Q2 Letter - 2023
Q2’23 – “Oh-No!” to FOMO (Fear of Missing Out)
The 2nd quarter of 2023 was another pleasant surprise, although much of the market returns were concentrated in the largest technology companies everyone is familiar with. These “Magnificent Seven” tech companies (Apple, Microsoft, Google, Amazon, Nvidia, Tesla, and Meta) accounted for 72% of the returns of the S&P 500 in the first half of 2023. In our view, there are three key reasons for this, 1) The Magnificent Seven have stronger balance sheets with a lower cost of capital ($200bn net cash) vs. Small and Medium Sized Tech companies ($20bn net debt), 2) Excitement around AI to drive productivity gains favors Big Tech because scale matters from an AI perspective due to larger data sets, and these companies have the largest install bases and customer subscriber pools for continued data acquisition, 3) These companies have the strongest and most defensible profitability margins despite having some of the most bloated cost structures, as they raced and competed against each other to snag the best talent. However, these companies have scrutinized their cost structure and rationalized their rate of investment. For example, Meta has decreased their 2023 expected operating expenses from $100 billion to a range of
$86 – $90 billion (inclusive of ~$4 billion of one-time restructuring expenses).
What’s Next? Opportunities…
For the second half of 2023, we expect these companies to continue to perform for three important reasons: 1)It appears long-term rates have hit a ceiling they can’t break out from. A 10-year treasury yield at 3.7%is not compelling enough to attract investors with long time horizons out of the equity markets, 2) Manyinvestors are still sidelined and are holding historically high levels of cash, with $5.7 trillion in moneymarket funds (up from $4.0 trillion in Q4 2019). 3) These tech companies are unique beneficiaries of aweakening US dollar (which hit a new 52 week-low in the 3rd week of July 2023) as they derive slightlymore than half of their earnings ex-US.
While we have become increasingly optimistic and don’t want to fight the positive trends in the market, we believe there will be a broadening out of opportunities to outperform the seemingly invincible big tech companies: valuations for the other 493 stocks in the S&P 500 sit at ~15x EPS vs. 40x for the Magnificent Seven, nearly the largest discrepancy ever. An example of sectors that are still inexpensive and overlooked, for example, would be oil and gas companies, which have underperformed drastically and are down ~2% on the year. Investor sentiment has shifted overly pessimistic in this sector, as proved by the Q2’23 Bank of America fund manager survey, which displayed that fund managers are the most underweight commodities they have been since May’20, the month after US crude went negative due to COVID lockdowns. We are constantly on the lookout for contrarian indicators such as this that can help us identify and take advantage of these potential market inefficiencies/mispricings.
Biggest Risk?
The Fed's action to combat inflation is still the most important factor in determining the fate of the financial markets. The markets are expecting one more rate hike, but if inflation begins picking up, the Fed will have to increase rates further than what is currently expected, and that could derail this market momentum as that increases the risk of a bank credit crunch or systemic credit event. However, June 2023 was the 12th straight month that we experienced disinflation. The solid start to July can largely be explained by the June CPI report being softer than expected, as both headline and core inflation rose only 0.2% month-over-month. The amount of disinflation was broad-based, as only 29% of the components within the core CPI basket had 3-month annualized inflation above 5%, compared to nearly 50% last June. For the time being, disinflation is a good thing for the markets as wage growth is outpacing the rate of inflation–a great environment for the economy, but that could begin to weigh on profitability margins if wage growth outpaces inflation for long and companies can’t increase pricing commensurately with the cost of their labor/inputs going up. Labor accounts for 70-75% of the S&P 500’s expenses, so the rate of wage inflation will be a continued focus point for us through the rest of the year.
The reason why we believe there is a risk of inflation re-inflecting later this year is two-fold: 1) There is a lack of coordination between the current policy regime, with loose fiscal policy via continued government stimulus making the job of the Fed more difficult. Monetary policy (raising interest rates) can only do so much to curb demand in certain parts of the economy, 2) The largest component of the CPI where there is still sticky inflation is the housing market, which is responsible for roughly 70% of the inflation we experienced in the latest inflation data. The housing data is measured by a survey conducted monthly to ask people how much they believe they could rent their home out for. As buying a home becomes increasingly expensive due to higher mortgage rates, rent prices will continue to increase as would-be buyers are forced into the rental market. It is estimated that the US currently has a shortage of 5 million homes, largely due to the fact that ~60% of homeowners have a mortgage below 4%, which they view as an asset they don’t want to get rid of (which is reasonable).
While continued strong housing inflation is the primary suspect in the potential reacceleration of CPI, our base case is for housing inflation to moderate in Q4 as homebuilders continue to post record quarters and increase home supply, and long-duration rates coming down slightly should increase housing supply as well because people will begin to accept mortgages in the 6%s as the new norm. People will delay moving up for as long as they can, given their low rates, but eventually life events will force some people to move (new job, kids, etc.), which should also increase housing supply.
Portfolio Strategy
We continue to believe that this is a market to remain invested in, and even in a downside scenario where the strength in the economy begins to falter, the Fed is in a position of strength right now as they have the ability to lower interest rates and thereby loosen the tight monetary policy regime we’re currently in to keep the economy from entering a painful recession. The US consumer is still too strong for a systemic collapse like we experienced in the 2008-2009 Great Financial Crisis, so we believe it’s too early to get too defensive in our portfolio positioning.
We are grateful for the trust that you have placed in us, and we look forward to continuing to serve as your partner in achieving your financial goals. If you have any questions or concerns, please do not hesitate to contact us.
Information presented reflects the personal opinions, viewpoints and analyses of the employees of Mirador Capital Partners, LP, an SEC-registered Investment Adviser. The views reflected in the commentary are subject to change at any time without notice. Nothing herein constitutes investment advice, performance data or any recommendation that any particular security, portfolio of securities, transaction or investment strategy is suitable for any specific person. Any mention of a particular security and related performance data is not a recommendation to buy or sell that security. Mirador Capital Partners, LP manages its clients’ accounts using a variety of investment techniques and strategies, which are not necessarily discussed in the commentary. Investments in securities involve the risk of loss. Past performance is no guarantee of future results. Visit us at miradorcp.com for more information.