Market Update for the Quarter Ending
December 31, 2023
It appears that The Federal Reserve is just about done raising short-term interest rates. We entered 2023 with the Fed in the midst of the most aggressive interest rate hiking cycle of the last 40 years after inflation had topped 9%. Most economists were predicting a recession, and investors were piling into cash and selling both stocks and bonds. Bank failures in March and April further reinforced the feeling that the economy was headed in the wrong direction.
However, a recession never materialized. Consumers continued to spend on travel, entertainment and other services that were held back during the pandemic. Nothing personified this more than Taylor Swift’s “The Eras Tour” last summer. It has been reported that Swift earned approximately $4.1 billion on tour – more than the economic output of 42 countries. Fans (aka, “Swifties”) paid an average ticket price of $456 and overall shelled out $1,279 per show on tickets, travel, hotels, merchandise, food and clothes. The trickle-down impact on the economy was significant. The Federal Reserve Bank of Philadelphia commented about the “Swift Effect” on local hotels over the summer. The economic benefits continue, as “The Eras Tour” movie is now in theaters for those that either missed the in-person concert or wish to re-live the experience. It’s no wonder that economic growth hit 4.9% in the third quarter and expectations are for 2% in the fourth quarter.
Consumers should continue to spend as long as the job market remains strong. Over 2.7 million jobs were created in the U.S. in 2023. Although this figure is less than the number of jobs created in 2021 and 2022, and the job market is showing signs of cooling, it was the fifth strongest year for job growth going back to 2000. The unemployment rate of 3.7% is among the lowest in history, and with wage gains now growing faster than inflation it is difficult to imagine a recession happening within the next six months. However, employment can be a lagging indicator and we are monitoring various leading economic indicators to continually assess the economic backdrop.
Stocks and bonds pivot with the Fed
2023 turned out to be a strong year for both stocks and bonds thanks to a year-end rally that saw more companies participate, in contrast to the narrow market performance of the first nine months of the year. The S&P 500 Index increased 11.7% during the fourth quarter and 26.3% for the year. Interestingly, the S&P 500 Equal-Weighted Index saw almost all its gains for the year in the fourth quarter, as it increased 11.9% in the quarter and only 13.9% for the year. Prior newsletters called for a broader stock market rally based on historical data and this finally materialized in November and December. The Russell 2000 Small Cap Index, which lagged throughout the first three quarters of the year, was the best performer of the quarter, up 14.0%, and 16.9% for the year. Small and mid-sized companies could continue to outperform if the rally further broadens out.
Despite the geopolitical headlines and conflicts abroad, the international scene has been better than most anticipated. The depreciation of the U.S. dollar to most other currencies in recent months has provided a tailwind to international investments. The MSCI Developed Market Index increased 10.4% for the quarter and 18.2% for the year. Emerging markets rallied 7.9% and 9.8% for the year. Outside of China, which drastically underperformed expectations coming out of 3 years of mandated pandemic lockdowns a year ago, emerging markets have performed reasonably well. Emerging market returns tend to positively correlate with easing monetary policy, and the Fed may be on the verge of reducing interest rates.
Bonds had a phenomenal year after it became clear that inflation was once again under control and that the Fed is likely done raising interest rates. Bonds are one of the worst investments in a world of inflation – as witnessed in 2022 and early 2023. However, with each successive report showing moderating inflation, bonds rallied. The U.S. Aggregate Bond Index returned 6.8% during the fourth quarter and 5.5% during the year. Bonds begin the new year with elevated yields and that bodes well for future returns.
Disinflation and the Fed largely responsible for 4th quarter rally
Inflation may turn out to be “transitory” after all. This was the term used by the Fed in 2021 to describe post-pandemic rising inflation. The theory at the time was that inflation was due to snarled supply chains that would naturally sort themselves out once the pandemic ends. The Fed may have been correct in calling inflation transitory, but disinflation took much longer than expected and the inflation peak was much more severe and painful than anticipated. Inflation is falling world-wide. The Fed’s preferred measure of inflation, the Personal Consumption Expenditure (PCE) Index is closing in on the 2% target if annualized over the last six months.
Falling inflation should allow the Fed to concentrate on its other mandate, which is full employment. It became clear in November and December that the Fed was growing comfortable with the direction of inflation and that employment would be more of a focus. This was exactly what investors wanted to hear. In response, the 10-year Treasury peaked at 5% in October and fell to just under 4% by year end. Bonds appreciated due to the decline in interest rates. Stocks rallied on the news of lower interest rates and given the expectations that employment would remain low, meaning that a near-term recession appears less likely.
Global Asset Allocation Strategy
Changes were made in the fourth quarter to the Global Asset Allocation Strategy. First and foremost, the strategy remains slightly overweight with stocks. Specifically, the portfolio has emphasized mid-sized companies given the current low valuation and possible catalyst of lower interest rates. Smaller companies are more reliant on debt and interest rates for funding and the recent drop in long-term rates jump-started the asset class in the fourth quarter. A continued broadening rally would benefit most companies outside of the mega cap technology companies that are currently known as the “Magnificent Seven”. Small and Mid-sized stocks are still inexpensive by most metrics and the expected returns are most attractive.
The strategy has a mix of active managers and low-cost, tax efficient exchange traded funds (ETFs). We did swap out an active manager for two new active managers within the mid-sized company space. The two new managers have exhibited a history of strong performance with a stable management team. The fund fees are well below average within their peer group and there is a long-term focus and emphasis on tax efficiency. We feel the processes that have been successful in the past are repeatable going forward with each of these new investment positions.
Within the bond portfolio, we lengthened duration to lock in yields for longer and slightly reduced cash. Unless inflation spikes, longer-term U.S. treasury and agency bonds have traditionally been more defensive if the economy does slow. The Fed’s next rate adjustment is likely down and the possibility of multiple quarter-point reductions would reduce cash money market returns over the coming quarters. Typically, bonds outperform cash once the Fed has reached the peak of the rate hiking cycle. Credit quality is strong, as there is less reason to reach for yield given that high quality bonds are yielding close to 5%.
The strategy remains balanced between stocks and bonds and among assets classes. There is usually a bull market somewhere and the diversification of the strategy aims to take advantage of volatility to enhance long-term returns and overall portfolio efficiency. The strategy invests with a 5-7 year time horizon.
Focused Equity Strategy
Within the Focused equity strategy, we were quiet during the fourth quarter, even though the market was not. For the year, we bought and sold about 10-12% of most portfolios, which is a lower turnover than the typical 15-25%. We like what we own but will sell for one of three reasons: a valuation that is too high and/or a position that is too large, a permanent change in the business prospects of a company, or a compelling alternative. Sometimes we will swap stocks for similar alternatives to realize tax losses.
During the year, we bought Disney (DIS) and 3M (MMM) and increased our positions in Taiwan Semiconductor (TSM) and Arista Networks (ANET). We’ve written about these companies in past newsletters, but believe they represent solid additions to our portfolio. We sold all shares of JD.com (JD) and Boeing (BA). These sales were due to permanent changes to the business prospects of these companies.
We also trimmed Nvidia (NVDA), Fairfax (FRFHF) and AbbVie (ABBV). This was mostly due to a combination of high valuations and large position sizes relative to the underlying risks. We still have sizeable positions in these companies.
Truist Financial (TFC), Fifth-Third Bancorp (FITB) and Huntington Bancshares (HBAN) replaced US Bancorp (USB) and Wells Fargo (WFC). These companies are similar, though the ones we now own have fewer problems with regulators. Exposure to banks increased modestly earlier this year when the financial sector turmoil punished most banks.
In general, we like what we own in the portfolios, but will consider adjustments as we move into the new year. Markets have appreciated in recent months, and we plan strategic moves to better balance the risks of the portfolio. As always, if the market presents us with compelling ideas, we will look to capitalize.
Earnings season underway
We are currently at the front-end of the fourth quarter corporate earnings reporting season. While interest rates and the Fed play an intricate role in forecasting and projecting returns, earnings are perhaps at the heart of determining valuations and the direction of stock prices. Stocks last bottomed in October 2022 in anticipation of an earnings recession. There was no year-over-year earnings growth for the three quarters ending in June 2023. However, earnings grew again in the third quarter, and we are expecting earnings to grow once again in the fourth quarter.
As always, guidance is even more important because it is management’s way of predicting future growth and trends – and financial markets are forward-looking. Per Factset, investors are expecting 12% bottom-line earnings growth in 2024 with over 5% top-line revenue growth. We do feel this is attainable as long as inflation continues to slowly retreat toward the Fed’s 2% target rate. Controlled inflation allows the Fed to consider implementing less restrictive monetary policy by lowering interest rates sooner than later – perhaps in the second quarter of 2024. The Fed should favor the full-employment mandate if there is less reason to fear inflation.
Our base case is for continued economic growth and earnings growth in 2024. However, we do expect volatility and generally higher levels of unease given that it is an election year. Regardless of who wins, risk assets can underwhelm leading up to an election, but finish the year strong once the uncertainty clears. There are a number of outcomes that can play out and this is the time to be on our toes and be ready to take advantage of any market opportunities.
Please call with any questions at any time regarding this newsletter or how any headlines may impact your investments and financial plan.
 “The Economy (Taylor’s Version)”. By Abha Bhattarai, Rachel Lerman and Emily Sabens. The Washington Post. 10/13/23.
 “U.S. Added 216,000 Jobs in December, Outpacing Forecasts”. By Talmon Joseph Smith. The New York Times. 1/5/24.
 All performance data generated from Commonwealth and NFS as of 12/31/2023.
 “Earnings Insight”. Factset. 1/5/2024.
All indices are unmanaged and investors cannot actually invest directly into an index. Unlike investments, indices do not incur management fees, charges, or expenses. Past performance does not guarantee future results. Certain sections of this commentary contain forward-looking statements that are based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is not indicative of future results.
Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is no guarantee of future results.