US equity strategists divided, but Boyar sees upside potential in historical data

Boyar Research, based in New York, argues in its latest quarterly letter to investors that multiples in the S&P 500, and the broader performance of US indicies so far in 2023, point to a statistical chance of a positive second half for US markets - although it also notes that US equity strategists have not been as divided on the outlook for some 20 years.

In the letter - published here: https://boyarresearch.substack.com/p/boyar-researchs-quarterly-letter - Boyar Research notes:

"If history is any guide, the NASDAQ 100's blowout start augers well for the remainder of 2023. According to data compiled by Bloomberg, years where the Nasdaq 100 rallies at least 10% (for the first half of the year) have produced average returns of about 14% over the second half of the year (or 8.3% when the first half gain exceeded 20%). Positive first-half gains for the S&P 500 are also bullish for the remainder of the year. According to Sam Stovall of CFRA Research, since 1945, the S&P 500 has risen an additional 5% when the index recorded a positive return in the first part of the year. What's more, when the index gained 10% or more during the first half, the gains in the back half of the year averaged 8%."

"Wall Street "strategists" (who started 2023 for the most part quite bearish on equities) have not been this divided at the midpoint of the year on how stocks will perform for the remainder of the year in two decades. There is a 50% difference between the most bullish forecast from Fundstrat (which forecasts a ~10% additional gain for 2023 with the S&P ending at 4,825), and Piper Sandler (which believes the S&P will decline 27% to 3,225) according to data from Bloomberg."

"The S&P 500 has advanced by 24% since its low on October 12, 2022, officially putting us in a bull market. Historically, the start of a new bull market has been a positive signal for future short-term returns. According to Bank of America Research, utilizing data dating back to the 1950s, the S&P 500 rose 92% of the time over the 12 months following the start of a bull market, with an average return of 19%."

Regarding market trends, Boyar Research has warned growth investors that the gains seen so far should not be relied on to continue.

"For the first 5 months of the year, growth outperformed value by 23%, the biggest divergence in 44 years of data. Investors are voting with their wallets and have pulled more than $15 billion from ETFs with a focus on value, the fastest withdrawal since at least 2016."

SME opportunities

Instead, the research outfit points to opportunities outside growth and outside the S&P 500 large cap stocks - albeit with a warning that fundamental analysis of individual companies is required, given the risks facing smaller businesses, such as borrowing costs.

"Small-cap value is the cheapest area of the US market (selling at 14.9x vs. its 20-year average of 16.8x), and it is where we see the biggest opportunities for future outsized gains. The Russell 2000 (an index of smaller company shares) is down 24% from its 2021 highs and has lagged larger stocks by more than 7 percentage points annually over the past 5 years. According to Charley Grant of the Wall Street Journal, that underperformance is among the worst relative 5-year returns since 1926.Investors are starting to warm up to the opportunity in small-cap shares, with about $3.5 billion having flowed into small-cap stock ETFs since the start of the year."

"However, investors in small-cap companies need to be especially wary of potential minefields in this area of the market: 45.5% of the companies contained in the Russell 2000 are unprofitable, and their EBIT covers a much smaller percentage of their interest expense than is the case for their large-cap brethren (see the accompanying chart for further details). Partly this is because smaller-cap companies rely much more on floating rate bank debt than large cap companies do (since they don't have the same access to the bond markets). If banks continue to tighten credit, some unprofitable companies could be in for a lot of pain. As a result, it is especially important to be selective and conduct extensive research when investing in this area of the market."

Valuations

"Valuation is also a concern for us. As of June 30, 2023, the top 10 stocks in the S&P 500 were selling for 29.3x earnings (fwd.), compared with an average valuation of 20.1x since 1996. The weightings of the S&P 500's top 10 stocks are also at a multidecade high. As of June 30, the S&P 500's top 10 stocks accounted for 31.7% of the index weight, a figure that in 1996 was only ~18% (and that even at the peak of the dotcom bubble was roughly 27%)."

"Also worryingly, the S&P 500's remaining stocks (outside the top 10) are not cheap, either, selling for 17.8x versus an average of 15.7x since 1996. Interestingly (demonstrating the market's lack of breadth), for the first half of the year, according to Bloomberg Intelligence the return spread between the seven largest stocks in the S&P 500 compared with the rest of the index hit the widest since the dot-com bubble. If you excluded the top seven largest stocks from the S&P 500, the index would have returned a mere 6.3% for the year (still not a bad return!), instead of 16%."

"The Nasdaq 100 has become so concentrated that the index provider has announced a "special rebalance" of the weightings of its components. Under Nasdaq rules, if the index's stocks with a weighting of 4.5% or more exceed 48% of the index, those components are rebalanced until they represent only ~40%. Such a rebalancing has happened twice before, in December 1998 and May 2011. As Eric Savitz notes in Barron's, a rebalancing is no small matter: hundreds of billions of dollars are invested in funds that track the Nasdaq 100, and the upcoming rebalancing could create temporary downward pressure for index heavyweights such as Microsoft, Apple, and Nvidia."

In conclusion, Boyar Research notes that investors need to remain disciplined and take a longer term view to eke out the best gains.

"We've said it before, and we'll say it again: individual investors stack the odds of investment success in their favor when they stay the course and take a long-term view. Yet data from Dalbar tells us that over the past 30 years, when the S&P 500 averaged a 9.65% annual advance, the average investor gained a mere 6.81%. Why such a degree of underperformance? Partly because investors let their emotions get the better of them and chase the latest investment fad (or pile into equities at market peaks and sell out at market troughs)—and partly because they sell for nonfundamental reasons, such as a rise in a company's share price (or in an index)."

"But history tells us that taking a multiyear view instead would tilt the odds of success in investors' favor. According to data from JP Morgan, since 1950 annual S&P 500 returns have ranged from +47% to -39%. For any given 5-year period, however, that range narrows to +28% to -3%—and for any given 20-year period, it is +17% to +6%. In short, since 1950, there has never been a 20-year period when investors did not average a gain of at least 6% per year in the stock market."