Following a strong first half of the year, particularly for the largest capitalization stocks, the equity markets experienced a correction during the third quarter.  The S&P 500 peaked in late July near 4,600, within 5% of all-time highs, but declined approximately 7% in August and September for a net loss in the third quarter of down -3.3% and a year-to-date gain of 13.1%. Small and mid-cap stocks followed a similar path over the last three months, albeit with a steeper correction as they tend to be more volatile. The small cap index, a key focus area for our investment approach where we find many of our long-term holdings, declined 5.1% during the quarter and is up 2.5% year-to-date.

The primary reason for the decline in stocks was the rise in interest rates. While the Federal Reserve slowed the pace of short-term rate hikes to a single 25bp hike during the quarter, the target range for the federal funds rate currently sits at a 22-year high of 5.25-5.50%. Longer-term rates moved meaningfully higher as markets finally priced in expectations for rates to remain “higher for longer.” The 10-year treasury yield rose from 3.8% to 4.8% from the end of June through September.

The rise in long-term rates impacts equity values in several ways. It weighs on stock prices as the present value of future corporate cash flows is lower due to the higher discount rate. Higher yielding bonds become relatively more attractive for investors than equities, and this impacted dollar flows between the asset classes. Equities can become riskier for investors when companies must pay higher interest expenses in the future as this reduces the profits available to shareholders.  The longer interest rates remain elevated, the longer the negative effects of the higher rates will hurt the economy and stock valuations.  In the housing sector, for example, residential mortgage activity plunged as rates more than doubled and are now at the highest level in over 20 years. Corporations across all industries will face much higher rates when they go to refinance fixed-rate debt and on their existing variable rate loans. The additional expense, all else equal, reduces the willingness of firms to invest and hire new employees.

However, higher interest rates are not always bad for stocks, and the relationship between stock prices and interest rates has been inconsistent over time. US government interest rates reflect expectations for future growth and inflation in the US economy. When the rise in interest rates is driven by expectations for better growth in the economy, it can be positive for stocks as higher growth leads to higher sales and profits for businesses. The improved growth and profit outlook can at times more than offset the negative impact of higher rates, such as what often happens early in an expansion following a recession when stocks and rates rise together. In 2022, stocks declined as the rate rise was triggered by inflation fears rather than improving real economic growth. More recently, the driver of higher rates seems to be improving long-term growth expectations rather than inflation, and the longer-term impact on stock prices is more ambiguous. We remain on high alert for any resurgence of inflationary pressure.

Returns for the year continue to be dominated by the “Magnificent Seven” mega-cap stocks – Apple (AAPL), Microsoft (MSFT), Alphabet (GOOGL, GOOG), Amazon (AMZN), Nvidia (NVDA), Meta Platforms (META), and Tesla (TSLA), which continue to drive the majority of the 13.1% year-to-date gains for the S&P 500. By comparison, the S&P 500 equal-weighted index (large caps weighted equally rather than by market capitalization, +1.8% gain YTD), S&P 400 (mid-caps, +4.2% gain YTD), and the S&P 600 (profitable small-caps, +0.8% gain YTD) have more modest gains. We selectively added to our holdings in GOOGL, AMZN, and MSFT where we continue to see upside based on valuation and growth rates, but we remain underweight the Magnificent Seven in aggregate. While we regret not taking greater advantage of the opportunity in the mega-caps at the beginning of the year, we believe the bulk of the outperformance has been realized and more compelling opportunities lie elsewhere at this point.

Looking forward over the next 3-5 years, we see tremendous potential for small- and mid-cap outperformance. The valuation gap between small caps (12-13x forward P/E) and large caps (18-19x forward P/E) is historically extreme across a variety of valuation metrics, as is the relative outperformance of large caps over small caps over the last 10 years (S&P 500 +11.9% per year vs. the Small Cap Index +6.6% per year). We have seen similar periods before in market history, such as the Nifty Fifty during the 1960s-70s and Dot-com bubble of the late-1990s, both of which were followed by multi-year periods of relative outperformance for small cap investors. The transition from large-cap to small-cap leadership was usually triggered by a peak in interest rates and a subsequent recession.  Although short term interest rates have increased by 5%, but we have yet to see whether we achieve a “soft landing” or if an economy wide recession takes hold.

It is impossible to know when the cycle will shift in favor of smaller companies, and returns may get more extreme in favor of large caps in the near term. We are optimistic as we look out over a multi-year time horizon. We are finding a remarkable number of companies that trade at single digit or low-double digit P/Es with defensible moats, robust double-digit annual earnings growth and high cash flow generation. Companies with these characteristics can become excellent investments.

Discussion of Third Quarter Performance and Positions

For the Shaker Fundamental Growth strategy, the largest positive contributors to returns during the quarter were Ollie’s Bargain Outlet (OLLI), Diamondback Energy (FANG), Alphabet (GOOG), Casey’s General Stores (CASY), and The Boston Beer Company (SAM). Our largest detractors during Q3 were Insulet (PODD), WESCO International (WCC), Dexcom (DXCM), Euronet Worldwide(EEFT), and Fortinet (FTNT).

In Shaker’s Small Cap Growth strategy, the largest positive contributors to returns during the quarter were Ollie’s Bargain Outlet (OLLI) and Sprouts Farmers Market (SFM). Our largest detractors were Insulet (PODD), WESCO International (WCC), Euronet Worldwide (EEFT), Dexcom (DXCM), DoubleVerify (DV), CoStar Group (CSGP), United Airlines (UAL), and Paycome Software (PAYC).

Broadly, the rise in discount rates had a distinct impact on valuations in higher multiple/higher growth stocks, but as mentioned above, we are increasingly seeing very attractive valuations in quality growing companies and continue to look to reposition the portfolio to take advantage of these opportunities. Looking at top contributors to the Small Cap Growth portfolio during the third quarter, on the positive side were two retailers – Ollie’s Bargain Outlet (OLLI) and Sprouts Farmers Market (SFM). The rest of the top ten contributors to returns fell during the quarter mirroring the the broader decline in small cap stocks. Of note, we saw declines in our Diabetes exposed names on concerns related to novel drugs to treat obesity. We will note that Dexcom (DXCM) revenue grew 27% year over year in the quarter and we remain confident in the long-term outlook for these businesses given the overall size of the market they serve and limited penetration at this point.

Investment Outlook

The investment outlook continues to oscillate between optimism and pessimism over the direction of the economy and markets. During the summer, stocks were near the highs for the year and on track to reach new all-time highs as investors anticipated a “soft landing” for the economy and lower interest rates as inflation returns to the targeted annual rate near 2%. Today, stock prices have corrected as investors fear the impact of the Federal Reserve holding rates “higher for longer” to control inflation, which many believe will lead to reduced profits and a high likelihood of recession. The reality is in between these two extremes – inflation is returning to normal at a slow and steady pace, and the Fed will likely keep rates higher for longer due to a healthy economy with limited risk of a recession in the near–term.

As we position the portfolio for the remainder of 2023 and into early 2024, below are a few important factors we think investors should consider:

• The unemployment rate and unemployment claims remain near multi-decade lows. Typically, a recession does not occur without a meaningful rise in unemployment, and there are no such signs today. The economy is growing, jobs are plentiful, and consumers are spending. Until that changes, the environment tends to be positive for corporate profits and the stock market.
• Recessions tend to start due to some unforeseen risk that catches investors, consumers, and businesses by surprise, such as COVID-19 in 2020. Expectations for an upcoming recession have been so widespread for over a year that perhaps one can be avoided as consumers and businesses have already taken sufficient precautions to make future cutbacks in spending and investment less likely. It is difficult to know what will be at the center of the next recession, and when it will occur, but it is unlikely to be the already well-known economic issues highlighted in today’s news headlines. Given the widespread expectations for negative impacts from higher interest rates, perhaps surprises will instead start to come to the upside rather than the downside for investors.
• With a major land war in Ukraine and the possibility of one developing in the Middle East, geopolitical risks are running very high. This tension may not be fully priced into the markets.
• While the economy has not experienced a recession, corporate profits arguably have. S&P 500 profits have declined on a year-over-year basis for the last three quarters, and profit margins peaked in 4Q 2021. Corporate earnings are expected to return to growth as they report 3Q 2023 results this Fall. Improving profits may be the catalyst to move stock prices higher.
• We have discussed in the past that the economy has experienced a series of “rolling recessions” depending on the sector and industry, and we expect that environment may continue – as one area recovers, a different area faces headwinds. This rolling correction environment can help prolong expansions and reduce the frequency of broader recessions. For example, in 2015-2016 the economy suffered an “industrial recession” with a downturn in the stock market but avoided a more widespread recession. Perhaps we will look back similarly on 2022-2023.

We are optimistic in terms of the growth prospects for our holdings and find they are trading at more attractive valuations than we have seen in a number of years. We have positioned to take advantage of the projected reacceleration in earnings growth following the downturn in profits over the last year. Historically we have found similar conditions to be a favorable environment for our investment approach as our holdings tend to achieve higher earnings growth relative to the broader market, while their valuations have similarly corrected through the downcycle. Should the earnings re-acceleration fail to materialize over the next several quarters, we are prepared to adjust our holdings and position the portfolio more conservatively.

We look forward to updating you in January and we are always available to assist in any way we can.

Sincerely,

The Shaker Investment Team