A Fresh Year With New Dimensions To Add To 2023’s Unfinished Business
Let me start out the first missive of the year by wishing everyone a Happy New Year. Here’s to happiness, good health, and success in every meaning of the word for 2024. I would be remiss if I didn’t say Thank You to all of you loyal readers. I very much enjoy the interaction, engagement, and inquisitions that stem from this communication. I am always eager to learn from you where our thoughts align and when you think I’m off my rocker. Either way, it forces us to learn and constantly reassess our work.
As for markets, thus far the Santa rally has been unable to get the S&P 500 to a new all-time high. Towards the end of last week, the S&P 500 got within a whisper of it as it rose to 4,793 (closing all-time high was 4,797), but it did end 2023 with a 24.2% gain. The Nasdaq was the big winner last year with a 43.4% gain on the year. However, only the Dow managed to make a new all-time high last year. It’s not much of a stretch to think the other two will join the Dow sometime in the first couple weeks of 2024. As for the rest of the year, who knows? Sure, we all have our opinions and guesses, but they are just that. What will be important, as was the case last year, is to be flexible with your views and have the willingness to change your mind as the facts change. This is something I think I both failed and succeeded at in 2023. I had a bearish bias on the economy and neutral view on equities through most of the first half of 2023 but acknowledged that the price action in the equity market wasn’t confirming my view. So, as the year progressed, I made sure to be open minded not only with my view but with portfolio positioning. This forced me to buy dips and carry a larger equity weighting in portfolios than my bearish view thought appropriate.
However, on the fixed income side I wasn’t nearly as flexible where I was too stubborn in my view that the Fed was overtightening, and that the economy would crater before yields got to 5.0%. As a result, clients had to endure a large drawdown with the long duration fixed income exposure we had on in portfolios for most of the year. It wasn’t until the last two months of the year (after the Fed decisively pivoted) that the bond market rallied meaningfully with yields in the intermediate and long-end of the curve reverting back to where they started the year. In the end the Fed’s resolve in the first nine months of the year was in the driver’s seat, but my resolve that they were going too far was vindicated by year-end.
Another thing I took away from 2023 was the expanding impact of passive investing on market structure and market outcomes. The dominance of index investing over stock selection was on full display up until the end of October when a short covering rally following the Fed pivot upended everything and set off a performance chase into year-end. Up until October 27th the largest stocks were outperforming significantly – the S&P equal-weight index was negative on the year, so was the Russell 2000 small cap index, and more than 50% of the constituents of the S&P 500 were down on the year. I fear the mass adoption of passive investing is nearing a critical point where there is no turning back until there is much more widespread recognition of the distortions it is creating: price inelasticity, market returns disconnected from economic indicators, increased valuations, and increased market concentration to name a few. When that occurs, I don’t know? In the meantime, it has become part of the mosaic investors have to account for in their thinking.
Speaking of that rip roaring rally in everything over the last two months of the year. Kevin Muir, in his latest MacroTourist substack put together a couple charts that contextualize just how magnificent it was for the traditional 60/40 portfolio. This portfolio mix soared to a +7.5% gain in November (the second largest monthly gain since 2007) and continued on in December with an impressive +4.3% gain. This marked the best end-of-year two-month gain in modern financial history.
Looking just at equities and putting this recent rally into perspective. In the aftermath of the mini-regional banking crisis this past March we saw the S&P 500 rally around 16% in the four months that followed the Fed stepping in with the Bank Term Funding Program (BTFP). The rally that ensued following the October 27th equity market low was almost 16% in just two months. So, the same absolute gain in half the time.
As for the bond market, it hasn’t taken much of a back seat to the performance of stocks in this year-end surge in almost everything. Since the peak in Treasury yields back on October 19th with the yield on the 30-year Treasury at 5.11% (it closed out 2023 at a yield of 4.03%), the long bond has generated a net total return of +20% (+10% for the 10-year T-note). At one-point last year the net return on the long-bond was -15%, but the plunge in yields following the Fed pivot caused a remarkable turnaround with the 30-year Treasury bond posting a near +3% total return in 2023. Thus, avoiding a third consecutive year of negative returns.
Gold had a solid year as well in 2023 where it posted its first annual gain in three years with a +13% advance. Oil on the other hand was the caboose to almost every other asset class last year as it fell -10.7% for the year (the sharpest decline since 2020) and sits at the low end of the $65-$120 range of the past two years even with the disruption in the Red Sea and the OPEC+ production cuts.
As for the setup from here, well it should come as little surprise for me to say it doesn’t look all that exciting at the moment. The forward P/E multiple on the S&P 500 is back up to the 20x threshold with analysts penciling in greater than 10% earnings growth in 2024. Although when looking at the change in market cap of the S&P 500 on a two-year basis you realize that the $8 trillion rise in 2023 just recouped the $8 trillion lost in 2022 – one long roundtrip where the all-time high was put in on the first trading day of 2022 and almost revisited on the last trading day of 2023.
It's not just valuations and the technical picture hitting extremes, but so are sentiment and positioning. The Market Vane sentiment reading has moved to a 61% bullish print and the same level it reached in January 2022 (70% is an extreme level if we were to get there). The CNN Fear and Greed Index is still sitting in the high 70’s after reaching 80 last week (both extreme greed territory, but at the lower end of ‘extreme greed’). As for positioning, the National Association of Active Investment Mangers (NAAIM) exposure index just climbed above the century mark at 102.71 versus and average level of 60.53 in Q3. This is the highest this metric has been in the past two years.
Bottomline, the setup to put fresh capital to work in either the equity or debt market just isn’t there. Sure, prices could go higher in both, but a better setup would arise after a bit of a cool-off period either through a modest correction or period of sideways consolidation.
As I look ahead to 2024 there are a couple major items that come to mind. The first being Fed policy actions and why? Is the Fed going to be easing only because they have conclusively slayed the inflation dragon? Hence, rate cuts occur so that policy doesn’t get more restrictive as inflation falls further (transitioning to a real-rate regime). Or is the Fed easing because economic activity softens more significantly than expected. In the case of the latter, the earnings outlook of +10% EPS growth would come down meaningfully and this would weigh on equities. Also keep in mind that the Fed’s most recent SEP (Summary of Economic Projections) forecast nominal GDP growth for 2024 to come in at +3.8%. Looking back over the past seven decades, only 17% of the time has nominal GDP growth been this weak or weaker. In other words, this is a fairly sober forecast on U.S. economic growth. No, it’s not a recession and we can all hope that the data comes in better than this expectation, but if it is accurate then it leaves little room for error. Keep this in mind as you are bombarded by all the calls for a ‘soft or no landing’ outcome for the economy. Thus far that is what has materialized and that is also where the markets are priced at the moment. The surprise and market price adjustment will arise if/when data comes in that justifies a different outcome.
Another thing that has yet to fully reveal itself as we segue from 2023 to 2024 is that households, businesses, and the economy are still digesting the most aggressive Fed tightening cycle in the past four decades. For sure, these groups (in aggregate) are not as interest rate sensitive as prior economic cycles. Moreover, there are quite a few who are benefiting from the rise in interest rates. Nevertheless, the rise in borrowing costs are having their intended restrictive impact on the monetary aggregates and bank credit, with both simultaneously contracting for the first time on record. Not to mention other warning signs like the leading economic indicator riding a 20-month losing streak, and a yield curve that is still inverted.
Let me state my opinion on the economy and capital markets as clear as I can as we kick off 2024.
On the economy I am slightly more pessimistic than consensus at the moment. It looks as though the ‘soft landing’ outcome is within grasp of policy makers and given this is an election year I expect the administration to pull out all the stops to support the economy as the year progresses. What worries me most about this view (even though I think it’s probably the right one to have) is how widely consensus it’s become. Not that consensus is always wrong, it’s just that when it’s so widely accepted it creates more risk for the economy and markets if an out of consensus outcome occurs.
On the equity market – the S&P trading at 20x forward earnings with 10% EPS growth penciled in by analysts does not excite me. I’m not a seller here and now, but I’m not a buyer either. I think there is an opportunity in the energy and healthcare sectors. Uranium miners have a fair amount of catching up to do relative to the underlying commodity in my opinion. Uranium was one of the best performing commodities in 2023 (+91%), but the miners as measured by URNM gained +52%. Furthermore, the uranium miners ETF has been in a state of consolidation since late September with the price virtually unchanged while the price of uranium has ripped by 15%.
With a proper sell-off that knocks the froth off the equity market I would likely put some capital to work, but I don’t intend to do a whole lot of adjusting (more just tweaking) outside of that. Don’t misunderstand my tone, I am not bearish, but rather just don’t see much opportunity after the recent run. I’ll await more information and the passage of time to evolve and tweak this view.
On the fixed income market – not much different than my view on the equity market. The late-2023 slide in yields corrected the summer spike in yields on Treasury funding concerns (I expect these to resurface throughout 2024) that were unwarranted. However, a further move lower in yields from here likely requires recession fears to reenter the equation. Possible, and I’d consider a recession a higher probability outcome than a ‘no landing’ scenario, but we’ll have to see how the data comes in as the year progresses.
So, not a lot to do at the moment on the fixed income side other than hold tight and re-invest short-term bills (2-years and shorter) while trying to take advantage of the elevated rates at the short-end of the curve for as long as the Fed sticks to the ‘higher for longer’ game plan.
Gold – own some, that’s my advice. You decide how much is appropriate for you. I wanted to get our client exposure back up to 4% coming into the year, but didn’t quite get there, so I will be adding to this exposure when opportunities present themselves.
The other major event on the horizon in 2024 is the U.S. election on November 6th. It is always difficult to unseat an incumbent, especially without a recession, but Joe Biden’s approval ratings, especially on the economy, are worse at this stage of the first term than any other President dating back to Jimmy Carter in the late 1970s. So long as Donald Trump manages to show up on state ballots, he does look like a shoo-in at this point – the issue of just how solid his support is, mind you, will come when the GOP field of candidates narrows to a one-on-one race. While there can be no denying that Trump’s term from 2016 to 2020 was met with internal chaos, the economy did just fine, interest rates were stable, and the equity market rocked and rolled in three of his four years in office. What would a second term look like? Nobody knows. But the case for gold as a hedge against political uncertainty does seem to be a strong one (ditto for the E&P stocks in the energy space).
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