It has been a rather extraordinary six months in the stock market thus far in 2023. It is not the absolute returns represented by the stock market indices that has been most unusual, it is how concentrated those gains were, particularly in the US.

The TSX gained a modest 3.1% in the first half of the year. The S&P 500 index, however, rose an impressive 16.9%. Once one digs a little deeper, however, one realizes that those returns south of the border were not as rosy as they may seem at first. This can be illustrated in several ways.

About half of the stocks in the TSX index outperformed the 3.1% average gain, with half underperforming – nothing remarkable there. In the S&P 500 index, however, only 30% of stocks surpassed the benchmark’s 16.9% return. Rarely have we seen 70% of stocks in the index underperform the average.

The gains have been concentrated in a handful of stocks that some have come to call the “Magnificent Seven”: Nvidia, Meta Platforms, Tesla, Amazon, Apple, Microsoft and Alphabet. And because each of these are mega-cap companies, their returns have a greater weighting in the market capitalization-weighted S&P 500 Index. By comparison, an exchange-traded fund that weights each of the 500 index constituents equally gained a more pedestrian 5.9% in the year to date.  That 11% disparity between the capitalization-weighted and equal-weighted returns has only been witnessed one other time in the past 20 years .

                                                    Source: Refinitiv

Causes of the Tech Outperformance

It is no coincidence that the Magnificent Seven are all technology-related stocks. (Note that while these are technology-related stocks, they are found across the Information Technology, Communications Services, and Consumer Discretionary sectors, and have powered strong gains in those three industry groups as can be seen in the above chart). There are several reasons for this tech rally. First, much of this year’s gain was simply recovering what was lost in 2022, when tech stocks saw dramatic declines. On average, those seven stocks fell 46% last year. As such, their 89% average recovery in 2023 has merely returned those stocks to 4% below their level at the beginning of 2022, on average (only Nvidia is more than 10% above where it was a year and a half ago).

Aside, perhaps, from some bargain-hunting, there were two key catalysts that brought investor interest back to the technology sector. First, a lot of Silicon Valley-based companies found religion on the need for profitability, pivoting from their growth-at-all-costs mentality. This shift in thinking was most clearly on display at Meta Platforms, the parent of Facebook, which undertook multiple rounds of layoffs and cost cutting efforts. Investors expressed their support for the new bottom-line focus by scooping up shares in companies taking on such measures.

The second catalyst for the sector was the release of ChatGPT in late 2022. This and other free-to-use Artificial Intelligence-powered tools opened the world’s eyes to how AI could boost productivity across a wide range of projects and tasks. Many of the Magnificent Seven are heavily involved in building out their AI capabilities and may be first movers within this trend.

A Soft Landing Could Lift the Rest of the Market

The main force holding back non-tech stocks has been concerns of a potential recession, which would hurt more economically-sensitive sectors such as Industrials, Materials, Financials and Energy – whereas technology stocks will be less impacted due to their sources of secular growth. Lately, however, that narrative has been undergoing a shift that could provide some insight into what may lay ahead for the stock market.

Despite the steady pace of interest rate hikes by global central banks, the job market has been surprisingly resilient all year. More recently, broader measures of the economic health have also performed better than expected. In the last week of June, for example, the final estimate for first quarter GDP growth showed that the US economy grew at a 2% annualized rate compared to expectations of only 1.4%.

The Citigroup Economic Surprise Index, seen below, gauges whether economic data has been beating or missing forecasts. The index has spent most of this year above zero, suggesting the economy continues to be stronger than expected.

                              Source: Refinitiv

As a result, more and more economists are pulling back on their calls for a recession this year. In December, a Bloomberg survey of economists indicated there was a 70% chance of a 2023 recession. That number fell to 50% by March and now the majority of those economists don’t see a recession at all this year. This increases the probability that the central banks successfully achieve the “soft landing” scenario, which has lifted the prospects of banks, oil producers, heavy equipment manufacturers and other companies that rely on healthy corporations and consumers. As such, since the beginning of June, shares of such companies have quietly taken over leadership in the market from the Magnificent Seven.

We believe this is one of the key trends to watch as we enter the second half of the year. If it continues, we could see the TSX, which has a greater weighting in financials and energy stocks, play some catch-up to its US counterpart.

Some Risks to Monitor

While we believe that markets can continue to recover in the second half of the year, they will not likely do so in a straight line. One reason for caution in the near term is that investor optimism has roared back in recent months. In a mid-June survey conducted by the American Association of Individual Investors, 45% of members were bullish on the prospects of the stock market. This number can rise above 55% during periods of more extreme optimism, but it is up from 19% in mid-March and was at the highest level of enthusiasm since November 2021, which was shortly before stocks began a year-long slide. Too much bullishness opens the door for an overreaction to the downside should any disappointments develop. Such disappointments could come during the upcoming corporate earnings season, the next round of central bank interest rate hikes, or during any brief easing of economic data that inevitably occurs. We do not believe, however, that the downside would be very steep in such a scenario. We would view a pullback as a healthy reset amid the ongoing recovery from the 2022 declines.

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