Quarterly Review & Market Outlook – 4th Quarter 2023
“The only function of economic forecasting is to make astrology look respectable.”
– John Kenneth Galbraith
We have cautioned against taking the gloomy headlines too seriously, but even the optimists have been surprised at how quickly inflation returned to normal in the second half of 2023. It was widely expected that regaining control of the price level would take several years and require a downturn. Instead, inflation has come down in most countries remarkably fast. Many central banks are either cutting rates or at least discussing the possibility. At the same time, economic growth has held up better than expected. Real wages are on the rise again.
The pandemic economy was hard to forecast. Consumer behavior changed abruptly and continued to evolve even after we started discussing COVID in the past tense. The Fed made mistakes but also showed humility and flexibility in the face of immense uncertainty. A year ago, we said that even though their models showed a million people would need to lose their jobs to get inflation under control, they would pivot to a more accommodative posture if the data warranted.
As we enter this year, our views are less contrarian. Experts may still be too pessimistic, but markets haven’t waited for them to catch up. Asset prices rallied during the quarter due to the increasing likelihood of proactive rate cuts. We agree that recent data is cause for relief, but investors need to remember that in recent years the economy has never been as good or as bad as it seemed in the moment. We look hopefully to the coming year, yet we suspect it won’t be a straight shot higher.
Quarterly Review
Nearly all fixed income sectors ended the year with solid returns as the Fed pivoted away from further rate hikes and toward a more balanced policy stance. Long-term Treasuries rallied sharply, providing a tailwind to all other asset classes. Cash generated a solid yield yet lagged credit-sensitive areas such as corporate bonds.
In equity markets, the large US technology companies dominating the indexes were the story for most of the year. The technology-heavy Nasdaq Index finished the year up a staggering 55%, although the total return over two years is surprisingly still negative. Returns don’t come without risk.
Performance during the quarter spread beyond technology. Small companies outperformed, with notable gains in the banking sector. The expectation of future rate cuts improved the profit outlook and relieved pressure on bank loan portfolios concentrated in the commercial real estate sector.
International markets performed well during the quarter, supported by a weaker dollar. Priced in local currency, the developed markets index has outperformed the US by a decent margin over the past two years. Dollar-based investors have not benefited to the same extent.
Market Outlook
The six largest US companies have a combined market capitalization of over $11 trillion, up more than 300% from just five years ago. They represent about 25% of the S&P 500 Index and about 10% of all public companies globally. They touch many corners of the economy beyond technology, with Amazon’s retail business being the most obvious example. They have business models built atop the internet that can grow quickly even at their current scale. They are also among the few non-governmental entities capable of investing the vast amounts needed to develop Artificial Intelligence, further cementing their position in the next phase of innovation.
We believe these are core holdings in a diversified portfolio. The question is how to size them. Future returns come from exceeding expectations, and expectations for the technology giants are very high. Microsoft enters the year trading at 31x next year’s earnings, which are expected to grow by 20%. This is a high bar for any company, especially one that earned $90 billion last year.
Outside of these names, we see a universe of reasonably-priced companies with characteristics we believe drive an attractive return profile regardless of the environment—strong earnings growth, defensive balance sheets, and consistent dividends. The median S&P 500 stock trades at a Price-to-Earnings ratio about 5% below its 10-year average. The tech-heavy Nasdaq is about 23% richer.
Small and Mid-cap companies ended the year on a high note yet remain broadly inexpensive. We use low-cost strategies that use fundamental analysis to identify companies with profitability metrics we favor. This has worked well relative to the indexes that hold many undesirable businesses.
Fixed income investing remains broadly attractive but is starting to require more nuance. Elevated yields on cash and other short-term bonds are unlikely to last much longer. While longer-term yields have come down, we still think income-focused investors should move beyond cash in order to earn more sustainable high-quality cash flows where possible.
In High Yield corporate bonds, credit spreads narrowed in the fourth quarter and all-in yields are back to their 20-year average. We had conviction a year ago that riskier bonds were mispriced, and this thesis has worked well. We still see opportunities for further upside, but we are also mindful not to overstay our welcome.
∞
The irony of markets is that investing was easier a year ago when there was more uncertainty. Investor sentiment was in the basement and assets were already priced for bad times. Excessively so, we argued at the time.
Expectations are higher now. Going forward, we think it will matter more how you invest, not just that you invest. We see ample opportunities to earn compelling returns across most asset classes but, as asset prices reach new heights, diversification and risk management become even more vital in protecting capital when the unexpected happens.
Please reach out to your trusted Waverly Advisor with any questions or comments. We wish everyone a healthy and happy 2024!
Written by Waverly Chief Investment Officers
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| Clay McDaniel, CFA
Chief Investment Officer Private Markets |
John B. Cox, CFA, CAIA
Chief Investment Officer Public Markets |
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