index Represents US large company stocks.

 

20240112.32132

Related Content