Defying Expectations, Shifting Narratives

Market Commentary | Q4 2023 

The annual tradition of declaring New Year’s resolutions can be documented as far back as 4,000 years, which is impressive longevity given that research shows many resolutions don’t make it past January. As humans, the beginning of the year provides a natural time to look backward and then to look forward, pondering and predicting what the year ahead will hold. This leads us to another annual tradition: market analysts predicting stock performance for the year ahead – often with similar accuracy as individuals predicting the success of their own resolutions. 

If we rewind to last January, we would find a broad array of doom and gloom predictions from market analysts. After wrapping up a difficult 2022 marked by interest rate hikes and falling stock prices, the consensus opinion called for a 2023 recession in the US. It is often the case that the ‘consensus opinion’ is merely an expression of recency bias, or the assumption that the current trend will continue rather than representing any prescient outlook. Indeed, the market took a different path than expected, and patient investors were rewarded as the S&P 500 finished the year within a few points of a new all-time high. 

In 2023, the US stock market saw prices move higher with large-cap company stocks growing by +26.3% and small-cap company stocks growing by +16.1%. International stocks added +18.2% during the year, and the real estate sector saw prices climb by +11.5%. On the fixed income side, the Bloomberg US Aggregate Bond Index added +5.5%.[1]

Annual growth or decline in financial markets is typically simplified to a single percentage return, with context relegated to the footnotes. Last year was no exception as portfolio returns reflect a positive year for investors, and while it certainly ended that way, the singular numbers hardly tell the full story. 

For the first 10 months of 2023, caution looked warranted. Inflation was still a concern despite slowing from its peak in 2022. GDP was still growing at a greater than 2% rate on an annualized basis in the first half of the year, then accelerated to 4.9% in the third quarter. This led the Fed to raise rates higher than investors had expected, which threw cold water on the expectations of rate cuts by the end of 2023. Rapidly rising rates led directly to a short-lived banking crisis and the collapse of First Republic Bank and Silicon Valley Bank. Investor confidence was further shaken by political dysfunction in Congress and chaotic negotiations about the debt ceiling. By the end of October, stock prices had retreated over 10% from the mid-year high. 

In the final two months of the year, the narrative shifted, and market prices reacted quickly. Economic reports released in November indicated inflation was under control and the Fed’s preferred inflation metric, Personal Consumption Expenditure (PCE), slowed to 3% on an annualized basis.[2] Traders began bidding up stock prices and positioning for the Fed’s next rate-cutting cycle, speculating it could start as early as March 2024. Sentiment pivoted from pessimism to optimism as investors recognized the Fed’s progress toward a successful soft landing, and accelerated when Jerome Powell signaled the possibility of future rate cuts in his remarks following the Fed’s December meeting. Interest rates and Fed decisions were the key drivers of market pricing over the entire year. 

The strong rally over the final two months of 2023 has led to the question of whether potential 2024 price gains may have been pulled forward. To some extent, we would say yes. Stock valuations aren’t unreasonable given where interest rates are, but they are pricing in a strong probability of several interest rate cuts in 2024. While interest rate decisions will continue to be a key driver of market pricing, there are a few additional themes being closely watched by investors. 

One ongoing storyline is the enthusiasm for tech companies that are investing in artificial intelligence (AI); in particular, a handful of large-cap US stocks dubbed the “Magnificent Seven.” This group, comprised of Amazon, Apple, Alphabet, Meta, Microsoft, Nvidia, and Tesla, accounted for 60% of the S&P 500 Index’s 2023 return. By year-end, these seven stocks accounted for 28% of the S&P 500 Index, with an approximate value of $12 trillion. The other 493 constituents are valued at $30 trillion.[3] While these are strong companies, there is always an inherent risk to the market when there is significant concentration in a limited number of stocks. Looking ahead, the S&P 500‘s return will depend in large part on how these seven companies fare over the course of the year – with current pricing indicating that investors are optimistic their outperformance will continue. 

Also looming on the horizon is the 2024 US presidential election. Despite investor concerns, the reality is that the US stock market is more apolitical than most want to believe. Historical data shows that markets have performed well and performed poorly under both political parties. While any one party or candidate may claim to be more pro-business, the actual results are more ambiguous and contextual. An economic downturn may trigger a political change that simply coincides with the final stages of a bear market. Or a robust economy overheats, prompting tighter policy from the Federal Reserve, thwarting both the stock market and reelection prospects for the current party in power. While political leadership impacts so many aspects of our lives and national policies, the performance of financial markets is more likely to be influenced by Fed policy than any other factor. 

As market prices ebbed and flowed alongside a frequently volatile news cycle, investors who remained invested were rewarded over the past year. While we welcomed the market rally that pushed stock prices higher in Q4, we want to ensure that portfolios aren’t over-exposed to equity risk as the economy tries to navigate a soft landing. With this in mind, we regularly rebalance both equity and bond allocations back to their long-term targets. We expect portfolios to benefit from higher interest income from bonds, as well as the possibility of rate cuts that would boost bond prices. The balance of stocks for long-term growth and bonds for stable income, plus real estate for diversification and income, rounds out our allocation heading into 2024.  

Whether or not the market can deliver on investor expectations in the coming year, our goal remains the same: stewarding portfolios to instill client confidence in their long-term financial resiliency and their liquidity for short-term surprises, as well as an alignment of their financial life with their own values and vision of the future. As always, we are grateful for the trust that our clients put in our team, and we look forward to continued collaboration and growth in the year ahead. 

Resources

[1]  12/31/23 returns for S&P 500, S&P 600, MSCI EAFE Index, FTSE NAREIT Index, Bloomberg US Aggregate Bond Index. Source: Morningstar Inc. 

[2]  This Key Inflation Metric Finally Hit Federal Reserve’s Target. Forbes 

[3] S&P 500 constituent companies by index percentage and market capitalization. Morningstar Inc.