The market and economy exceeded most expectations in 2023.Indeed, after a very challenging 2022, investors came into the year with very low expectations. And with low expectations, a little good news went a long way to support strong gains across equity markets.
Indeed, the economy proved fiercely resilient, despite the Federal Reserve’s (Fed) fastest rate hiking cycle in decades, which provided support for forward earnings estimates to reach a record high.
Moreover, the buzz and promise of artificial intelligence (AI) aided an expansion in market valuations and drove the technology sector to a 57.6%gain and the S&P 500 to a total return of 26.3%. Dominant growth names dubbed the “Magnificent 7” (Mag 7) rose a whopping 76.2%.
Yet, some perspective is in order. If one zooms out for the cumulative return over the past two years, the S&P 500 including dividends, is up only 3% and the Mag 7 is up just 6%. Indeed, we have basically done a round trip from where we were two years ago.
Speaking of round trips, the 10-year U.S. Treasury yield, which was a dominant market driver in 2023, also finished basically where it started. Indeed, despite a sharp intra-year move higher, which saw the 10-year yield touch 5%, yields settled out below 4%.
This decline in yield—alongside improved inflation trends and Fed Chairman Powell opening the door for potential rate cuts—provided fuel for a sharp market rally into year end. Notably, the markets finished with a bang, and the S&P 500 went on a 9-week winning streak, the longest since 2004.
Unlike most of the year, we saw the market rally broaden out to include strong performance by small caps and the average stock. Still, even with the rally, the average stock, as proxied by the S&P Equal Weight Index, trailed the traditional S&P 500 by 12.4% over the past year, the most since 1998.
Indeed, with only three sectors outperforming the S&P 500—technology, communications, and consumer discretionary—it proved to be a challenging period for many investment managers.
So where do we go from here?
Heading into 2024, keeping an open mind remains of utmost importance as the post-pandemic playbook remains challenged. And it will be just as important for investors to be prepared –be prepared that 2024 will not be the year to keep an investment strategy on autopilot.
Indeed, key questions remain about whether the Fed will be able to achieve what is now a consensus call for a soft economic landing—if inflation has truly been defeated. Moreover, there are more than 40 elections around the globe, including in the U.S.
There will also certainly be unexpected events that rise to the front page. Indeed, a year ago, AI was not part of many outlooks, nor was the Ukraine/Russian war the year prior. That’s why, as important as an outlook, is being prepared to adjust as new information emerges.
As a starting point, a reasonable baseline total return estimate for the S&P 500 is in the range of 5% to 10%,yet history suggests that the probability of a much more dramatic move is elevated. This implies valuations remain supported at current levels by easing monetary policy and inflation trends and earnings grow around trend.
The good news is even while the market enters the year extended on a short-term basis, the recent price momentum has counterintuitively been a good intermediate sign for the S&P 500.
On a forward 12-month basis, the S&P 500 has been up 87% of the time following similar conditions.
That said, after such a strong run, we expect a digestion period.
This aligns with our work that shows the first part of an election year tends to be choppier along with the more optimistic sentiment picture—the percent of retail investors who are bearish is half of what it was heading into 2023—suggesting the bar for positive surprises has risen and is almost the mirror image of where we began last year.
- Stick with the underlying positive market trend and be prepared to use pullbacks as opportunities.
- Continue to prefer U.S. over international markets. The U.S. economy and earnings continue to outperform.
- We are still emphasizing large caps. Yet, we see the S&P 500 Equal Weight Index as an attractive way to diversify the concentration risks in large caps alongside the traditional market cap weighted index.
- On pullbacks, look to add to small caps, which are still relatively cheap and are showing improved relative price strength.
- Expect a better environment for active managers relative to a difficult 2023. The likelihood that the top stocks dominate to the same extent in 2024 is much lower after such a strong run.
- Focus on high quality and limit exposure to riskier bonds until spreads present a better entry point.
- We tactically downgraded bond duration in late December to neutral after the sharp move lower in interest rates. For new capital, we would wait for a better entry point to extend duration.
The weight of the evidence will continue to be our guiding light. We look forward to keeping you informed as our views evolve throughout the year.