As we turn the calendar to 2024, we want to wish you all a Happy New Year! We also want to provide a Market Update as a lot has happened since our last post. The new year often prompts each of us to reflect on the year that has passed and from that reflection, bear out a game plan for the coming year with new and/or updated goals and intentions for the months to come. With this blog, we’ll summarize and give our insights on what stood out to us in 2023, leading to where the market is today, and then give you some food for thought on our 2024 outlook.
An adage that circulates from time to time is: “Even if you had, in advance, every single economic report that will be published in the coming year. You still can’t predict with any accuracy where the stock market will end up as a result.” The year 2023 certainly bore this out in a remarkable way. The reason this tends to be true is because the stock market is a discounting mechanism that combines the opinions of every single participant simultaneously. Efficient market theory would say that all available information is immediately priced into or reflected in stock prices. While we think that is true to an extent, it misses some key factors – fear and greed. These two emotions can result in overshoots, both to the upside and to the downside.
As investors, we do our best to determine what is and what isn’t “priced in” to the market at any given time. What we mean by priced in is the reactionary function of the market to new information. You might see a stock or an index jump or fall rapidly when a news report comes across the wire… that is the market “pricing in” the new information. So, at any given time the market is priced with expectations of certain outcomes, driven in theory by probabilities of those outcomes. An example of this is the current outlook where the stock market appears to be pricing in six interest rate cuts (150 basis points) from the Federal Reserve in 2024: See the CME Fed Watch Tool Here. Whereas the Fed has projected only three 25 basis point rate cuts (75 basis points total) in its summary of economic projections from the last meeting. So why is the market pricing in six 25 basis point cuts? One possible explanation is that in the event of a recession in 2024, there could be as many as 300+ basis points of rate cuts (this is speculation). That equates to 12 rate cuts of 0.25%. If you put a recession probability for 2024 at say 30% and no recession at 70% – and consider the probability weighted result, you land at roughly 6 rate cuts. What’s strange is the market seems to be pricing in 6 rate cuts but ignoring the reasons that would drive the additional 3 cuts (recession of some magnitude). This market optimism is a theme that played out in much of 2023 and we’ll get into that further below. Perception vs. reality is very important.
Some highlights of 2023 are as follows:
Completion of one of the most aggressive rate hiking cycles in history.
Interest rate volatility.
Returns concentration to the “Magnificent Seven”.
Soft Landing vs. Hard Landing
Artificial intelligence goes mainstream through generative AI.
Extensive multiple expansion.
We won’t go into each of these with too much detail but it’s helpful to get a feel for where the market is right now. The Federal reserve appears to have completed their current rate hiking cycle that began in early 2022 and they are now assessing the timeline for introducing rate cuts in 2024. We witnessed some of the biggest bank failures in US history in 2023, partially due to the rapid nature of the interest rate increases by the Fed which resulted in many banks having to markdown their assets significantly and a few becoming insolvent. As rates go up, the market value of existing bonds falls. Consider the influx of cash into the system in 2020 and 2021 that banks needed to invest somewhere at a time when interest rates were near zero. They had to buy longer dated bonds, think 10-year and 20-year bonds, to get any kind of return. Well as interest rates started to climb, those longer dated bonds on bank’s balance sheets began to decline in value. This wouldn’t be an issue if the bank never had to sell. If they were able to hold to maturity, they’d get their principal back and the only issue would’ve been they missed out on some potential interest income. However, when depositors start withdrawing significant funds, to fulfill those withdrawals, banks are forced to liquidate assets to satisfy the withdrawal requests. If this continues, they may be forced to sell assets they’re underwater on. I’m sure you can see the problem here – this situation wasn’t unique to just a couple of banks and we potentially could’ve seen a much worse outcome for the financial system in 2023 as a result. The Fed, US Treasury, and FDIC, through various channels and emergency lending, were able to reassure depositors so there wasn’t a widespread bank run across the country. It seems this intervention gave a shot in the arm to investors, as it led to significant asset appreciation in the following months, despite relatively flat earnings growth. When investors think the Federal reserve will swoop in to save the day, no matter what, it heightens animal spirits and risk taking, because if the Federal Reserve and Government will always prop things up, then what’s the risk? That’s a strange and possibly dangerous precedent, but it’s what we are currently living through, and we think this concept partially explains why the market turned optimistic after March of 2023.
This chart should look familiar as we had the same one with a different timeframe in a past blog, but by October of 2023, the divergence became even more extreme:
As you can see in the chart above, most sectors were either flat or negative on the year from January to the end of October in 2023 with the exception of Technology, Communication Services and Consumer Discretionary. These sectors have a significant concentration in the largest companies in the US: Apple, Microsoft, Amazon, Alphabet (Google), Meta (Facebook), Nvidia, and Tesla. These companies have been referred to as the “Magnificent Seven” in 2023. Primarily because they were some of the only stocks going up in value for most of the year, but also because of their influence on the major stock indexes. A concept we want you to understand before moving on here is the difference between Market Cap weighted vs. Equal weighted when it comes to indexes. The S&P 500 and Nasdaq 100 are market cap weighted indexes. That means the total market value of a business relative to the others represents its influence on the index. So, of the 500 companies roughly that are in the S&P 500, in an equal weighted index, each company would be 1/500th of the index. But in a market cap weighted index their weighting is based on their market capitalization (business size). To cherry pick the two largest at the time – AAPL and MSFT stock each had a weighting of around 7% in the S&P 500. What that means is roughly 14% of the S&P 500 was represented by just two companies. On any given day a move up or down by Apple or Microsoft has a much bigger impact on the S&P 500 performance than any other stock. If we add the rest of the magnificent seven stocks to the mix, we get to just under 30% of the S&P 500 allocation represented by only 7 companies. This is a significant level of performance concentration to a small number of stocks, all of which did very well in 2023. This masked the underlying performance to a certain extent. The S&P 500 and Nasdaq were both up quite a bit for the year in October 2023, but looking under the hood, the average stock was not doing very well more broadly speaking. This all changed in November and December, but we wanted you to get a feel for where things were at 10 months into the year, now we’ll talk about the final two months of the year and lead into 2024 from there.
When there is the level of dispersion as seen above, there is often a reconciling period and going into November there was speculation as to whether the rest of the market would start to catch up to the magnificent seven stocks in the final months of the year, or if the magnificent seven stocks would move back down to be more in line with the rest of the stock market. We ended up getting the former and we’ll give you our take on why that happened. Since the beginning of 2022 when the Federal reserve began raising interest rates to bring down inflation there has been debate over whether that would lead to a hard landing or a soft landing in the economy. Hard landing meaning, as a result of raising rates to fight inflation, the economy tips into a recession. Soft landing being the scenario where the Fed is able to bring inflation back down to its target without causing a recession. At different times, each scenario has seemed more or less likely than the other, but much of the economic data that came out in November and December along with the Federal Reserve meetings supported the case for a soft landing. The data being a continued strong labor market and inflation dropping more quickly than expected. As a result, stock prices began pricing in soft landing outcome with a much higher probability. Lifting stock prices across the board for the most part.
The gains seen in 2023 were primarily based on multiple expansion. We’ve touched on this in past blogs, but a common method for valuing stocks is the Price to Earnings (PE) Ratio. Investors go back and forth discussing the “multiple” that stocks or indexes are trading at and whether that is cheap or expensive. When stocks go up without earnings growth, the multiple expands, getting more expensive. Since stocks moved up in 2023 without earnings growing, they are pricing in future growth expectations. Which means those expectations need to be met at some point down the road and any disruption to those expectations could be problematic.
This brings us to 2024 and a whole new year of potential investing risks and rewards! As you know, we are entering an election year which has many implications, completely outside the normal ebbs and flows of the business cycle and economic environment. With that in mind, we’ll paint the picture of what we think the bulls and the bears are currently hanging their hats on and give you our take on some of it.
By our assessment, the bullish outlook requires a few things to happen:
Inflation continues to drop like a rock, getting back to the Fed’s target faster than expectations.
Earnings reaccelerate and hit at least 12% growth in 2024.
Currently, earnings expectations for the S&P 500 in 2024 are at $244/share, roughly 12% higher than 2023 earnings. To match or beat expectations, they need to hit 12% growth.
The Fed starts cutting rates in March and continues to cut rates at all but one of the subsequent meetings for the remainder of the year. (6 cuts total).
The reason for these cuts also needs to be that they are cutting because they can, not because they have to. This is important, if they are cutting because inflation is dropping and the labor market is still strong, that’s very positive. But if they’re cutting because the labor market is weakening, that’s not a great sign in isolation.
Soft landing is achieved without inflation reemerging.
Continued strength in the labor market is a key component of this.
Artificial intelligence unlocks new and substantial productivity.
Government spending continues to flow unabated.
This is a continued wild card as it was in 2023. The recession timeline could continue getting kicked down the road by government spending. With this being an election year, it’s especially important as incumbent presidents generally want their voters to feel good on election day.
We don’t think it’s impossible for the above to become a reality, but there are a couple of holes in the bullish case that stand out to us with only one possible solution that is apparent to us. Inflation is good for earnings initially, because companies can charge higher prices for their goods and services – this increases the top line (revenues). But then as inflation hangs around, workers demand higher wages, we have seen this play out in many cases, an easy example being the UAW (united auto workers) strikes. As wages go up, this puts pressure on the bottom line (earnings), unless prices also keep going up or other efficiencies can be realized.
The first phase we described is good for businesses but bad for the consumer – prices going up faster than wages. We’ve all felt this meaningfully the last couple of years. However, we are now at a place where wage growth is slightly greater than inflation. The average hourly earnings YoY for November was 4.01% and December just came out at 4.10%. While CPI in November was 3.14%. This is good for the consumer if they stay employed but could be bad for businesses in the near term.
Businesses became much leaner in 2023 as all the predictions for recession, slow down, etc. have forced CEO’s to cut costs aggressively to be prepared for said recession. For earnings to now accelerate up 12% in 2024, there needs to either be further cost cutting and/or an increase in the top line. We think it will be difficult for revenues to increase dramatically in a disinflationary environment. As mentioned, inflation does help the top line for businesses as they are able to raise prices. However, the flip side is also true – growth in revenue becomes difficult as price increases are less frequent and even discounting and lower prices could become a factor in 2024.
The one solution we could see solving this problem – artificial intelligence. Technological advancement is the key to increasing productivity, and AI may or may not move us to the next level of productivity. One of the issues we have with this concept is the fact that AI has been around in businesses for years, but it’s just been brought to everyone’s attention in the last 12 months or so. So, we are still asking the question of whether that alone can result in the reacceleration in earnings and productivity that the market seems to be pricing for. Another rescue for the earnings issue we mentioned above is for businesses to raise prices further, but then that rears the ugly head of inflation again and probably takes rate cuts back off the table, all of which would be negative for stock prices in our opinion. The bull case needs to have a lot of things go right for it to work out, some of which appears to be contradictory – earnings growth, strong labor market, and inflation continuing to drop. It would seem only 2 of these 3 things could happen at the same time. But we’ll see what 2024 brings.
By our assessment, the bear case requires some combination of these factors to play out:
Earnings results come in below expectations – disappointing to the downside.
Unemployment begins moving up in a meaningful way.
As businesses begin feeling the bite of higher interest rates, to maintain the bottom line or solvency, they are forced to lay off workers.
Resurgence of inflation – or even inflation not falling as quickly as expected.
Economic data that starts to support a hard landing rather than a soft landing.
The recession indicators that have been flashing finally get proven correct after 14+ months of being wrong.
Some examples are:
Yield curve inversion for 17+ months straight (10-year vs. 2-year): Link
ISM manufacturing PMI in contraction for 14 months in a row: Link
ISM new orders index in contraction for 16+ months: Link
Conference Board, US leading indicators index, 20 months of declines: Link
Note, the report linked to this one is worth reading if you have time.
Stock prices were the only positive component in November, this highlights the optimism we’ve been discussing.
A black swan event happens:
Although any black swan event is unlikely in isolation… the last several years we’ve lived through make it seem as though some kind of black swan event is almost inevitable in any given year. Whether it has a meaningfully negative impact on stock prices is another question entirely, however.
US debt becomes unsustainable.
Our current stance on 2024 would be best characterized as somewhat pessimistic, but aware of the potential upside to asset prices because of government spending and potential efficiencies realized from AI. The rally in 2023 and most notably the move in the last two months of the year indicate to us that investor sentiment has improved dramatically. This isn’t necessarily a bad sign, but it does mean the market is more vulnerable to downside catalysts, because people don’t seem to be expecting them. The majority of the time when the Fed raises interest rates as aggressively as they have, it leads to a recession and the average drawdown for stocks in a recession is about 30%. See here. The recession economists have been expecting to materialize for more than a year now hasn’t shown up yet. However, that doesn’t mean it never will. We believe the massive fiscal stimulus is primarily responsible for kicking the recession bucket down the road. To give a sense of what we mean, David Rosenberg has done some work on this and claims, “two-thirds of the growth last year in the economy came from the juice from fiscal policy and that acted as a huge antidote to what the Fed was doing” Link. This is why we’ve said it’s still a wild card in 2024 and could continue to delay a slowdown.
It's worth noting that often throughout history, many have declared that a soft landing is happening at different times only to discover months later that the hard landing just hadn’t materialized yet. We are currently in the phase where the consensus is for a soft landing. We don’t know what the case will be this time around, but when the market is pricing in a high likelihood of a soft landing… it would seem to leave more room for possible downside than upside and possibly significant downside if the soft landing does become a hard landing. If we see the hard landing starting to materialize, as you are aware, we will be working hard to minimize the downside risk to our portfolio and manage through that season.
The bulls would say we are in the early stages of a new business cycle and AI is going to lead to new and substantial increases in productivity. The bears would say we are late cycle, and any incremental productivity boost will be overshadowed by the deteriorating consumer and higher interest rates which will soon lead to a recession. As indicated above, we lean more towards the bear case right now. To be early cycle and achieve years of sustained growth, you would normally be starting from a different place than where we are today. Economic expansion comes from some combination of labor and productivity. A new cycle would usually start when unemployment is elevated and there can be years of adding workers back into the economy. As we stand today there is still roughly 1.4 jobs available per every 1 unemployed person. This means that expansion in labor is very hard to come by right now. Couple this with auto loan delinquencies hitting decade highs link, same with credit card delinquencies link – it feels more like late cycle than early cycle to us. The jury is still out on whether AI is going to catapult us into greater levels of production than where we are today – investors are certainly optimistic on this front. We are concerned they may be overly optimistic and that’s causing them to ignore the potential risks. Stay tuned for what comes next!
With all of that being said, we want to end on a positive note. Even if we do tip into a recession and the market sells off somewhere in the ballpark of 30%, we will do our best to limit how much of that downside our strategy participates in. On the other side of any market sell off, are incredible and sometimes generational investing opportunities to buy exceptional companies at fire-sale prices. We will be working constantly to identify those opportunities and to take advantage of them for our clients. We are very optimistic about the long term, but are wary of the near term outlook.
If you’ve made it this far in reading – thank you for sticking around!! Some of this can be dry but we hope this update has brought some understanding of what’s been going on in the markets recently and where we are at with our investing strategy. We thank you sincerely for trusting MFG with the management of your investments. If you’ve stumbled across our blog somehow and are not a client, we welcome you to reach out to us and see if there’s a good fit for working with our team.
Authored by: Michael McCracken CFP®, ChFC and Jeffrey Gardner, Financial Advisor The information presented above has been prepared for informational purposes only and the commentary represent the opinions of the author and are subject to change at any time due to market or economic conditions or other factors.