As we enter the second half of 2023, the S&P Total Return Index is up 16.9% and is now just 5.6% from making a new all-time high. Looking at the chart to the right (Chart1), ever since the top of the bear market downtrend channel was broken and then tested back in January, it has been off to the races for bulls.

But as we look towards the second half of the year, is the market glass half full or half empty?

Global stocks and other risk assets have brushed off regional bank failures, the arrest of a former president (and favorite for challenging candidate in 2024), fears of a US recession, the gating of large real estate funds, disappointment in China’s reopening, and further interest rate increases from the US Federal Reserve, the European Central Bank and other major developed world central banks. In short, stocks have done an impressive job of climbing the proverbial “wall of worry.”

There are a number of factors that can explain this rally. Better-than-expected economic conditions in the first half of 2023 have contributed to this dynamic. Another obvious one is hopes of large productivity gain from artificial intelligence. And finally, tamer inflation numbers, thanks in part to stable energy prices (Chart 2).

Investor’s confidence in a “soft landing” has powered gains across risk assets, leading to a historic first half of the year. But are they right? And more importantly, going forward will the rally continue?

It would be very on brand for stocks to melt up into recession, right before a hard landing. Just as investors start piling into stocks because of the “fear of missing out” on returns. While we believe a recession has likely been delayed, we do not think a harder landing is properly priced into asset markets. The economy is still digesting the effects of lagging monetary policy, and the Fed is likely not done raising rates. The Fed still highlights risks that the market has written off as ambivalent.

While there is scope for economic data to remain resilient over the near-term and continue to support equities over a tactical investment horizon, we doubt that this resilience can be sustained over the longer term. Instead, the elevated likelihood of a recession over a 12-month horizon will eventually weigh on the performance of equities. Moreover, recovering stock prices suggest that equities are not priced for recession, making them more vulnerable to the downside in the event of an economic downturn.

The Bond market is much more reflective of this dynamic. After moving in tandem with stocks for the past several years, they have meaningfully diverged in 2023 (Chart 3). Additionally, the yield curve remains inverted and bond volatility significantly higher than equity.

Whatever the reason, the divergence of bond and equity volatility still raises the fear that equity market volatility will play catch-up with the signal being sent by the bond market (Chart 4).

Therefore, after remaining neutral in our broader asset allocation in 2023, we have reduced equity exposure to be prudent to underrealized risks. We have increased allocations to our fixed income positions, which we feel provide better risk/reward dynamics. Ultimately, we believe risk management is the most important factor to wealth accumulation and preservation. We build portfolios with the objective of minimizing downside capture. After an incredible rally to start the year, we believe it’s prudent to begin to underweight risk assets in our portfolios. We will continue to monitor our portfolios as the facts change and will remain tactical as the situation evolves.

Past performance is no guarantee of future results. Performance prior to January 1, 2018 was earned on accounts managed at a predecessor firm, JAForlines Global. The person primarily responsible for achieving that performance continues to manage accounts at Donoghue Forlines in a substantially similar manner. The material contained herein as well as any attachments is not an offer or solicitation for the purchase or sale of any financial instrument. It is presented only to provide information on investment strategies, opportunities and, on occasion, summary reviews on various portfolio performances. The investment descriptions and other information contained in this Markets in Motion are based on data calculated by Donoghue Forlines LLC and other sources including Morningstar Direct. This summary does not constitute an offer to sell or a solicitation of an offer to buy any securities and may not be relied upon in connection with any offer or sale of securities. The views expressed are current as of the date of publication and are subject to change without notice. There can be no assurance that markets, sectors or regions will perform as expected. These views are not intended as investment, legal or tax advice. Investment advice should be customized to individual investors objectives and circumstances. Legal and tax advice should be sought from qualified attorneys and tax advisers as appropriate. The calculation and presentation of performance has not been approved or reviewed by the SEC or its staff.

The Donoghue Forlines Global Tactical Allocation Portfolio composite was created July 1, 2009. The Donoghue Forlines Global Tactical Income Portfolio composite was created August 1, 2014. The Donoghue Forlines Global Tactical Growth Portfolio composite was created April 1, 2016. The Donoghue Forlines Global Tactical Conservative Portfolio composite was created January 1, 2018. The Donoghue Forlines Global Tactical Equity Portfolio composite was created January 1, 2018.

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