Published on July 18, 2023

The S&P 500 has generated double digit returns so far in 2023, but the gains have been narrowly focused. Heading into the second half, we will be watching to see whether the rally broadens or the market capitulates.

Beware the Narrow Market

With the S&P 500 up nearly 17% year-to-date through June 30, 2023, one might assume that we are in the midst of a broad rally underpinned by a healthy and growing economy. However, stock market gains have been unusually narrow so far this year. In fact, through the end of May 2023, just seven companies – each of which benefited from recent excitement around artificial intelligence (AI) – had driven all the gains in the market. Excluding those companies, as of 5/31, the S&P 500 was down year-to-date, and there are many crosscurrents in the economy that are creating significant uncertainty:

  1. Inflation is clearly easing, but it remains double the Fed’s target
  2. Unemployment is near multi-decade lows, which means jobs are plentiful, but tight employment may contribute to elevated inflation and thus higher interest rates
  3. The overall economy continues to grow, but we see indications of severe stress in key sectors

The question going forward is whether we are in the midst of a “soft landing”— in which case the recent market gains will almost certainly broaden out — or if we are facing a “hard landing” whereby the narrow market capitulates. Regardless, we believe that the best course of action for equity allocations is to own a concentrated portfolio of Quality Growth companies that generate significant free cash flow and growing dividends to help protect against downside risk while still participating in potential market upside.

Less than Meets the Eye

On the surface, it appears that the economy is as healthy as ever, with risks rapidly receding after a bout of rampant inflation in 2021 and 2022. For instance, the most recent report from the Bureau of Labor Statistics reported year-over-year headline inflation at 4.0% as of May 2023, down from 8.6% in May 2022. Unemployment of 3.7% as of May 2023 reflects a very tight labor market near multi-decade lows. And real GDP growth in the first quarter of 2023 came in at a tepid, but respectable, 1.3% year-over-year.

However, scratch the surface and the picture is a little less clear. While inflation has certainly come off the 2022 highs, it remains double the Fed’s 2% inflation target. This has forced the Federal Reserve to hike its key interest rate to over 5% and signal that it may further raise rates in 2023. And while low unemployment is a welcome boon for workers and supports wage gains, the tight labor market has been a key support to stubbornly high inflation and thus persistently high interest rates. These elevated interest rates have played an influential role in a rash of regional bank failures, leading to tightening credit conditions across the economy. We have also seen a marked increase in bankruptcies of troubled retailers and office real estate properties as liquidity has dried up (in fact, the running joke in real estate circles is that Class B office values are now measured by land value less demolition costs). As for corporate earnings, these are on track to be down 2.1% year-over-year for the first quarter of 2023. In addition, key metrics from companies we carefully track indicate that low-income consumers are facing significant economic stress, while middle income consumers are increasingly reliant on credit card debt.

The Magnificent Seven

Overall we think risks remain elevated for the economy. So why is the S&P 500 up so much this year? As mentioned above, a big part of the answer lies in a very narrow market supported by a small handful of large technology companies that have rallied significantly. Shares in Nvidia, Meta (Facebook), and Tesla have rallied well over 100% so far this year, and Apple is up over 40% — we do not hold any of these companies in our core equity or income portfolios. Microsoft, Alphabet (Google), and Amazon, all of which we own in size, have been bid up as well.

In fact, excluding these seven companies, which have been dubbed the “Magnificent Seven,” the S&P 500 was down year-to-date as of 5/31/23. These firms now account for about 30% of the index and have generated the largest year-to-date outperformance for the cap-weighted index vs. the equal-weighted index on record.

All is Not Lost

While we are cautious about the near term, it is important to remain level-headed. The economy appears to be slowing, but with low unemployment and inflation grinding lower — albeit at a gradual pace — it is possible that we are in the midst of a “soft landing,” whereby the economy slows without crashing into a recession.

Interestingly, in roughly the last week and a half of June, the rally has broadened to include a larger swathe of the market. If this trend persists, it could indeed reflect a soft landing.

And counterintuitively, the fact that a recession is so widely expected may actually drive companies to take actions that reduce recession risk. The Conference Board recently noted a 99% chance of recession in the next twelve months. Bloomberg has even called this “the most-anticipated downturn ever.” With such broad anticipation of a recession, companies have laid off workers and significantly slowed hiring, which may actually create a release valve for tight employment and thus help alleviate inflation, potentially enabling the Fed to back off on future interest rate hikes. The fact that unemployment has crept up to 3.7% vs. a low of 3.4% may reflect a gradually loosening labor market in the context of a growing economy.

Regardless of where the market is headed, we view a defensive quality tilt within equities as the prudent course of action: If the market rally broadens out, remaining invested should reward investors; and if the rally ends, owning quality assets should help mitigate downside risk.

Do Not Chase the Market

As always, we think it is dangerous to simply chase the companies that are driving the latest stock market gains. Rather, more than ever we believe that investing in a concentrated portfolio of Quality Growth companies represents the right course of action. Quality Growth companies have durable competitive advantages that allow pricing power and/or market share gains, enabling growth in earnings and free cash flow through most environments, including through inflationary periods. And Quality Growth companies are often well capitalized, usually pay growing cash dividends, have good management, and benefit from secular tailwinds. Investing in a concentrated portfolio of these companies at attractive valuations and having a long-term view should enable solid participation in market rallies while protecting against market turmoil.

We have also found that this narrow market has created dislocations in great businesses that we believe are temporarily out of favor, and we are actively taking advantage of sell-offs in the share prices of individual companies. As the economy stabilizes and eventually grows at a healthier pace, we anticipate broader participation in market gains and a recognition of the value of many of the Quality Growth companies we hold.

Please reach out should you have questions.

John Osterweis

Founder, Chairman & Co-Chief Investment Officer – Core Equity

Gregory Hermanski

Co-Chief Investment Officer – Core Equity

Nael Fakhry

Co-Chief Investment Officer – Core Equity


John Osterweis

Founder, Chairman & Co-Chief Investment Officer – Core Equity

John Osterweis

John Osterweis

Founder, Chairman & Co-Chief Investment Officer – Core Equity

After graduating from business school, John Osterweis served as a Senior Analyst concentrating on the forest products and paper industry for several regional brokerage firms and later for E.F. Hutton & Company, Inc. In addition to his activities as an analyst, Mr. Osterweis served as Director of Research for two firms and managed equity portfolios for over ten years.

In late 1982, Mr. Osterweis decided to devote himself full time to his portfolio management activities, and in April of 1983 launched Osterweis Capital Management. Mr. Osterweis has served as Director of the Lucas Museum of Narrative Art, Director on the Stanford Alumni Association Executive Board, Trustee of Bowdoin College, Director and Vice Chairman of Mt. Zion Hospital and Medical Center, and President of the Board of Directors for Summer Search Foundation. He currently serves as a Trustee of the San Francisco Ballet Association, Director of the San Francisco Free Clinic, and President Emeritus of the San Francisco Ballet Endowment Foundation, as well as Trustee Emeritus of Summer Search Foundation and of Bowdoin College.

He is a member of the firm’s Management Committee, a principal of the firm, and a co-lead Portfolio Manager for the core equity, growth & income, and flexible balanced strategies.

Mr. Osterweis graduated from Bowdoin College (B.A. in Philosophy, cum laude), and Stanford Graduate School of Business (M.B.A. with top honors in Finance).

Gregory Hermanski

Co-Chief Investment Officer – Core Equity

Gregory Hermanski

Co-Chief Investment Officer – Core Equity

Prior to joining Osterweis Capital Management in 2002, Greg Hermanski was a Vice President at Robertson Stephens and Co. where he was in charge of convertible bond research. Prior to that, Mr. Hermanski was a Research Analyst covering convertible, high yield, and distressed securities at Imperial Capital, LLC, and a Valuation Consultant for Price Waterhouse, LLC.

He is a principal of the firm and Co-Lead Portfolio Manager for the core equity, growth & income, quality cyclical growth, and flexible balanced strategies.

Mr. Hermanski graduated from the University of California, Los Angeles (B.A. in Business/Economics).

Nael Fakhry

Co-Chief Investment Officer – Core Equity

Nael Fakhry

Co-Chief Investment Officer – Core Equity

Prior to joining Osterweis Capital Management in 2011, Nael Fakhry worked as an Associate at American Securities, a private equity firm, and as an Analyst in the investment banking division of Morgan Stanley.

He is a principal of the firm and Co-Lead Portfolio Manager for the core equity, growth & income, quality cyclical growth, and flexible balanced strategies.

Mr. Fakhry graduated from Stanford University (B.A. in History, Phi Beta Kappa) and the University of California Berkeley, Walter A. Haas School of Business (M.B.A., C.J. White Scholar).

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Osterweis Fund Quarter-End Performance (as of 3/31/24)

Fund 1 MO QTD YTD 1 YR 3 YR 5 YR 7 YR 10 YR 15 YR 20 YR INCEP
OSTFX 3.39% 10.04% 10.04% 26.94% 6.37% 12.40% 11.09% 8.40% 11.30% 8.23% 10.42%
S&P 500 Index 3.22 10.56 10.56 29.88 11.49 15.05 14.09 12.96 15.63 10.15 10.40
Swipe Table for Full Data

Gross expense ratio as of 3/31/23: 0.97%

Performance data quoted represent past performance; past performance does not guarantee future results. The investment return and principal value of an investment will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance of the Fund may be higher or lower than the performance quoted. Performance data current to the most recent month end may be obtained by calling shareholder services toll free at (866) 236-0050.

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Where applicable, charts illustrating the performance of a hypothetical $10,000 investment made at a Fund’s inception assume the reinvestment of dividends and capital gains, but do not reflect the effect of any applicable sales charge or redemption fees. Such charts do not imply any future performance. During the period noted, fee waivers or expense reimbursements were in effect for the Osterweis Fund.

The S&P 500 Index is an unmanaged index that is widely regarded as the standard for measuring large cap U.S. stock market performance. The index does not incur expenses, is not available for investment, and includes the reinvestment of dividends.

References to specific companies, market sectors, or investment themes herein do not constitute recommendations to buy or sell any particular securities.

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The S&P 500 Index is an unmanaged index that is widely regarded as the standard for measuring large-cap U.S. stock market performance. The S&P 500 Equal Weight Index is an unmanaged index composed of the stocks held in the S&P 500 Index using an equal-weighted approach instead of market cap-weighted.

Cash flow measures the cash generating capability of a company by adding non-cash charges (e.g., depreciation) and interest expense to pretax income.

Free cash flow represents the cash that a company is able to generate after laying out the money required to maintain and expand the company’s asset base. Free cash flow is important because it allows a company to pursue opportunities that enhance shareholder value.

A yield curve is a graph that plots bond yields vs. maturities, at a set point in time, assuming the bonds have equal credit quality. In the U.S., the yield curve generally refers to that of Treasuries.

Osterweis Capital Management is the adviser to the Osterweis Funds, which are distributed by Quasar Distributors, LLC. [OSTE-20230710-0925]