Quarterly Market Perspective for 4Q23
Summary
Higher interest rates continued into late October, but at that point positive inflation news and encouraging statements from Federal Reserve Chairman Jerome Powell led to a massive “Santa Claus rally” in both stocks and bonds. Treasury Secretary Janet Yellen shifted debt issuance exclusively to short maturity bonds, so without new supply, long term bond demand forced interest rates down sharply. Many sectors that previously struggled with rising rates surged once rates began to decline. In fact, small caps outperformed large caps and real estate outperformed technology last quarter[i]. Only the energy sector was lower, as U.S. shale production was so strong that the crisis in the Middle East did not lead to supply disruption fears and gas prices stayed low.
Foreign stocks also benefitted from falling rates in the United States. Lower U.S. bond yields took the pressure off foreign currencies not tied to the dollar. Latin America was especially strong, with both Brazil and Mexico adding more than ten percent[ii]. India also had a strong quarter and year, probably due to the relative decline of China. European stocks were competitive with U.S. stocks in local currency (Euros primarily), but they trailed badly in dollar terms. Hedging one’s developed market exposure helped – Japan provided returns almost 20%[iii] higher if the weak yen was hedged back to the dollar.
Bonds behaved like a beach ball released under water. It was obvious to most that when the Federal Reserve let it be known that the interest rate hiking cycle was over, bonds would rally furiously. The hard part, of course, was determining when. Before bonds bottomed out on October 19th they were down close to -4% on the year – confounding those that expected the interest rate peak to occur much earlier in the year. Surprising economic resilience meant the Fed was under very little pressure to cut interest rates, so they could easily wait for inflation to come down on its own (which it finally has). Bonds rallied almost 9% in the last ten weeks of the year to close the year up 5.5%[iv].
Most commodities (-7.9%) struggled during 2023 as slowing world growth reduced demand. Gold was a modest exception; Gold bullion ETFs rose just under 13% in 2023.
Activity
The most important consideration last quarter was making sure portfolios were as “risk-on” as risk tolerances permitted once interest rates turned lower. This required increasing small cap exposure, which we had under-weighted earlier in the year when high quality was the dominant investment factor. We also increased bond duration, which we had reduced earlier in the year because short term debt was paying 5.25% or more. A 5.25% annual rate is only a little over 1.3% per quarter; when interest rates are plunging bond investment returns can exceed 1.3% in a week. We are still modestly underweight bond duration. Lastly, we sought to be more discriminating in our international exposure. Where appropriate, we used ETFs that targeted India and/or Japan and de-emphasized or omitted China entirely. As U.S. interest rates began to tumble, we exchanged out of some of our currency-hedged exchange traded funds (ETFs) because a falling dollar would no longer be a headwind to foreign stock performance.
Outlook
My experience is that making forecasts just makes one look bad in retrospect. The economy did better and interest rates stayed higher last year than anyone forecasted back in January 2023. This year the markets started out believing there would be six rate cuts in 2024 but they are already backing off from that as employment and retail sales trends continue to be fairly robust.
When I re-read what I and others wrote last year I saw more pessimism than was ultimately warranted. I believe it is okay (if not essential) to identify real and potential market risks ahead of time. The key is not to let them unduly influence you. I was concerned that investors might sell stocks last fall in order to lock in the best short-term rates since 2007, but I also knew that stocks tend to be seasonally strong after Halloween and if the Fed were to hint at being done raising rates, the broad stock market could have a “surprisingly strong rally”.[v]
The fact is that it is very hard to identify significant market peaks before they happen. One can know that interest rates or unemployment is rising or that stocks are expensive relative to history, but these conditions occur with some frequency without causing major sell-offs. What one cannot predict in advance is a crisis of confidence. Sharp declines occur when existing concerns suddenly coalesce into an overriding crisis narrative which drives investors to sell because they perceive that things are getting worse and that most others feel the same way and are going to respond by selling their shares. This is what is known as the “Doomsday” trade, and financial writer Jared Dillian likens it to “flypaper for idiots”.[vi] Not that bad things don’t happen, but true crises of confidence happen so infrequently that it is financially harmful to panic every time you hear someone express worry. The world is dealing with a war in Ukraine, another war in Gaza, and countless somewhat lesser provocations (attacks on ships in the Red Sea, the American political system) and despite all that here we are at all-time highs on all major U.S. stock indices. Worry if you want, put 10% in T-bills if it helps you sleep at night, but by all means keep focused on the long term, which is statistically overwhelmingly likely to be positive. Pessimism always sounds smart, but it has a lousy track record[vii].
Commentary – The Two Economies
I have a theory that there are two types of economies right now. There is the “old” economy, which is made up of all sorts of economically and/or interest rate sensitive companies. These companies grow and contract as the economy does and their growth and stock returns are, therefore, linear (think 2,4,6,8,10 etc.). Taken as a whole, their value rises maybe 4-8% per year. If interest rates fall, the market might push their values up 15-25%. If interest rates rise on the other hand, those stocks may post 5-15% losses, but intrinsically their annual growth averages around 6%. Most companies in the world fall into this category.
Then there is the “new” economy. Today these are the companies that build and maintain “platforms” or “networks”, where the more entities that are attached to it the more it is worth exponentially (think 1,3,6,10,15, etc.) The new economy group includes companies that we have come to call the “Magnificent 7” (Apple, Amazon, Microsoft, Meta, Alphabet, Nvidia, and Tesla) plus the companies that supply them the components they need to keep growing, such as Taiwan Semiconductor, ASML, Broadcom, Adobe, AMD, and several others. They are on what we currently think of as the cutting edge – cloud computing and artificial intelligence (AI). Best of all, they are nearly impervious to overall global economic activity trends and interest rates because investors believe they are the future regardless of whatever else happens.
Is this theory true? It doesn’t matter. This is the narrative the stock market trades off of today and has been since roughly 2016 (interrupted briefly by Covid in 2020; see the chart). Investment success has increasingly depended upon how much one has shifted towards new economy stocks. The new economy narrative isn’t original – investors told a similar story in the late 1960s after the transistor was invented and in the late 1990s when the commercial internet was born. The narrative typically ends when the growth rate of the new economy stocks converges (downward) with the growth rate of the average company[viii]. As the chart shows, there are long periods of time after the narrative is broken in which all stocks trade as if growth is linear. Technology crashed over 80% between March 2000 and October 2002 and was not a leading sector again for over a decade.
If you wonder why the U.S. has out-performed foreign markets so dramatically since 2013 or so, the biggest reason is the percentage exposure of the U.S. market to technology (over 30%) versus the average foreign market’s technology exposure (less than 10%). As the chart below shows, European stocks outperformed by roughly 72% in a decade where technology languished. Two other major factors for U.S. out-performance were the much lower cost of energy in the U.S. due to the shale revolution and the strength of the U.S. dollar relative to other currencies[ix].
There is no guarantee that new economy stocks will continue to provide substantially better returns going forward; in fact, the more they rise the harder this becomes. Technology stocks represent 30.8% of the U.S. market today, according to Standard & Poor’s. Add Amazon (3.5%), Alphabet (3.9%), and Meta (2.1%) each of which are not considered technology[i], and the total exceeds 40%. I believe that this is not sustainable. There are natural limits. For example, a company growing at 6% per year cannot boost its tech spending by 50% annually for very long before running out of money.
I believe we are in a market being driven by a new economy narrative and as long as that lasts, this narrow yet important group of stocks is going to generate superior returns. I don’t know how close we are to the end of this particular chapter of the technology bull market, but having managed money through the “dot com crash”, I know that I don’t want to get caught “holding the bag” so to speak. Tech stock had a 33% “correction” from January 4th to October 14th, 2022 and we look at that now as a blip. When the narrative finally collapses (and it might be from much higher levels than today), history suggests the decline will be well over 50%. That is the kind of loss one has a hard time coming back from, and one which we feel is our primary job to avoid. Investors need to have exposure to Microsoft[xi] and Nvidia and the others because they are driving the economy of the future (as we see the future today), but they also need to own companies like McDonalds, Visa, Berkshire Hathaway, and Costco. These companies, while perhaps not as exciting, have proven to be very reliable over time. We want to make sure our portfolios balance the timely with the enduring.
[i] From strategasrp.com, Real Estate gained 18.8% versus Technology’s 17.2% return. Energy lost 6.9%. The S&P small cap 600 Index outgained the S&P 500 15.1% to 11.7%.
[ii] Foreign index performance also courtesy of strategasrp.com.
[iii] The differential between the hedged Japanese stock index ETF (DXJ) and the unhedged version (EWJ).
[iv] JPMorgan Guide to the Markets 2023, page 33.
[v] Outlook section, Trademark 3Q23 Quarterly Market Commentary.
[vi] Jared Dillian in The 10th Man, November 24, 2023
[vii] In The Psychology of Money, author Morgan Housel writes that we respond better to financial pessimism because optimism sounds like a sales pitch while pessimism sounds like someone trying to give you a helpful warning.
[viii] The narrative was beginning to burst in 2022 on surprisingly poor earnings reports from five of the Mag 7, but it was re-invigorated with a vengeance when OpenAI initiated the Artificial Intelligence mania last January.
[ix] For dollar-based investors. In local currency terms, the performance gap was much smaller.
[x] Amazon is a consumer cyclical (retail) stock, and both Alphabet (Google) and Meta (Facebook) are in the communications services industry.
[xi] Microsoft, for instance, lost more than 2/3 of its value between March 2000 and March 2009.
DISCLOSURE
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