Market Summary and Outlook
2023 proved to be a resilient year across financial markets, with various themes upending narratives that were either overblown or underappreciated heading into 2023. The S&P 500, Russell 2000 and NASDAQ Composite ended 2022 down 18%, 15% and 33% respectively, as fear over inflation, duration of the Federal Reserve’s tightening cycle, and subsequent potential for an economic hard landing created significant uncertainty. This fear proved to be an attractive entry point, especially for the broad market indices, where new themes around Artificial Intelligence (AI), began to overshadow concerns over the impact of “higher-for-longer” interest rates. The S&P 500 increased 24% in 2023, benefitting from gains within the Technology, Consumer Discretionary and Communication Services sectors, where concentration in the “Magnificent Seven”: Apple Inc. Microsoft Corp. Amazon.com Inc. Nvidia Corp. Alphabet Inc. Tesla Inc. and Meta Platforms Inc, boosted returns. The prevailing narrative around these companies is that each will be a winner from the seismic shift AI will have on the productivity potential of the economy.
For most of the year, the theme of AI was all the market rewarded. Year-to-date through October, the S&P 500 and Russell 3000 were up 10% and 9% respectively, while the tech-heavy NASDAQ composite was up over 23%. This was despite the yield on the 10-Year government bond peaking at nearly 5%. Rising bond yields throughout much of 2023 reinforced the theme that small cap stocks would face significant headwinds, as their business operations are more exposed to higher borrowing costs and the belief small cap companies would not see the same overarching benefit of AI that large-cap tech-focused businesses would benefit from.
Since peaking on October 19th, the yield on the 10-year government bond has declined by 115 basis points, precipitating a broadening rally in equities, with the Russell 2000 up 22%, beating the return of the S&P 500 by over 900 basis points. The outperformance of the Russell 2000 is a byproduct of continued disinflation in the U.S. economy, accelerated by a “pivot” from the Federal Reserve. In their last meeting of 2023,
Federal Reserve Governors updated their “Summary of Economic Projections” or SEP, which included a “dot-plot” of their median projection for the federal funds rate. Median Board of Governor projections call for three (3) 25-basis-point rate cuts by year-end 2024. However, with news of the Fed’s “pivot”, Fed Funds futures are now implying between six and seven 25 basis point rate cuts by year-end 2024. The market is either anticipating inflation to fall much faster than the Fed is projecting (soft landing), or the market is saying the economy will weaken significantly, which will force the Fed to lower rates as a stimulative measure (hard landing, but accommodative monetary policy). While the Fed’s comments resulted in a “dove-ish” risk-on rally, the rate cuts that are being extrapolated by the market are taking place over a shorter period than we envision. The timing of rate cuts is highly uncertain, seemingly changing with every piece of economic data. What is certain is that generationally tighter monetary policy conditions will have lagged effects across the economy. These effects have started to show their signs yet are not reflected in broad equity valuations.
We view the economy as much weaker than what the market is pricing in, with valuations on the indices increasing given the lack of breadth driven by skyrocketing multiples for the Magnificent Seven. We question whether investors will be willing to continue to pay 20x earnings for the S&P 500 going forward. This is considering a softening environment where the implied equity risk premium is at-or-near zero when compared to available bond yields. Fortunately for us as active managers, the lack of breadth has led to a wide valuation dispersion, meaning that there are areas of opportunity where stocks are priced attractively. We continue to find stocks with idiosyncratic catalysts and asymmetric payouts with great balance sheets and ample free cash-flow to invest in.
As markets now expect an increasingly accommodative monetary environment, we feel equity markets will continue to look past potential economic weakness, an opportunity most attractive for value stocks. The largest 10 stocks in the S&P 500, primarily the Magnificent Seven, have continued to grow as a percentage of the index despite muted earnings growth; meanwhile there are attractive areas of the market that have yet to recover after pricing in a recession throughout most of 2023. This bifurcated environment has only started to correct. Smaller capitalization stocks within economically sensitive sectors continue to look attractive in terms of valuation, particularly in an environment where broad market valuations are at-or-near fair value.
The Easterly Snow Capital Long/Short Opportunity Fund (SNOIX) enters 2024 with its largest overweight allocations to the Energy, Technology and Health Care sectors. Within Technology, the Fund’s holdings trade at 13.8x forward earnings estimates. Conversely, the Russell 3000 Value’s Technology constituents are trading at 20.6x forward earnings estimates. We believe the idiosyncratic catalysts of our holdings in Technology will ultimately be rewarded by the market, relative to the larger, more expensively trading stocks that led the rally in 2023. Furthermore, Energy stocks are trading at a wide discount to historical valuations, and JP Morgan estimates the Energy sector has the highest operating leverage as revenue rises. We believe the demand for commodities, particularly in a soft-landing scenario, should be supportive of oil and gas prices; greater capital discipline from U.S. producers and OPEC’s production cuts in a coordinated effort to balance the crude oil market, presents an intriguing risk reward opportunity for the Energy sector entering 2024.
We believe the Fund continues to excel as we stick to our core philosophy and process of identifying structurally sound companies going through short-term, often self-inflicted difficulties where an earnings recovery leads to a P/E multiple re-rating. A dislocated macro backdrop, such as the one we see today, suits our style well given we have historically outperformed as the market emerges from periods of elevated volatility, where our fundamental research process is able to identify the best opportunities, and where valuations do not reflect underlying fundamentals. This can include the aftermath of periods where correlations are elevated and equities trade down in tandem with their peer groups or following broad market selloffs. The Fund’s long portfolio has an 87% active share relative to the benchmark (Russell 3000 Value) and 107% active share when including our short and hedge positions. This enables us to pick best-of-breed companies and not be beholden to lower quality subsections of the index.
At year end, the Fund’s gross exposure was 130%, consisting of 105% long and 25% short exposure. Accounting for our options exposure, our delta adjusted net exposure was 68%. Our short positions are primarily intended to dampen market volatility, although active shorts make up ~1/3 of our short exposure. As we position for 2024, we have added short positions to reduce our exposure to the Energy sector, the Fund’s largest overweight. While we are encouraged by the outlook for our long Energy holdings, we have opted to reduce our commodity exposure in the near-term, due to concerns that demand may be impacted from macroeconomic pressures coupled with a muted response in supply.
We are committed to delivering strong performance in 2024 and appreciate your continued trust in Easterly Investment Partners.
Investors should carefully consider the investment objectives, risks, charges and expenses of the Fund. This and other information is contained in the Fund’s prospectus, which can be obtained by calling 888-814-8180 and should be read carefully before investing. Additional Fund literature may be obtained by visiting www.Funds.EasterlyAM.com.
Risks & Disclosures
Past performance is not a guarantee nor a reliable indicator of future results. As with any investment, there are risks. There is no assurance that any portfolio will achieve its investment objective. Mutual funds involve risk, including possible loss of principal. Effective 10/2/2023, the Easterly mutual funds are distributed by Easterly Securities, LLC. Easterly Investment Partners, LLC and EAB Risk Solutions, LLC are affiliates of Easterly Securities, LLC, member FINRA/SIPC. Orange Investment Advisors, LLC and Ranger Global Advisers are not affiliated with Easterly Securities, LLC. Certain associates of Easterly Securities, LLC are registered with FDX Capital LLC, member FINRA/SIPC.
Short sales involve unlimited loss potential since the market price of securities sold short may continuously increase.
Diversification does not assure a profit nor protect against loss in a declining market.
Derivatives may involve certain costs and risks such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested.
Mutual fund investing involves risk; principal loss is possible. Investments in smaller companies involve additional risks such as limited liquidity and greater volatility. Investments in foreign securities involve greater volatility and political, economic and currency risks and differences in accounting methods. These risks are greater in emerging markets.
Investments in debt securities typically decrease in value when interest rates rise. This risk is usually greater for longer-term debt securities. The fund may invest in lower-rated and non-rated securities which present a greater risk of loss to principal and interest than higher-rated securities. The fund may invest in other investment companies, and the cost of investing in the Fund will generally be higher than the cost of investing directly in the shares of the mutual funds in which it invests. By investing in the Fund, you will indirectly bear your share of any fees and expenses charged by the underlying funds, in addition to indirectly bearing the principal risks of the funds. The fund also invests in ETFs. They are subject to additional risks that do not apply to conventional mutual funds, including the risks that the market price of an ETF’s shares may trade at a discount to its net asset value (“NAV”), an active secondary trading market may not develop or be maintained, or trading may be halted by the exchange in which they trade, which may impact the Fund’s ability to sell its shares. The Fund may use options and futures contracts which have the risks of unlimited losses of the underlying holdings due to unanticipated market movements and failure to correctly predict the direction of the securities prices, interest rates and currency exchange rates. This investment may not be suitable for all investors. Small- and Medium-capitalization companies tend to have limited liquidity and greater price volatility than large-capitalization companies. Performance over one year is annualized.
THE OPINIONS STATED HEREIN ARE THAT OF THE AUTHOR AND ARE NOT REPRESENTATIVE OF THE COMPANY. NOTHING WRITTEN IN THIS COMMENTARY OR WHITE PAPER SHOULD BE CONSTRUED AS FACT, PREDICTION OF FUTURE PERFORMANCE OR RESULTS, OR A SOLICITATION TO INVEST IN ANY SECURITY.