IWM Market Highlights: 2023 Q3

In the first half of 2023, the stock market’s 17% return outperformed expectations. However, these gains were driven by the superior performance of only a few stocks who investors see as beneficiaries of recent advances in artificial intelligence. Since the overwhelming majority of the stock market has been directionless, we look to the bond market, which perhaps is giving us a clue about what will happen in the second half of the year.

S&P 500 vs. Dow: who’s right?

The S&P 500 and the Dow Jones Industrial Average (“Dow”) are two of the most popular large cap US stock indices.  With the rise of passive management where investors try to “track the market”, an important question to ask is “which market?”  The S&P 500 and the Dow are both diversified across industries and contain some of the most mature and profitable companies in the US, but you have to dive deeper to understand why the S&P 500 gained 17% while the Dow only gained 5% in the first half of the year.¹

The significant discrepancy in performance boils down to a small list of overachievers (returning between 35% and 190% so far this year!) that are included among the roughly 500 companies in the S&P 500 (like Alphabet/Google, Amazon, Nvidia, Tesla, Meta/Facebook) but not among the 30 companies in the Dow.^2,3  Among the high achievers, only Apple and Microsoft are common to both indices.  The other difference is that the S&P 500 weights its constituents according to the size of the company whereas the Dow weights its constituents according to each stock’s price (with higher price stocks having a higher weighting).⁴  This means the seven overachievers have a weight of 27% in the S&P 500, but only 10% in the Dow.^2,3  The point is that not all indices are created equally and it’s important to understand what you’re investing in and why.

What are bonds yielding?

Bond yields are relatively high, reaching levels we’ve rarely seen in the last 15 years especially for shorter maturities.¹  Here’s a table of bond yields for treasuries of different maturities.⁵  

Normally, investors can earn higher yields by locking up their money for longer periods of time. The fact that longer-term yields are below short-term yields (called an inverted yield curve) implies that short-term rates are expected to go down over time. One reason that short-term rates would go down could be a policy response to stimulate an economy that has fallen into a recession. Surely, not every market cycle acts the same, but past experiences can certainly guide our understanding of the likelihood of various outcomes.

Is inflation finally under control?

Inflation is well off its highs but is still stubbornly above the Fed’s target of 2%.  Some of the impact of the Fed’s interest rate increases could have a delayed effect on the economy but more increases may still be needed to bring inflation fully down to target.  While there is optimism that the economy is in decent shape and hasn’t yet fallen into a recession, recession risks remain and the second half of the year could be volatile depending on whether the economy slows too much or just enough to cool inflation.