What a difference a quarter makes. October continued last quarter’s weakness amid disappointingly high inflation readings that supported the higher-for-longer interest-rate scenario. But investor sentiment turned sharply positive in late October as disinflationary signs took hold despite solid economic indicators, with the Federal Reserve signaling in December an end to its tight monetary policy. Global stock markets rose, while interest rates fell dramatically.
The S&P 500 reported an impressive gain of 11.7% for the quarter, pushing the full-year return to 26.3%. Importantly, the fourth quarter’s gain was broad-based, with participation by more than just the “Magnificent 7.” There was particular strength among the more interest-sensitive and cyclical sectors, including Real Estate, Financials, Information Technology, and Industrials. Lagging sectors included the more defensive Utilities and Consumer Staples sectors, while Energy posted negative returns for the quarter in response to the 20% decline in oil prices. These three sectors were the only ones to post losses for the full year as well. Leading sectors for the year were primarily driven by the sizable returns of the Magnificent 7, with Information
Technology, Communication Services, and Consumer Discretionary leading the way. Smaller caps also participated in the quarter’s rally, with the Russell 2000 advancing 14.0%, pushing its full-year gain to 16.9%. Small cap sector performance was similar to large caps in the quarter, although a strong rebound among Biotech stocks and Homebuilders placed Health Care and Consumer Discretionary toward the top as well. Full-year returns among small cap sectors were led by the more cyclical and growth-oriented Industrials, Consumer Discretionary, and Information Technology sectors.
Growth and Value styles both posted good fourth-quarter gains among large caps, although, as has been the case all year, Growth was the stronger performer. Among smaller cap stocks, Value regained some relative strength in the quarter, although it was not enough to offset Growth’s lead for the year. Given the double-digit quarterly gains, stocks with lower-quality attributes performed well, which is not atypical, especially among smaller cap names, as non-earners, smaller size, and lower ROE names outperformed.
Despite the resilient economy, inflation has slowed meaningfully, and has finally come down toward the Fed’s 2% target for many measures of inflation. This has given the Fed confidence to suggest several rate cuts are in store for 2024. Against this backdrop, the setup for 2024 looks quite positive, as labor markets remain solid, consumer confidence has improved, capital spending should be bolstered by Inflation Reduction Act spending, and corporate earnings should grow nicely. On top of this, corporate cash balances remain high, which should support dividend growth, share repurchases, and M&A activity. Investors have also amassed multi-trillion-dollar cash balances that are likely to move back toward risk assets once money market yields begin to wane with the Fed rate cuts.
Yet, lest we just declare victory for the 2024 soft landing, it is wise to consider some of the risks we face in the new year. There are the imponderables of a widening of hostilities in Ukraine or the Middle East, and the unknown outcome of many pivotal elections around the world.
There is still the risk of recession caused by the typically long lag time between Fed rate hikes, the inverted yield curve, and the reduction in the money supply. The weak ISM Manufacturing survey and sluggish housing demand would support this fear. On the flip side, there is the possibility that the surprisingly strong economy could lead to renewed inflation and a reversal of the recent drop-in interest rates. The low unemployment rate and high housing prices would support this scenario. So, while the market’s bias is clearly toward the soft landing/lower-rate scenario, we will keep any eye out for developments that might put us down an alternative path.
While the market’s strength would suggest stocks have gotten only more expensive, in fact market gains have been offset by higher earnings expectations going into 2024, leaving US large cap equities selling at about 20.5x earnings, or a 4.9% earnings yield. With the drop in 10-year Treasury yields to about 3.9%, the ratio of equity to fixed income yields has actually improved over the course of the quarter to about 1.25x.
While we are optimistic about prospects for equity markets in 2024, we are aware there are several factors that could derail our favorable outlook. As such, our primary goal remains investing in quality companies that have strong management teams that should successfully guide them through any economic environment and allow them to outperform their less skilled competition.