I recently reviewed my commentary from one year ago which summarized the 2022 investing year. Interestingly, I closed with a suggestion to savers. I encouraged readers to take advantage of low stock prices that would “not be on sale forever”. Today, we’re in the middle of one of the strongest market rebounds in history, and while it’s fun to see even a half-hearted prediction come true, I’ll admit that this one didn’t put me as far out on a limb as you might expect. In fact, every market downturn in history has eventually rebounded to new highs. Armed with this knowledge, long-term investors would do themselves a favor to think like buyers, not sellers when prices drop. 2023 was not unique. Stocks can rise while bad things happen. So can bonds. And as we’ll review below, the so-called experts are wrong on short-term predictions more often than they’re right.
Year in Review
2023 marked an inflection point for markets with strong gains across both stocks and bonds. The S&P 500, Dow, and Nasdaq generated exceptional returns of 26.3%, 16.2%, and 44.7% with reinvested dividends, respectively. The S&P has come full circle and is now only a fraction of a percentage point below the all-time high from exactly two years ago. The U.S. 10-Year Treasury yield climbed as high as 5% in October before falling to end the year around 3.9%, pushing bond prices higher in the process.
Perhaps the most important lesson of 2023 was that news headlines and economic events don’t always impact markets in predictable ways. Last year’s positive returns occurred despite historic challenges including the worst banking crisis since 2008, rapid Fed rate hikes, debt ceilings and budget battles in Washington, the ongoing war in Ukraine, the conflict in the Middle East, cracks in China’s economy, and many more. If we could have warned you about these headlines with you at the start of 2023, you would have reasonably assumed that a worsening bear market or a deep recession lay ahead.
Instead, the S&P 500 stock index finished the year at a level of 4,770. This was far ahead of nearly every large investment firm’s estimate1. The lowest published prediction was 3,400 and the highest was 4,500. The average was 4,000, or 19% below the actual close for 2023. This demonstrates how even the most “skilled” strategists can get it wrong.
At the risk of oversimplifying, the key factor driving markets the past few years has been inflation. High inflation affects all parts of the markets and economy including forcing the Fed to raise interest rates, slowing growth, hurting corporate profits, dampening consumer spending, and acting as a drag on bond returns. This is exactly what occurred in 2022 but many of these effects reversed in 2023 as inflation rates improved.
The headline Consumer Price Index, for instance, jumped 9.1% (on a year-over-year basis) in June 2022 but only grew 3.1% this past November. Unfortunately for consumers and retirees, this does not mean that prices will fall back to pre-pandemic levels – only that they will rise more slowly. For markets, however, what matters is that the rate of change is slowing, and that core inflation may well approach the Fed’s 2% long run target. This change has occurred without a spike in unemployment, a welcome surprise to many (see chart below). This allows the federal reserve to focus less on inflation and more on “managing the business cycle” to mitigate or avoid a recession.
The past year serves as a reminder that it’s important to stay invested and diversified during all phases of the market cycle, rather than try to predict exactly what might happen on a daily, weekly, or monthly basis. Below we look at some key trends that defined 2023 and how they might impact 2024 and beyond.
Still No Recession?
A recession has been widely anticipated for nearly two years, but many economic strategists have reduced the odds or backed off from their prediction all together. We’d put the odds of a recession in 2024 no higher than 50%. Here’s why:
- Household and corporate balance sheets are strong.
- 61% of consumers have a mortgage rate below 4%, and 23% have a rate under 3%2.
- 76% of public corporate debt is fixed, versus just 50% in 2007, meaning that higher interest rates have had less of an impact on businesses than many assume. Corporate cash is making over 5% which helps offset the cost of higher interest rates3.
- Workers are still in demand, but wage growth is not growing at a rate that would stoke more inflation (and drive interest rates even higher).
- Savings rates are positive but declining3.
- Credit card delinquencies are rising but less than the 10-year average3.
- Auto loan delinquencies are rising but mostly with sub-prime or “high risk” consumers3.
More Than Just Seven Stocks
While the so-called “Magnificent 7” did double in value, other sectors also began to perform better as market conditions improved. The Magnificent 7 made it difficult for prudently diversified portfolios in 2023. As the chart below illustrates, having too much exposure to those 7 stocks in 2022 would have wreaked havoc on a portfolio as they declined 47% compared to the S&P 500 which fell 18% including dividends. Additionally, the weights of the “Mag 7” drove returns in their three respective sectors in 2023 and were the only ones to outperform the S&P 500. The Technology sector includes Apple, Nvidia and Microsoft; Communication Services includes Meta and Alphabet (Google) and Consumer Discretionary includes Amazon and Tesla.
Earnings Growth is Back
We are also seeing signs that earnings growth is recovering. Earnings-per-share for the S&P 500 are expected to have been flat in 2023, but Wall Street consensus estimates suggest that they could grow by double digits each of the next two years. While this will depend on the path of economic growth, any increase in earnings will help to improve valuations and support the stock market.
As we have stated in prior writings, the stock market tends to follow corporate earnings in the long run. The following chart illustrates that while the price and earnings of the S&P 500 do not line up perfectly, they do follow the same broad trends.
Bonds Rebound as Interest Rates Stabalize
Bonds had a much better year with interest rates rising through October then falling on positive inflation data (interest rates and bond prices move inversely). While bonds have not fully recovered their 2022 losses after a historic spike in inflation, recent performance has been a reminder that bonds are still an important asset class that can help to balance stocks in diversified portfolios. This is true across many sectors of the bond market including high yield, investment grade, and government.
It is our view that short-term rates have peaked. Research from JP Morgan (see chart below) indicates that when CD rates, a proxy for short-term rates, reached their highest yield, the bond market index measured by the Bloomberg US Aggregate outperformed over the next 12-month period. We lengthened maturities in most portfolios in August and since then, the bond market outperformed cash by over 2% through the end of the year.
As you can see below, over the last two years, bond prices have been extremely volatile. We haven’t seen this much price movement since the Great Financial Crisis. The end of the Fed rate hikes (or even the anticipation of it) has led to a decrease in volatility and a rebound in bond prices. Please note that the chart below exhibits volatility, not price.
The Fed is Expected to Cut Interest Rates in 2024
Improving inflation coupled with a historically strong job market have helped the Fed to achieve its policy objectives. While it’s too early to declare victory, many expect the Fed to begin cutting rates in 2024. The Fed’s own projections suggest they could lower rates by 75 basis points (.75%) by the end of the year. Market-based expectations are much more aggressive and are expecting twice as many cuts. Whether the Fed cuts and how much is less important perhaps than why they cut. Lowering rates because the economy is faltering and needs help is a different narrative entirely than doing so because of confidence in persistently low inflation that is under control. While it’s hard to predict exactly what the Fed may do, the fact that rates could begin to fall could help to support financial markets and the economy.
The Economy Has Been Remarkably Strong
The economy has been stronger than many expected over the past twelve months. GDP grew by 4.9% in the third quarter, one of the fastest rates in recent years. Consumer spending helped as did a rebound in business investment as the interest rate outlook stabilized. Unemployment is still only 3.7% and while monthly job gains have slowed somewhat, the labor market is still far stronger than economic theory would have predicted given the sharp increase in interest rates.
Expectations for 2024
Inflation should continue decelerating and moving toward the Fed’s 2% target allowing them to focus less on inflation and more on managing the business cycle. Economic growth is likely to slow from 2023 but not contract. Because of this, the Fed will likely lower rates. Fortunately, if we are wrong, it will probably be because of an economy that surprises to the upside. For the first time in many years, bond yields have risen substantially and should enhance returns while providing more stability to investment portfolios.
As far as the stock market is concerned, there are 5 themes we’re focused on:
- Measured by the S&P 500, the market is fully valued based on historical averages.
- There are high quality stocks more fairly valued than the broad market.
- Continued economic and earnings growth should provide a level of support for stock prices in 2024.
- Since 1933, the average return for the S&P 500 in election years is 11%4.
- Finally, market performance in recent weeks suggests a change from a “narrow” market, dependent on just seven names, to one with increasing “breadth”, a good sign for broadly diversified portfolios.
As shown in the chart above, last year was actually low on the volatility scale, at least in terms of the number of large pullbacks. We wouldn’t be surprised if that changed this year. While overall returns in 2024 have much more to do with the Fed, the economy, and Washington D.C.’s political climate, volatility is usually driven by the unexpected. Tensions in the Middle East, civil unrest related to the 2024 election, and any number of potential news events are all easily capable of jostling stock prices significantly in the short-term before things settle back down to the trendline.
As 2023 reinforced, we urge investors to remember that if your investment goals are long-term, the best defense against short-term market downturns is to remember your time horizon, and to stay the course.
What We’re Doing
We feel that small company stocks (“small caps) are more fairly valued than large company stocks. Although most of our clients have small cap exposure already, we’ve added exposure to some accounts with a higher risk tolerance as this is a volatile segment of the stock market. Our allocation to technology has been maintained to take advantage of ongoing work productivity trends gained through technological means. The ongoing labor shortage promises to support this trend in the future.
We’ve reduced short-term bond holdings and added longer maturity bonds to position clients for eventual Fed rate decreases. High yield bonds have also been reduced in anticipation of a potential slowdown in economic growth.
We’ll continue to monitor all accounts for the opportunity to rebalance, and we’ll also be looking at whether adding international exposure again makes sense from a risk/reward standpoint. We’ve remained underweight in this sector for several years now compared to the benchmark.
Our hope is that 2024 is a boring and predictable year. But while we can hope all we want, we’ll need to stay diversified and prepared for any and all eventualities. As we’ve covered above, the odds of predicting the short-term accurately are slim, and the practice itself holds little value over time for long-term investors. Fortunately, if you’re a client of ours, your investment time horizon extends far beyond 2024.
Thank you for your trust and partnership. We wish you health and happiness in the new year!
Chris Proctor, CIMA®
Chief Investment Officer
1 Fund Strat; 2 Apollo Group; 3 JP Morgan Asset Management; 4 Clearnomics
Legacy Financial Strategies, LLC (“LFS”) is an SEC-registered investment adviser. Information included herein is provided for illustrative and informational purposes only and is subject to change. Some information included herein is derived from outside sources, and although those sources are believed to be reliable, no representation is made by LFS about the accuracy or completeness of such information. All investments involve risk, including loss of principal invested. Past performance does not guarantee future performance.