“Far more money has been lost by investors in preparing for corrections, or anticipating corrections, than has been lost in the corrections themselves” – Peter Lynch
The fourth quarter and 2023 are officially in the record books. After finishing October in the red, the S&P 500 staged a blistering rally, gaining just over 14% in the last two months of the year. The index finished the quarter up more than 11%, bringing its total return for the year to more than 26%. The S&P narrowly missed reaching a new all-time high, pulling within 20 points of the record it set in late 2021.[1]
The fourth quarter rally in stocks started in earnest following the Federal Reserve’s November meeting. In our opinion, investors perceived a more dovish tone from Fed officials leading to speculation that the Fed was nearing the end of its tightening cycle and would begin cutting rates in 2024. In addition to boosting stocks, the expectation of a dovish pivot from the Fed also spurred a significant decline in interest rates. In December, the 10-year US Treasury yield fell below 4% for the first time since August, propelling the Bloomberg US Aggregate Bond Index to a gain of more than 6.5% for the year.[2]
While stocks and bonds had happier times in 2023 compared to the year before, sentiment on markets and the economy coming into 2023 were dismal. Recall that at the beginning of 2023, it seemed as if every economist was calling for a recession at some point during the year. Instead, the US Economy grew each quarter including 5.2% GDP growth in the third quarter, while adding an average of 240,000 jobs per month.[3] Investors were equally as pessimistic coming into 2023. One of our research partners observed this in their annual outlook for 2023, “Sentiment reflects the lack of positives. By many measures (AAII, put/call ratios), investors have never been as or more bearish towards the stock market than they are now.” [4]
We saw things a bit differently. Yes, there were legitimate concerns that the Fed was too aggressive in hiking rates and would tip the economy into recession. However, there was plenty of evidence that 2023 was setup to be a decent year for stocks and bonds: Inflation was moderating, stock valuations had come down to acceptable levels and volatility in bond and currency were starting to subside. Looking at history, since 1926 and following peak inflation rates, average returns for stocks and bonds have been positive for the next twelve-month period.[5] To us, the weight of the evidence was positive, and the market and economy proved that out.
For us, the fly in the ointment for stocks in 2023 was the top-heavy, concentrated, nature of the market, which we wrote about extensively last year. As you can see in the chart below, seven mega-cap stocks dubbed the “Magnificent Seven”[6] did much of the work for the S&P 500 last year, up 76% as a cohort and rebounding from a dismal 2022. If you take out the top seven and look at the remaining 493 stocks, the index was up 10%.[7] While the fourth quarter saw the market broaden out with the remaining 493 beginning to participate to the upside. However, it wasn’t nearly enough to catch up to the massive head starts of the seven mega-caps. In our view, this was a year in which diversification didn’t pay off for stock portfolios.
One final note on 2023. Sometimes growth expectations and /or valuations become extreme. While we’re not market timers, prior episodes of peak concentration in the market have led to a digestion period in the market.[8] This typically favors the “average stock”, and we wouldn’t be surprised to see them take leadership over the largest seven stocks. Just looking at forward P/E Ratios, the Magnificent Seven are significantly more expensive than the rest of the market.[9] Valuations can always stretch further, but at some point, there’s reversion back to the mean.
Looking ahead, there are several themes we’re paying attention to this year. We believe monetary policy and the Federal Reserve will be the most impactful theme. Monetary policy historically operates with a lagged effect on the economy, making it difficult for Fed officials to determine when to stop raising rates. What’s clear from the Fed’s most recent meeting is that officials are now focused on rate cuts for 2024. This is the “dovish pivot” we mentioned earlier in this letter. Markets are now pricing in a 78% chance that the first rate cut will occur in March.[10] Given the runup in stock prices and loosening of financial conditions (bond yields down, US Dollar down, oil down), we believe the Fed will do its best to hold off on cutting rates until the second quarter. Especially with many economic indicators continuing to reflect a strong economy.[11]
Over the last several years, markets have been keying off monetary policy. Market expectations for the Fed and what the Fed will actually do have implications for stock and bond prices this year. As of now, markets are pricing between 6-7 rate cuts in 2024.[12] Barring a significant slowdown in the economy, we don’t see 6-7 cuts coming up for this year and believe that the market will also have to temper expectations. If market expectations and Fed policy become out of sync, we expect volatility in both stock and bond prices to pick up.
Speaking of volatility, 2023 was a calm year, but we don’t expect that to last. In 2022, the S&P 500 had 46 days that were either up more than 2% or down more than 2%. 2023 had just two.[13] In addition, The VIX, which measures the stock market’s expectation of volatility, is at a multi-year low (see below). We believe there is a level of complacency in the market that could make it susceptible to volatility shocks.
The same thing goes for bonds. However, unlike stocks in 2023, the bond market remained volatile last year. We see the bond market remaining volatile in 2024, with continued sensitivity to economic datapoints, particularly inflation and payrolls data. Similar to the past two years, we wouldn’t be surprised to see reactions to these data points cause wild swings in price that then quickly reverse, without much more clarity over the direction of the economy.[14]
Finally, and not that anyone needs a reminder, 2024 is a Presidential Election year. Since 1948, the strongest equity returns in the 4-year Presidential cycle have occurred in non-election years (2023). While history doesn’t always repeat, Presidential Election years (2024) have averaged returns of 10.4% since 1948.[15] As the Presidential campaign begins in earnest, regardless of who the candidates are, we expect the rhetoric to be noise rather than signal. Meaning, we don’t pay attention to it as we make investment decisions.
Our bottom line for 2024 is that inflation has been on a durable downward trend since June 2022 and the Fed is done with the rate hiking cycle. Yes, there are some recession signals out there but, on balance, the economy remains on mostly stable footing. For stocks, a wide valuation gap between the market leaders and all the rest means that there are many attractive opportunities within the market beyond the concentration of the Magnificent Seven. For bonds, they tend to perform very well after the Fed has paused its rate hiking.[16] As we’ve said many times before, starting points matter. With the Fed likely to cut rates this year, to us, bonds look much more compelling than cash. We expect continued volatility in bonds and renewed volatility in stocks while recognizing that stock volatility is coming off of historically low levels. For investors holding excess cash, volatility could present a great opportunity to buy stocks or bonds at more attractive levels.
We hope that you and your family have a wonderful start to the year. We are privileged to serve you. Please don’t hesitate to reach out with any questions or concerns. We’re grateful for your continued trust in us.
Jack Piper
Founding Partner & Portfolio Manager
[1] Dorsey Wright January 5, 2024
[2] Dorsey Wright January 5, 2024
[3] Zacks Investment Management December 26,2023
[4] Bespoke December 23, 2022
[5] Blackrock September 30, 2022
[6] Seven mega-cap stocks are: Apple, Microsoft, Google, Amazon, Nvidia, Meta and Tesla
[7] Y-Charts January 11, 2024
[8] The London Company January 12, 2024
[9] Dynasty Financial Partners January 10, 2024 – Mag Seven 28x, S&P 493 17.4x and S&P600 (small-cap) 15x
[10] US Federal Reserve & CME FedWatch Tool as of December 31,2023.
[11] Dynasty Financial Partners January 10, 2024
[12] Goldman Sachs January 15, 2024
[13] Morningstar December 31, 2023
[14] Blackrock December 31, 2023
[15] Dynasty Financial Partners January 10, 2024
[16] Blackrock December 31, 2023
Disclosures
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This information should not be considered investment advice. Opinions expressed reflect the judgment of the authors and are current opinions as of the date appearing in this material only. While every effort has been made to verify the information contained herein, we make no representation as to its accuracy and it should be regarded as a complete analysis of the subjects discussed. All investing involves risk, including the loss of some or all of your investment.
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