A look back at a remarkable stock market year, and what should worry investors into 2024
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From my perspective, the biggest investing story of the year (I am not speaking of global conflicts like Russia-Ukraine or Hamas-Israel) is that while the public seems convinced inflation remains very high and we are in some kind of serious economic slowdown, the markets seem to think otherwise. I would side with the markets. Making sense of 2023’s two biggest events The two biggest investing events of 2023 were: AI and the growth of the Magnificent 7 The recession that never came The first (AI and the growth of the Magnificent 7) was grounded in historical trends: once a consensus emerged that a new technology was sufficiently disruptive, money rushed into the main players. This happened with railroads, the telegraph, the telephone, radio, television, the microchip, computers, the internet, and now AI. Four observations about the Magnificent 7 Observation 1: Hand-wringing that these were the only AI beneficiaries was simply not true; many other companies benefitted as well. Not just other semiconductor companies like AMD, but almost anything involved in the cloud business had big moves as well, like Arista Networks and Cloudflare. Other AI Beneficiaries in 2023: AMD up 123% Arista Networks up 96% Cloudflare up 89% If this plays out like other disruptive technologies, you can expect the ecosystem around AI to expand dramatically. Observation 2: Hand-wringing that this would lead to stupid valuations has not occurred to any great extent, at least among the largest players. Microsoft’s 2024 price-earnings ratio, at roughly 28 times forward earnings, is only slightly above the 5-year average of 26.7; same with Apple at 26, only slightly above its 5-year average of 23; Meta at 20 is exactly inline with its 5-year average of 19.5. Nvidia, at 26, is lower than its 5-year average of 36; same with Alphabet, which at 21 is below its 5-year average of 22; Observation 3: Since rates began declining in late October and the “soft landing” scenario became the dominant paradigm, the influence of the Magnificent 7 has waned. While tech stocks are still strong, the market has dramatically broadened out since November 1, with small caps, value, and equal-weight indexes leading. The “soft landing” effect: (since Nov. 1) S & P Smallcap 600 Value (IJS): up 25% Russell 2000 (IWM): up 24% S & P 500 Equal Weight (RSP) up 16% Nasdaq 100 (QQQ) up 17% S & P 500: up 13% Observation 4: What are we to make of the biggest lament of 2023: the endless worry that the advance of the Magnificent 7 was the biggest reason for the S & P’s 24% gain in 2023? First, it’s true. A few days ago, S & P noted that the S & P 500 total return of 25.85% would only be up 9.49% ex the Magnificent 7. Second, long-term investors would say, so what? If you own the S & P 500 long-term, you are participating in those gains. That’s the point of staying with the market and not trying to pick winners or losers, or timing your entry and exit. The recession that never came The other main event for 2023, the recession that never came, was also rooted in the market’s reading of historic events. In this case, it was the observation that “soft landings” are very rare events. Most of the time, when the Fed has raised rates this aggressively, they have overshot and caused a recession. Short-term investors, looking at the landscape in the fourth quarter of 2022, reasonably concluded that the odds of a recession were extremely high in 2023. They were wrong. The least likely outcome (a soft landing) has indeed occurred, at least for 2023. The reasons will be debated for years (the most likely explanation is that the Fed flooding the country with money during the pandemic created a cushion, the effects of which are still being felt) but regardless: the S & P bottomed at 3,577 on October 12, 2022. The S & P is up 1,200 points (25%) since then and is knocking on the door of an historic high. .SPX YTD mountain S & P 500, YTD Once the market began to truly believe in the soft landing, and that the Fed was done raising rates and would likely cut in 2024, interest rates began to decline and the market rally, largely confined to big-cap tech, began to broaden out in November. What’s interesting is that while concerns about a recession have faded, concerns about inflation remain very high, at least in the general population. What’s the right way to look at these two events? What are we to make of these two events? Neither was an obvious call in the fourth quarter of 2022; even AI enthusiasts in 2022 would be shocked to hear Nvidia was up over 200%. The lesson is that attempting to time markets is a fruitless endeavor. Selling the Magnificent 7 in the fourth quarter of 2022 would have been disastrous, just like selling the S & P 500 would have been disastrous. The central problem with market timing is you have to be right twice: you have to be right going in, and you have to be right going out. Almost no one ever gets both of those right. The obvious solution is: 1) understand your risk tolerance, 2) decide what percentage of your retirement income you want in stocks and bonds, and 3) because the market tends to rise over long periods, keep saving and let compounding interest work its magic. 2024: What worries me In compiling any list of “what worries me” the simplest place to start is to take the opposite position of the consensus on the macroeconomy and earnings. This is particularly relevant when there is a large consensus; i.e. when everyone is relatively bullish or bearish. Right now, the Street is expecting a lot of rate cuts next year (five or six). Almost everyone is in the “soft landing/no landing” camp. And Wall Street is expecting record earnings. So here is your list of worries: Fewer rate cuts than expected: Interest rates are falling, which can usually translate into higher market multiples: the market puts a higher value on a future stream of earnings when rates are lower. However, this trend may not persist into 2024: housing inflation may show declines, but overall economic growth and wage inflation may be more resilient than expected. The Fed does not have to raise rates for there to be a slowdown; just delaying rate cuts could cause the market to hiccup. Economy goes into recession: The word “recession” has been used so much in the last few years it has become more of a state of mind than a precise term. What is clear is that the economic stats do not support the notion of a notable slowdown in the economy, even though a large percentage of the population believes that is happening. However, the “soft landing” is still a fragile idea. All we need is a few disappointments in the numbers on inflation or wage growth or job openings and the financial press will trumpet “the recession is finally here” and the public will indeed slow down spending just enough to have everyone agree we are in a recession. These two developments — fewer rate cuts and economy goes into recession — are not mutually exclusive. The economy could slip into a modest recession yet, because inflation metrics do not come down sufficiently, the Fed may delay rate cuts. This is a worst-case scenario but not out of the question. Earnings/revenue disappointments: Bottoms-up analysts are expecting record earnings in 2024, roughly 11% higher than in 2023. While it is very early, the small number of companies reporting fourth quarter earnings that end in November (there are 16) have noted much lower pressure from inflation (implying much more difficulty raising prices), and lower volumes. While 15 of 16 are beating on the bottom line, only 50% are beating on revenues, according to Earnings Scout, with big names like Nike, FedEx, General Mills, Wayfair, CarMax, and PayChex coming up short. That is a very large number of misses; typically 80%-90% beat on revenues. As a result, analysts have begun lowering forward estimates for many of these companies. This is a trend that bears watching. Gaming out the early 2024 correction: it’s hard We are going to get some kind of correction, but not this week. Unfortunately, it’s not a terrible attractive time to put money to work, unless you’re willing to look long-term. The S & P 500 is overbought and expensive on most metrics. S & P 500 technical readings: Relative Strength Indicator (RSI): 72 (overbought) % stocks over 50-day- moving average: 89% (high, overbought) Forward earnings P/E: 19.6 (expensive) Earnings growth: 11% (high) Still, trying to fade the rally has been a bad idea so far, particularly with the strong seasonals. In January, you can expect a small amount of buying around the usual “mean reversion” trades of buying the most-beaten up sectors and stocks of 2023. 2023 Sector Laggards: Energy down 3% Consumer Staples down 3% Utilities down 11% So don’t be surprised to see little mini-rallies around utilities like AES or NextEra Energy (down 33% and 27% in 2023, respectively), or staples like Campbell Soup or General Mills (both down about 25%) or picking at energy underperformers like Devon (down 24%) or Chevron (down 15%). But there is going to be limits to those kinds of mean reversion rallies. Utilities still have serious competition with Treasuries in the 4% range. Consumer staples have seen lower demand and some disinflation. Oil has been rallying but there is too much supply (OPEC has far less influence than it did in the 1970s). What’s it all mean? Sometimes, you just have to relax a bit and appreciate that it’s been a great year. The S & P 500 up almost 25% in a year is the kind of problem a lot of people would be happy to have.
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