By Edward Miller, CFA®, CMT®
2023 finished on a strong note as most asset classes enjoyed impressive gains in the 4Q. After experiencing negative returns in the 3Q, US stocks surged in November and December to finish the year with double-digit gains. In addition to US equities doing well, it was encouraging to see non-US equities – which have lagged US stocks for several years -- likewise post relatively healthy returns, with the MSCI All-Country World Index excluding-USA gaining 16.2% in 2023.
After suffering through 2022, the worst year on record for many fixed-income vehicles, bonds rebounded in 2023 as US high yield bonds returned 13.4%, investment-grade corporate bonds returned 10.7% and the Bloomberg Barclays US Aggregate Bond Index returned 5.5%. For much of 2023, bonds did indeed struggle as interest rates continued to rise and the 10-year Treasury yield approached 5%. But then a welcomed shift occurred by mid-October as rates reversed course and started to decline, serving as a forceful tailwind for both bonds and equities. The primary reason for the pivot in rates was inflation continuing to ease, despite a very strong economy, prompting the Fed to suggest no more rate hikes were planned and if anything, several rate cuts could be expected in 2024.
Perhaps the two most notable takeaways of 2023 were 1) the extremely skewed returns of the S&P 500 due to seven stocks (aka the “Magnificent 7”), and 2) the highly anticipated economic recession that never happened. While the S&P 500 return of 26.3% was sensational, the equal-weighted S&P 500 return of just 13.2% paled in comparison. As I’ve discussed in prior investment letters, the seven largest stocks in the Index were responsible for the bulk of the positive return. In fact, the “Magnificent 7” stocks (Apple, Amazon, Alphabet (Google), Microsoft, Tesla, Meta (Facebook) and NVIDIA) rose by 112% on average in 2023!
It’s not uncommon for the conventional, cap-weighted S&P 500 to differ from the equal-weighted version when it comes to returns, but the disparity of 12.5% experienced in 2023 was by far the largest difference in over 20 years. The following table shows calendar year returns for both the S&P 500 and the equal-weighted S&P 500 ETF (ticker: RSP) going back to 2003.
The 12.5% return difference between the cap-weighted S&P 500 and the equal-weighted version is more than twice as large as the next greatest yearly disparity of 5.7% set in 2020. Note that over time the S&P 500 and its equal-weighted version tend to trade fairly close together, with an average annual disparity of just -0.6% over the 21-year period. We fully expect the current dramatic difference in returns to converge back to some degree of normalcy, as a reversion to the mean should occur.
As for the long-anticipated recession that has yet to arrive, several proven recession indicators first started flashing red during the second half of 2022, and nearly all of those indicators remain red to this day, indicating a recession is (still) forthcoming. ClearBridge Investments tracks 12 economic variables that have a solid track record in predicting recessions and as shown below, the overall signal from these 12 variables continues to call for a recession (red “X”).
In fact, the overall signal first turned red in August 2022 and since then has remained red, amounting to 17 consecutive months of signaling a recession is imminent. Admittedly, it’s becoming a bit like the boy who cried wolf! The extended delay of a recession occurring, despite the bearish indicators, can explain why an increasing number of economists are shifting to the “soft landing” camp, believing the economy will successfully avert a slowdown. The Fed has seemingly never been able to orchestrate a soft landing in the past, but those who believe it can happen this time are uttering the phrase, “this time is different.” I’ve written before that perhaps the scariest notion in investing is the belief that the current state of affairs is different than at any other time in history. Spoiler alert: it usually is not.
It’s also worth stating that it’s quite common for there to be a lag before the onset of a recession. Once reliable indicators turn bearish, it can take anywhere between three months to two years until a recession actually arrives. But in addition, as I discussed in the 3Q 2023 letter, another likely reason for the long delay is due to the massive stimulus injected into the economy from both the Fed and federal government in response to the COVID crisis. However, the approximate $5 trillion in total stimulus is now about three years old and its positive effects have gradually diminished with each passing year.
To illustrate the drying up of this stimulus, the following chart shows household excess savings since 2020:
Excess savings for households peaked in August 2021 at $2.1 trillion. But these excess savings have declined by more than 80% in that time and are on pace to be completely depleted by the 1Q of 2024. It will be interesting to see if the US consumer continues to behave the same even after excess savings are all but gone.
What do we expect for 2024? As I wrote in the 4Q 2021 client letter:
With the advent of a new year, we can expect to see the usual deluge of market outlooks and annual forecasts from Wall Street strategists. And at this time I always recall more than one such strategist privately confessing that he/she hated putting together these outlooks, admitting it was more or less educated guesswork trying to predict what would happen during the year, but that they were pressured to do so because clients expected it. In fact, a good argument can be made that it’s easier to predict what will happen either next week or in ten years than it is to forecast what will occur in the next twelve months.
With that caveat in mind, we will offer at least a few observations about what we anticipate could happen in 2024. As already discussed, with excess household savings fast approaching zero and several proven recession indicators continuing to flash red, it would not surprise us if the US economy slowed down and possibly entered a recession during the first half of 2024. Equity valuations remain fairly extended which puts stocks at increased risk if in fact the economy were to stumble. Also, we would expect the extremely narrow leadership in the S&P 500 to finally broaden, with the so-called “Magnificent 7” stocks unlikely to repeat their astounding performance in 2023. As shown in the next chart, the seven largest stocks in the S&P 500 are at levels that have not sustained in the past:
I put together the next chart in response to many investors believing that declining interest rates are bullish for stocks. That’s not actually true.
The top portion of the above chart is the Fed Funds Rate (red) with a moving average (blue), and the lower portion shows the S&P 500 (green). The interest rate environments that are most bullish for stocks are either already low interest rates (not declining) OR rising interest rates. The worst environment for stocks is when the Fed is cutting rates, usually drastically. When the red line has crossed down through the blue line (indicating a trend change as the Fed begins cutting rates), that has typically occurred at the start of significant equity market corrections. I inserted vertical orange lines to identify three such occasions since 1999.
The rationale for this makes sense since a Fed rapidly cutting rates usually means the economy is in bad shape, requiring immediate stimulus in the form of interest rate cuts. Equities then tend to sell off as investors are much more concerned about the weak economic conditions, all but ignoring the beneficial stimulative effects associated with the rate cuts. If anything, the above chart seems to confirm: 1) the Fed is almost always late when finally pivoting to cut rates, and 2) with the Fed cutting rates, it may further fuel the concerns of investors as they fret that even the Fed is very concerned about the economy, further stoking overall fear.
For the start of 2024, we continue to position client portfolios defensively. Until we see more convincing evidence that a recession is unlikely, we prefer to err on the side of caution.
As always, if you have any questions, please feel free to call or email.
The entire team at Measured Wealth wishes to thank you for entrusting us to deliver on your financial goals.
Ed Miller, CFA, CMT
Chief Investment Officer
Measured Wealth Private Client Group
Important Disclosures
Historical data is not a guarantee that any of the events described will occur or that any strategy will be successful. Past performance is not indicative of future results.
Returns citied above are from various sources including Factset, Bloomberg, Russell Associates, S&P Dow Jones, MSCI Inc., The St. Louis Federal Reserve and Y-Charts, Inc. The content is developed from sources believed to be providing accurate information. The information in this material is not intended as tax or legal advice. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information and should not be considered a solicitation for the purchase or sale of any security. Investing involves risks, including possible loss of principal. Please consider the investment objectives, risks, charges, and expenses of any security carefully before investing.
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