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Stock market momentum and direction remain elusive as the third quarter of 2023 yielded few clues for future asset class leadership.  For over a decade the trend was clear – large technology companies were the chosen sector.  Low interest rates fueled extraordinary evaluations for fast growing technology companies.  With the sharp increase in interest rates in the third quarter of this year, that has all changed.  The two largest inputs in valuing growth companies are revenue growth rate and a low discount rate (interest rate) in present value calculations.  As the Federal Open Market Committee (FOMC) remains in a tightening (moving short-term rates higher), both revenue growth and discount rates are negatively impacted. 

Institutional investors and hedge funds are keenly aware of the effect higher rates can have on growth stock valuations (stock prices).  The main street investor, maybe not so much.  Investors often ignore seismic shifts in valuation approaches in favor of recency bias.  In D’Arcy Capital’s opinion, the pullback in technology growth stocks is not temporary.  Growth stocks are worth much less as interest rates remain elevated.

The good news is that there is a plethora of stock opportunities outside of large growth technology shares.  Almost all other stock sectors have been ignored during the technology sector domination.  Value stocks, international stocks, and small cap stocks could all be the recipients of the migrations out of technology growth stocks.  These “unloved” sectors have seen valuations become very attractive.  Additionally, dividend paying stocks can thrive within a higher interest rate environment.  What is bad for large growth stocks (higher interest rates) can be good for value stocks.

Successful investors going forward will likely need to detach from large cap technology growth sector and hitch themselves to a stock, sector, or asset class that has the potential to outperform during an elevated interest rate environment. 

Third Quarter Key Points

  • Stock markets were broadly lower for the third quarter.  The Dow Jones Industrial Average defended the best while only losing 2.10%.  The S&P 500 lost 3.27%, the NASDAQ declined 3.94%, international stocks (MSCI EAFE) shed 4.04%, and the Russell Small Cap Index retreated 5.14%.
  • Year-to-date the NASDAQ remains in first place with 27.11% (although it lost 32% in 2022). The S&P 500 and the Dow are up 13.06% and 2.733% respectively for the first nine months of 2023
  • The large swings of the NASDAQ (and its constituents) capture the headlines, but other indices may be better options in terms of risk and return.
  • Interest rates were the big story in the third quarter.  Most of the stock market decline can be attributed to the rapid rise in mid-term interest rates.  Specifically, the U.S. Government 10-year Treasury note went from 3.84% on June 30th to 4.57% on September 30th.
  • U.S. politics also provided a “headwind” to stocks as the empty threat of a government shutdown found its way into the public’s consciousness.

Key Points Going Forward

  • Short-term interest rates are likely to remain elevated through the end of 2024.  D’Arcy Capital doesn’t expect the Federal Reserve to announce that rate increases are complete but expects the Federal Reserve will raise interest rates one more time. 
  • Short-term Treasury bills are yielding more than 5.0%.  Long-term investors should not abandon stock and bond strategies for short-term T-Bills.  Historically T-bills approximate only the rate of inflation and stocks have achieved a much higher rate than inflation.  However, for individuals with high savings balances, T-bills are a great alternative to holding cash in the bank.
  • D’Arcy Capital believes almost every asset class other than Large Cap Growth Technology, general market index funds, and Real Estate are reasonable targets to deploy cash.  D’Arcy Capital anticipates Small Cap Stocks, International Stocks, Value Stocks and Municipal Bonds will do well going forward.
  • Now is the time to spread money into sectors and asset classes that are undervalued.  Once the stock market recognizes the opportunity in these forgotten sectors, the appreciation could be swift.
  • Now is not the time to lose patience with the stock market.  The stock market has remained relatively flat for the last two years.  D’Arcy Capital expects a breakout to the upside in 2024.
  • D’Arcy Capital believes successful strategists will rotate from index funds/ETFs to stock picking and active management.
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  • Ken Kerper
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    Thank you Brett.

    Ken

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