Economic Brief: Portfolio Theory

This quarter’s economic perspective of Jon Manchester, CFA, CFP® (Senior Vice President, Chief Strategist – Wealth Management, and Portfolio Manager – Sustainable, Responsible and Impact Investing) runs the gamut from Harry Markowitz to Taylor Swift. 

In late June, at 95 years old, Nobel prize-winning economist Harry Markowitz passed away in San Diego, CA. He leaves behind an immense legacy in the investment field, with his fingerprints in virtually all professionally-managed portfolios today. As the Financial Times put it: “The study of finance can easily be split into two eras: before and after Harry Markowitz.”¹ Prior to the 1952 publication of his groundbreaking University of Chicago PhD dissertation titled “Portfolio Selection,” investment portfolios tended to be assembled in a somewhat haphazard manner, a collection of individual securities each assessed in isolation from a risk and return perspective with scant attention paid to how the puzzle pieces fit together. Diversification was a well-known concept, but Markowitz’s work provided a mathematical approach to evaluate risk/return tradeoffs holistically, at the portfolio level. Rob Arnott, founder of asset management firm Research Affiliates, noted “Before Harry, investing was a bunch of rules of thumb.”²

In awarding him the 1990 Alfred Nobel Memorial Prize in Economic Sciences—shared with Merton Miller and William Sharpe for separate (but in Sharpe’s case, related) achievements—the Royal Swedish Academy of Sciences lauded Markowitz’s pioneering contributions to portfolio choice. Importantly, Markowitz illustrated the importance of how each asset in a portfolio contributes to the overall risk by considering how the securities move in relation to one another. In other words, how correlated are the assets in a given portfolio? This had significant and enduring implications for portfolio management. Adding a high-risk biotechnology stock to a portfolio otherwise composed entirely of low-risk, regulated utilities stocks could in fact lower the risk of the overall portfolio compared to a broad equity benchmark, given the low correlation between the price movements of the two vastly different industries. This enabled investment managers to evaluate a potential investment in the context of the overall risk picture, and gave rise to the construction of more well-diversified portfolios across asset classes.

The adoption was not immediate, however. According to a Financial Analysts Journal article, Markowitz’s ideas took more than 20 years to catch on.³ It required the “shock wave of the early 1970s stock market selloff and the passage of ERISA” to compel investors to build sturdier portfolios, plus the eventual development of faster computing power to handle the necessary calculations.

The investment world has, not surprisingly, evolved at a dizzying pace in the half-century since the inflationary 1970s, but Markowitz’s core architecture of creating optimal, efficient portfolios across the risk-return spectrum still has a place in the latest iterations of his Modern Portfolio Theory (MPT). It does not necessarily help CNBC gain viewers, though, which is why a recent Bloomberg opinion piece on Markowitz observed that “most investment coverage today is about which securities will go up or down in price, not which ones are shrewd bets, and definitely not which ones have desirable correlations to be part of portfolios with attractive risk/return ratios.”⁴

The Big Seven
One can’t help but wonder how Markowitz would assess the current state of the U.S. large-cap equity market. As someone who was reportedly consumed with the statistical properties of portfolios of securities, it’s probably safe to assume he would be intrigued by the very narrow band of stocks carrying the overall Standard & Poor’s 500 Index. The Index returned 8.7% including dividends in the second quarter, taking its year-to-date total return up to 16.9%. Nearly three-quarters of the Index’s 2023 return thus far can be attributed to just seven stocks: Apple, Microsoft, Nvidia, Amazon, Meta Platforms, Alphabet, and Tesla. Three of those companies—Nvidia, Meta Platforms, and Tesla—saw their stock prices soar more than 100% higher during the first half of 2023. Media outlets have started referring to this group as either the “Big Seven” or sometimes the “Magnificent Seven,” which in itself is concerning. When stocks have done well enough collectively to earn a nickname, it might suggest that future profits are fairly well discounted in the stock prices. At present, the Big Seven trades for an average forward price/earnings ratio of roughly 36x. The overall Index trades at a robust 20.5x estimated 2023 operating earnings per share, and Morgan Stanley calculates that the median S&P 500 stock valuation lands in the 89th percentile historically.⁵

For companies outside the Big Seven, returns haven’t been as gaudy. The median total return for S&P 500 companies was a relatively pedestrian 4.8% over the first half of 2023. Tracing back further to the end of 2021, one trading day short of the market’s all-time peak, only 35% of S&P 500 stocks had higher prices on June 30 compared to then. The remaining 65% were still trying to climb back following an ugly 2022, and that list includes Big Seven members Tesla, Alphabet, and Meta Platforms. All this is to say the list of winners within the U.S. large-cap universe is a fairly exclusive club, and a common theme for outperformers this year has been stocks perceived to benefit directly or indirectly from generative artificial intelligence (AI). Per a Bloomberg article: “The market’s fascination with the power of generative AI has trumped every major issue that could potentially drag down sentiment this year: recession fears, elevated levels of inflation, prospects for more Federal Reserve hikes, geopolitical risks, the debt-ceiling debate and the collapse of a few regional banks.”⁶

Despite the AI frenzy, research from Strategas points out that the real bull market has been in money market flows. Since the S&P 500’s low point last October, investors have directed four times as much into money market funds as compared to equity exchange-traded funds.⁷ Strategas believes those flows reflect a “ton of equity market apathy,” but sharply higher money market yields are no doubt a major factor as well, plus the scramble to avoid holding bank cash above limits insured by the Federal Deposit Insurance Corporation (FDIC). The Federal Reserve’s (the Fed’s) monetary tightening campaign has lifted short-term yields up near 5%, attracting the income-focused crowd. Meanwhile, the distrusted rally in equities continues to climb the wall of worry that Bloomberg outlined, and it has the potential to continue as more investors get off the sidelines and belatedly look to participate in further upside. There are some signs of froth in the markets, however, whether it’s increasingly rich valuations paid for growth stocks or the mid-June initial public offering (IPO) of unprofitable restaurant chain CAVA Group, which saw the stock nearly double on its first day of trading amidst a dearth of listings.

Mind the Lag
Economic growth in the U.S. has aided the markets thus far in 2023 by being neither too hot nor too cold, the precise porridge that can keep bears at bay. Gross Domestic Product (GDP) rose at a 2% annualized pace in the first quarter, adjusted for inflation, and the Atlanta Fed’s GDPNow estimate for second quarter growth is about the same. With many economists initially projecting a mild recession during 2023, the economic data thus far has proved better-than-feared. Bloomberg’s ECO Surprise Index measures the aggregate differentials between the actual values of economic releases and analyst forecasts. After a flattish start to the year, the ECO Surprise Index moved steadily higher in May and June to its highest level since April 2021. While asking if it’s time to cancel the recession altogether, Bloomberg columnist Jonathan Levin observed that economists have started throwing in the towel on a recession starting in the third quarter.⁸ The consensus estimate for Q3 real GDP annualized growth is now roughly flat, up from a trough forecast of -0.9% in May.

There remain ample reasons to be pessimistic. Chief among those is the Fed’s yet unfinished inflation battle. Although inflation has shown significant improvement—with the headline Consumer Price Index (CPI) decelerating to a 4.0% year-over-year growth rate in May—the Fed’s dot plot indicates it expects to raise the target Fed Funds rate by another 50 basis points⁹ to 5.75% at the upper end. Whether or not that happens, there is concern that the economy has yet to truly feel the impacts of tighter monetary policy. There is typically a lag between the policy changes and when economic metrics start to reflect those moves. Given the Fed lifted its target rate by five percentage points between March 2022 and May 2023, the fastest hiking pace in over four decades, it seems reasonable to withhold judgement before declaring the economy immune to higher rates.

There is also the inconvenient truth that the U.S. Treasury yield curve has been consistently inverted for a year now, with the two-year yield at 4.89% as the second quarter ended, versus 3.83% for the 10-year note. Historically, this has suggested a recession lies ahead. The Conference Board’s Leading Economic Index (LEI) hasn’t inspired confidence either, moving lower 14 consecutive months through May. Projecting that the U.S. economy will contract over the Q3-2023 to Q1-2024 timeframe, The Conference Board said the “recession likely will be due to continued tightness in monetary policy and lower government spending.”¹⁰

This dour outlook for economic growth remains at odds with the surprisingly sanguine economic data we’ve seen. Notably, few cracks have emerged in the all-important labor market. Retail sales advanced at a 1.7% year-over-year rate in the three months ending in May, which might qualify as desirably lukewarm. Perhaps music superstar Taylor Swift deserves some credit for the economic resilience. As her current tour rolls around the country providing a boost to local economies—which some have compared to hosting the Super Bowl—one study estimated the Swifties will generate $5 billion in economic impact, more than the GDP of 50 countries.¹¹ While admittedly small in the context of a roughly $26 trillion U.S. economy, Swiftonomics is clearly not the problem. We just need her to continue touring the states indefinitely, until generative AI is ready to take over completely.

1 “Harry Markowitz, economist, 1927-2023,” www.ft.com, 6/30/2023.
2 Ibid.
3 “Harry M. Markowitz: Profile of an Industry Leader,” www.cfainstitute.org, Q4 2017.
4 “Nobel Laureate Harry Markowitz Was a Misunderstood Economist,” www.bloomberg.com, 6/26/2023.
5 “US Equity Strategy,” Morgan Stanley Research, 6/26/2023.
6 “Big Seven Powering $5 Trillion Nasdaq 100 Rally,” www.bloomberg.com, 6/30/2023.
7 “Key Charts For 1H Client Letters & Look Ahead,” Strategas ETF Research, 6/27/2023.
8 “Is It Time to Cancel the Recession Altogether?,” www.bloomberg.com, 6/27/2023.
9 A basis point (bp) is 0.01%.
10 “LEI for the U.S. Declined Further in May,” www.conference-board.org, 6/22/2023.
11 “Generating $5 billion, the Taylor Swift The Eras Tour has an Economic Impact Greater than 50 Countries,” www.bloomberg.com, 6/8/2023.