Q4 2023: PFM Quarterly Commentary
Market returns are peculiar when you think about them. We are conditioned to presume performance is generated smoothly and in even increments throughout the years, resulting in tidy average annual returns. In truth this is never the case. Short-term performance of variable markets such as stocks and bonds is non-linear in nature with an upward bias over the longer term. Physicist Leonard Mlodinow accurately described this behavior in his 2008 book The Drunkard’s Walk: How Randomness Rules Our Lives. At times, market returns give the appearance of randomness, a drunken walk of sorts, which can overwhelm the rational part of investors’ minds which seek order and predictability. For many, the result is distrust in the markets or the belief that they will never make new highs despite their impeccable 150-year long track record of generating wealth over the long term.
Applying Dr. Mlodinow’s treatise, it is easy to picture the stock and bond markets’ paths over the last two years: drunkards stumbling around aimlessly in every direction, yet seemingly against all odds, arriving home safely and in pretty good time to boot. In our last letter, we described in detail the yearslong malaise in which many markets had been mired, resulting in a collapse of investor sentiment. In that same letter, we highlighted several trading patterns and cycle data that foreshadowed a possible fourth quarter rally; that a continuation of the bull market started October 2022 could be led by a broad range of asset classes and not just by the “Magnificent Seven”, which drove most of the performance in the S&P 500 to that point. To explain further, The Magnificent Seven, a 1960’s classic Western directed by John Sturges, tells the story of seven American gunmen hired to protect a small Mexican village from bandits. Michael Hartnett, a Bank of America analyst, smartly repurposed the film’s premise in 2023 by coining the phrase “Magnificent Seven” to describe the outsized impact of Alphabet, Amazon, Apple, Meta Platforms, Microsoft, NVIDIA, and Tesla on the overall equity market. [i] Anyhow, to say our forecast that diversification would lead any recovery was contradictory to the popular opinion at the time is a spectacular understatement. Still, we had a reasonable basis for our conviction.
By the beginning of the fourth quarter, markets kept faltering and the mood among investors grew ever more despondent. Interest rates, represented by the ten year Treasury, reached 5.02%, the highest level since mid-2007.[ii] The fallout from the sudden rise in rates was headline news as 30-year fixed rate mortgage rates crossed 8% and the national debt expanded by nearly $700 billion in just over a month which was followed by the credit rating agency Moody’s cutting the credit outlook of the U.S. to “Negative”.[iii] Additionally, as the average credit card interest rate soared to a record 22.77%, concern grew that consumers would be squeezed and spending would falter.[iv]
In the domestic equity market, the disparity between the Magnificent Seven and most other stocks reached historic levels, creating one of the narrowest markets in history. Apple and Microsoft each grew larger than the entirety of the Russell 2000 Index, which measures 2,000 domestic small capitalization companies. These seven stocks came to comprise over 25% of the entire S&P 500 as most of the other 493 companies in the index experienced minimal growth at best. For reference, just ten years ago, no single stock in the S&P 500 had more than a 2.8% weighting and the largest twenty-five stocks accounted for only a third of the index. By late 2023, Microsoft and Apple were each more than 7.2% of the S&P 500 and the top twenty-five companies represented greater than 50% of the index’s weight.[v] Given the equity market’s appreciation was of limited breadth, pundits started to declare the death of diversification. It was poetic that many would forsake diversification in the very same year that Harry Markowitz, the Nobel Prize winning economist whose research into the benefits of diversification was instrumental in the creation of Modern Portfolio Theory, passed away.
By mid-October, everything began to change. For the final ten weeks of the year asset prices soared. Naturally, the S&P 500 garnered most of the attention, rising 8.9% in November alone (the 15th best performing month in the last fifty years) and 16.2% from late October through the end of the year on a total return basis. As spectacular as those numbers are, they were far surpassed by many other assets classes. Domestic real estate, small-cap stocks, large-cap value, mid-cap equities, and healthcare stocks generated total returns of 24.4%, 23.9%, 21.7%, 20.1%, 17.7%, respectively, from their October bottoms. Similarly, global bonds rallied sharply, experiencing their best monthly returns in November since 2008. Long-term bonds, international corporate bonds, international Treasury bonds, and domestic corporate bonds generated total returns of 19.5%, 12.9%, 11.4%, and 11.3%, respectively, from the peak in interest rates on October 19. Like equities, these diversifying bonds outperformed their plain vanilla cousin, the U.S. Aggregate Bond Index, which returned 9.3%.[vi]
This sudden surge in broad asset price appreciation speaks to our original point about market returns – they follow no set path. They can languish for excruciatingly long periods of time and then move sharply in an instant without warning. For most asset classes, after years of stumbling around aimlessly, they just generated a year or two’s worth of returns in a handful of weeks, with some markets now at or near all-time highs. These sudden sharp moves are what make market timing and other popular (and mostly ineffective) investment techniques so detrimental to long term returns.
So, what was the impetus for the market’s sudden turn of fortune? You guessed it. We need look no further than the Federal Reserve. Since the mid-1960s, on average, the Federal Reserve begins cutting interest rates eight months after its final rate hike in a tightening cycle. On five occasions it was five months or less.[vii] The Fed’s last rate increase was in July, and despite numerous communications that further interest rate increases might be warranted, the longer the Fed went without a subsequent hike, the greater the perception that interest rates had peaked. Given the history between the end of rate hikes and the beginning of rate cuts, astute investors began positioning for a Fed announcement suggesting a policy pivot they wagered could come as early as December. As a result, markets rose swiftly and continued to trend higher over the last nine weeks of the year.
By nature, markets are a forward-looking discounting mechanism. This descriptor simply means that markets react long before news or data is revealed that justifies their movement. On November 9th, Fed Chair Powell was indicating further rate hikes when he proclaimed, “If it becomes appropriate to tighten policy further, we will not hesitate to do so,” at his opening remarks at the Jacques Polak Annual Research Conference hosted by the International Monetary Fund. Then, on December 1st, during his opening remarks at a Spelman College economic forum, Powell told reporters that “it would be premature to…speculate on when policy might ease.” However, just twelve days later at the Federal Open Market Committee’s press conference on December 13th, Powell changed his tune. While stating that it would be appropriate to maintain a restrictive stance “for some time”, he quickly pivoted to add that cutting rates “clearly is a topic of discussion” and “begins to come into view.” At that point, markets had already been rallying for nearly seven weeks and the S&P 500 had risen 14%.[viii] Clearly, market participants were many steps ahead in anticipating this important change in the Fed’s monetary policy. The lesson is that by the time a change in narrative goes mainstream, it has long been assimilated by markets, which is why reactionary investing based on the ponderings of the financial media rarely succeeds.
Looking forward to 2024, we can make some market assumptions based on historical factors, such as seasonality and the Presidential Election Cycle, that acted with precision over the last few years. Of course, these factors don’t guarantee anything about the future but they do serve as a useful basis when forming an outlook. According to the market research firm Bespoke Investment Group, going back to 1928, the fourth year of a presidency is generally positive rising 6.2% on average.[ix] Intuitively, this pattern makes sense; if markets and the economy are good, then the incumbent likely stays. If not, then voters – particularly those undecided – tend to vote with their wallets and elect new representatives. James Carville (also known as The Ragin’ Cajun), former Democratic strategist for Bill Clinton, said it best in 1992 when he quipped to a journalist that when it came to winning the undecided voter, “It’s the economy, stupid!” With that perspective, accommodating government policy and/or Federal Reserve monetary policy could serve as a market tailwind in 2024. However, as noted earlier, markets rarely move in a straight line and coming off one of the best two-month rallies in memory, market weakness to begin the year would not be unexpected. Normal seasonality and the Presidential Election Cycle support this notion that the early part of the year will start soft before rallying into the spring. Of course, markets can follow whatever path they choose, and innumerable extraneous and unforeseen factors can influence their direction. Still, if the past serves as prologue, then this pattern is a good place to start as we turn the page on 2023 and peer forward.
Wishing everyone a happy, healthy, and prosperous new year,
Peak Financial Management
Disclosures:
The views expressed represent the opinions of Peak Financial Management as of the date noted and are subject to change. These views are not intended as a forecast, a guarantee of future results, investment recommendation, or an offer to buy or sell any securities. The information provided is of a general nature and should not be construed as investment advice or to provide any investment, tax, financial or legal advice or service to any person. The information contained has been compiled from sources deemed reliable, yet accuracy is not guaranteed.
Additional information, including management fees and expenses, is provided on our Form ADV Part 2 available upon request or at the SEC’s Investment Adviser Public Disclosure website. https://adviserinfo.sec.gov/. Past performance is not a guarantee of future results.