The fourth quarter posted strong performance results across the securities markets with stocks and bonds rising together on news that the Fed was done raising rates.
During the Federal Reserve’s meeting in October, The Federal Open Market Committee decided to hold the target range for the federal funds rate at 5 ¼ to 5 ½ percent. Further, the committee signaled to markets that rate cuts could be introduced in 2024. This decision and subsequent statement sparked a broad price rally in both US equities and US bonds. Investors began buying stocks of high-quality dividend paying companies and speculated in lower quality companies, even those with loads of debt on their balance sheets. Bonds of all types and quality and duration also rose as future expectations for lower interest rate levels became the commonly expected outcome for 2024.
The US economy remains healthy, including resilient consumer spending and low unemployment. Many companies appear to be posting stronger results and inflation appears to be under control. Investors have good reason to believe that more profits are on the horizon.
And…as often happens…it is possible that the fourth quarter quickly and violently priced in much of that (yet to be realized) uncommon economic outcome known as a “soft landing.”
A year ago, most prognostications and predictions were for a tough 2023 in the securities markets, and with good reason. Markets tend to perform badly when money supply tightens, and interest rates rise. As we enter 2024, most predictions are for a much better and safer year for investments. But I cannot help but wonder how much of the future good news was priced into the Q4 rally. And a few questions linger….
Will the Fed actually cut rates if the economy continues to show strength, or will rate cuts only come if the economy slows? And what be the reaction of investors if either rate cuts do not occur, or if rate cuts occur in a spate of layoffs, corporate downgrades and a consumer spending slump?
The Magic Lamp and Three Rate Cut (wishes)
One Thousand and One Nights is a collection of Middle Eastern stories and tales. The works were collected over many centuries and by various authors and translators. The English translation appeared in 1706 and was named “Arabian Nights.” Among the most popular of the stories was Aladdin and the Enchanted Lamp, although it was not part of the original collection, but was added by Antoine Galland along with other tales like Ali Baba and the Forty Thieves and Sinbad the Sailor.
As with many works that are compiled, translated and recounted over hundreds of years, there are many versions of the Aladdin story. In the 4th quarter of 2023, the securities markets acted out a version of the story of the magic lamp. I guess technically, investors have acted out the first part of the story, having found a magic lamp, they imagined all the wealth that might come to them if and when they wish for, and receive, interest rate cuts compelling Jerome Powell, the all-powerful genie to cut rate three times or more thus providing riches and happiness to all.
But what would happen if Aladdin were to lose the lamp before making his three wishes?
Comments on the Securities Markets
For the first nine months of 2023, the market performance was lackluster and narrow, with most stock, bond and real estate prices falling or moving sideways. The indexes appeared far better than the realities of the average stock as two primary topics garnered much of the attention of investors – interest rates and artificial intelligence. The “Magnificent Seven” stocks (Apple, Alphabet, Microsoft, Amazon, Meta, Tesla and Nvidia) which are broadly viewed as using or developing some of the most exciting and new AI capabilities, finished 2023 with an average gain of 111%. These seven “magnificent” stocks represent 29% of the S&P 500 and made up the majority of the index gains for the year.
The Intersection of Wall & Main (Streets)
It is always interesting, and worthy of considering, how Wall Street (professional investment companies and investment product creators) and Main Street (the citizenry; consumers and investment purchasers) receive information differently, act and behave differently and assimilate or adapt in distinctly different time horizons.
As we enter 2024, the prevailing opinion on Wall Street is for three rate cuts in 2024, the continuation of a strong jobs market and a “soft landing” for the economy. Wall Street has already declared AI to be a huge success, adding more than $7 trillion in market value to stocks with AI aspirations in 2022-23.
Main Street is still feeling the miserable effects of personal inflation rates, which for many, are higher than the stated consumer price index (CPI) - the official inflation rate in the U.S. Only recently has data begun to suggest that Main Street believes inflation is subsiding. But if wage increases cannot keep up with actual personal inflation, or worse, if layoffs occur, people will suffer a real loss of purchasing power. Meanwhile, artificial Intelligence has been received with equal parts anticipation and dread, with some beginning to use AI for things as varied as research to poetry. Others worry about future implications for humanity.
Wall Street has a history of rewarding new technological developments (with immediate stock advances) even before society benefits from them. In the late 1990’s the development of the internet for broad use became a lottery sweepstakes for any company that could add “dot com” to their name. Many were charlatans and their stocks later came crashing back to earth, but those with true technological advancement and useful products went on to further gains. As with so many important developments, the internet changed how we access the world and has become an integral part of lives. On Wall Street the immediate stock price rewards were fast and enormous. However, adoption and integration of the new technology took time, and many stocks suffered large setbacks in prices, before stabilizing again and then rising as the technology advanced. The data and analytics company Gartner, Inc. calls this the “hype cycle.” Consisting of five key phases of a technology. First, there is an “innovation trigger” followed by the “peak of inflated expectations” the “trough of disillusionment” the “slope of enlightenment” and the “plateau of productivity.” In 2022-2023 artificial intelligence journeyed through of phase one and toward phase two, the “peak of inflated expectations.”
Other recent technological development hype cycles included crypto assets, automated driving and blockchain to name a few. In the health care sector weight loss drugs are near the peak of inflated expectations. A hype cycle is not propaganda, nor is it meant to be negative. These are real and exciting new developments. But these important breakthroughs are often met with hysteria once they reach “collective consciousness” before falling back as the cycle unfolds.
My main point is that Wall Street has a history of moving too far, too fast during initial stages of technological advances. Volatility in both directions remains extreme during these initial phases. Investors tend to only fret over downside volatility. With nearly one-third of the entire value of the S&P 500 index tied to AI and other hype cycle advances, there exists a real possibility of higher-than-normal volatility, and the possibility that the 2024 market gains will now be more reliant on mature companies in less exciting market sectors related to consumer spending, telecommunications, health care and industrial activity.
And back to our main question….if the economy remains strong, how will we get three rate cuts?
There is no guarantee the Fed will reduce rates if the economy remains strong. And, if the economy does indeed slow down, then layoffs are likely, and some portion of US consumers may experience financial insecurity. Will investors who are betting on rate cuts really be bullish about adding more money into stocks? Possibly, but we should be cautious.
The S&P 500 index is trading near all-time high price-earnings multiples. Previous elevated levels were associated with the “Roaring 20’s” and the “dot-com” hype cycle. Price multiples do not necessarily suggest market tops. In fact, on several occasions “expensive” market prices have powered higher for longer than predicted. However, they do provide information about future returns over the long term. Stock returns are greater over a long period of time when the initial purchase occurs at a time when multiples are lower. Higher price multiples tend to reflect strong tailwinds, and the market’s view on lower rates and strong economic activity certainly would justify a higher multiple on stocks.
Bonds should experience decent total returns and lower volatility in 2024. The past few years have seen bond price volatility and price declines. Both 2021 and 2022 resulted in losses for bond holdings. The fourth quarter of 2023 finally generated positive results for bond holders. With the Fed most likely looking to avoid political headlines in a Presidential election year unless forced to reduce rates, bonds could experience a sideways price trend and generate yields of 4-6%.
In 2023 most market prognosticators foresaw a tough year for the securities markets, and they were right until they were suddenly wrong. Entering 2024, most of the same people are looking for a good year for bonds and stocks. And while they could turn out to be right, attempting to predict a single-year outcome is a fool’s game. And not necessarily helpful to investors anyway.
Unemployment is low and economic activity remains robust. Inflation is abating and consumers are adjusting to new price levels. In Q4 markets reacted strongly to expectations of lower future interest rates, and throughout 2023 AI-driven technology exploded higher. Stocks are somewhat expensive using historic comparisons and bonds offer a fair yield.
Important Inputs and Questions:
Gains in our portfolios in Q4 were strong and welcomed by all of us. And we still need to allocate our capital less on hope (rate cuts) and more on hard facts and data. If Wall Street has priced in three rate cuts, and the economy is currently still constructive, then our portfolios are still properly positioned. A slight tilt toward conservatism with equity allocations slightly below or in line with long-term asset allocation compositions as determined by financial modeling.
As always, these comments are not meant to encourage market timing, which is a waste of time and costly to long-term performance. Instead, it is a commentary on the state of mind of Wall Street and highlighting some of the most important developments that are on the minds of investors.
Comments on Wealth Management
Wealth is having an abundance of valuable resources, including assets. Money is not a goal, it is a resource. Successful wealth management is a lifelong endeavor of accumulation, use and transfer. Investing (resources) should always occur in the context of the lives of owners and heirs.
Security selection is the last step in a long series of decisions, inputs, discussions and goals. Sound financial advice is about prudence, sound decision-making, identification of biases or emotional triggers, designing of goals and the creation of a framework to achieve both quantitative and qualitative objectives. It is not about avoiding market losses but reducing and avoiding cognitive mistakes. The last two years roller coaster in markets again prove that the long-term application of a well-defined strategy will win out over trying to time the markets or avoid losses in a single year.
All the best to you in 2024. We look forward to working together this year.
*The foregoing content reflects the opinions of Van Hulzen Asset Management DBA "Van Hulzen Financial Advisors" and is subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or construed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. Past performance may not be indicative of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. Securities investing involves risk, including the potential for loss of principal. There is no assurance that any investment plan or strategy will be successful.