• Stocks ended the year on a nine-week winning streak, as the S&P 500 TR Index erased all the losses in 2022 reaching new all-time highs during the quarter.
• The year-end rally in stocks was one of the strongest ever and was based on the expectations of a Fed policy rate change and expectations of a “soft landing”, where inflation comes down without hurting economic growth.
• 2023 was the opposite of 2022 in many ways. Sectors that did the worst in 2022, did the best in 2023 and vice versa. All in all, many major markets ended 2023 near the same levels they started 2022.

Market Summary

2023 began with most people anticipating a recession. The Fed was fervently raising interest rates, businesses were cautious, and inflation remained high. Despite these concerns, 2023 was a good year for the economy and an even better year for the stock market. By the end of the year, inflation was clearly on the decline, and it appeared that the Fed had engineered a soft landing, perhaps for the first time in its history. U.S. large-cap stocks (as measured by the S&P 500 TR) rallied over 26% in 2023. The S&P 500 TR Index fully recovered from the declines experienced in 2022, reaching new all-time highs.

Stocks staged a major comeback at the end of the year, rising nine weeks in a row. The strong fourth-quarter rally helped broaden the rally from just a handful of large-cap tech stocks to other sectors and markets. For example, small-caps were up 21.9% in November and December, the fourth-best 20-month gain since 1979 (1). This helped move our technical indicators to the positive camp and set us up for another positive year.

The catalyst behind the reversal was the shift in Fed policy. The Fed raised interest rates 4.25% in 2022 and another 1% this year to the highest level in over 20 years. Raising interest rates led to not only tightening credit conditions but also a loosening of the labor market (a rise in unemployment, a drop in the number of job openings, and a fall in the quits rate), a decline of the manufacturing sector, slowing demand for services, and a fall in inflation.

The cumulative impact of the Fed’s actions resulted in the Fed achieving its objective to slow demand and reduce inflation toward its target of 2% without causing a recession. At their December meeting, officials signaled that no additional increases were expected, and they will likely lower rates in the coming year.

Sectors that did the best in the 2022 bear market lagged significantly in 2023, while those that did the worst in 2022 did the best in 2023. It was especially good for the mega-cap technology stocks and other large-cap growth companies. The emerging boom in artificial intelligence technologies and solid earnings growth contributed to their gain.

The Morningstar US Large Growth Index had its biggest gain since 1998 and outperformed the Morningstar US Large Value Index by 35 parentage points, the second-largest margin of the past decade, coming in just behind 2020′s returns (2) (see chart).

Bonds also managed a noteworthy comeback, avoiding an unprecedented third straight year of losses to finish positive on the year. Bloomberg’s broad bond market benchmark returned a solid 5.5% for the year after being negative year to date as late as October.

The past two years serve as a reminder that market returns are not always smooth and are difficult to predict. Markets were characterized by strong moves both down and up, which, although normal, were not easy to stomach. The graph below illustrates how a portfolio of US stocks and bonds rebounded in 2023 and emphasizes the importance of maintaining a long-term investment strategy (3).

The COVID pandemic and the subsequent recovery continued to distort the economic data, causing many traditional recession signals to fail (at least so far) this cycle. As a result, the most anticipated recession in history became the most delayed recession in history. There’s still room for the traditional leading economic indicators to be accurate going forward, which we continue to monitor closely. Perhaps they are delayed rather than broken.

One of the primary reasons for avoiding recession was consumers being more prepared than ever heading into the year. Households repaired their balance sheets for years following the Great Financial Crisis in 2008. In addition, many borrowers had already locked in low borrowing rates and were much less sensitive to higher interest rates. That dynamic limited the economic drag from the Fed’s hikes.

The economy was also supported by a range of fiscal stimulus from the Inflation Reduction Act and CHIPS Act to increased savings from government subsidies during COVID. So, while the economy would have been slow to respond regardless, the effective fiscal easing steps helped drive continued strength during the year.

For 2024, the economic resilience in the US and elsewhere is helping boost the outlook, but as investors learned last year, the only thing certain is that there will be plenty of uncertainties. 2024 debates are focused on whether the economy will continue to avoid recession, whether inflation will stay on its moderating path, and whether the Fed will cut rates as aggressively as investors expect. Investors are also likely to be closely following the upcoming presidential election in the US. But it’s worth noting that the political party that wins the White House is just one of many factors investors consider when pricing assets, and stocks have generally trended upward regardless of which party holds the presidency.

Below is a summary of the benchmark returns (4).

Portfolio Positioning

It’s difficult to remember another time when the economic outlook was so uncertain. Recession or expansion? Inflation or deflation? Higher interest rates or lower? Take your pick, and you will find a pundit arguing for each scenario as if it were a foregone conclusion. Your portfolio is not positioned for any one scenario. Instead, you hold diversified positions that consider several different potential outcomes.

Technical indicators continued to be positive, suggesting stocks could continue to produce solid gains in 2024. At the same time, investor sentiment was overly optimistic, so we wouldn’t be surprised to see a pullback in the first quarter. We will attempt to exploit any equity weakness by increasing equity positions.

Markets dramatically repriced bonds during the fourth quarter, moving the 10-year yield down 1% and pricing in around six rate cuts in 2024 and an additional three in 2025. This appears extreme and keeps us overweight shorter duration bonds. Long-term bonds could suffer if the economy remains resilient or inflation doesn’t return to the Fed’s 2% target.

Bonds continue to be important in a portfolio, especially in a recession. Bonds typically rise in price when there is economic weakness, and stocks typically outperform during economic strength. This dynamic helps to provide ballast during uncertain or “risk-off” market environments. Short-term bonds have been a better ballast the last three years and are another reason we prefer to stay in shorter-term bonds.

Performance Review

Equities

Equities increased significantly in the quarter, and our overweight equity exposure helped. We were generally underweight growth sectors like technology that outperformed. We were also underweight non-US, which helped relative performance. Our small-cap and mid-cap positions also helped.

Fixed Income

Our fixed-income positions were up in the quarter, but our short-term bonds and money markets funds exposure didn’t go up as much as longer-term bonds.

Alternatives

On balance, alternative positions contributed to performance during the quarter. Positions in the re-insurance markets helped, while small positions in gold also helped. Small positions in commodities hurt, however. Alternatives continued providing good sources of uncorrelated returns over extended time frames.

Not all portfolios are identical. We manage accounts that have additional complexities not discussed in this update. Some of the statements are forward-looking but do not guarantee future performance. Please reach out to your advisor with any questions.

Sources:

1. Ryan Detrick, as measured by the Russell 2000 Index
2. Morningstar Direct. As of 12/31/2023
3. Vanguard. Shows the cumulative performance from January through December each calendar year going back to 1928. Data for 2023 performance is through December 21, 2023. Stocks: S&P 90 Index from 1928 through March 3,1957; S&P 500 Index from March 4, 1957 through 1970; Wilshire 5000 from 1971 through April 22, 2005; MSCI US Broad Market Index through June 2, 2013; CRSP US Total Market Index thereafter. Bonds: IA SBBI U.S. Intermediate-Term Government Bond Index through 1972; Bloomberg U.S. Government/Credit Intermediate-Term Index from 1973 through 1975; Bloomberg U.S. Aggregate Bond Index thereafter. 60/40: Simulated portfolio with 60% allocated to stocks and 40% allocated to bonds.
4. Morningstar Direct, as of 12/31/2023
5. Alternatives benchmark includes 50% SG Trend Index and 50% Swiss Re Global Cat Bond TR Index.

Index Definitions:

The Barclays Aggregate Bond Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the US investment-grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities.
The Standard & Poor’s 500 Index is a capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. It cannot be invested into directly.
The Russell 2000 Index is an unmanaged index generally representative of the 2,000 smallest companies in the Russell Index, which represents approximately 10% of the total market capitalization of the Russell 3000 Index.
The MSCI Emerging Markets Index is a float-adjusted market capitalization index that consists of indices of approximately 800 stocks and is designed to measure equity market performance in 23 emerging economies: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Greece, Hungary, India, Indonesia, Korea, Malaysia, Mexico, , Peru, Philippines, Poland, Qatar, Russia, South Africa, Taiwan, Thailand, Turkey, and the United Arab Emirates.
The MSCI EAFE (Europe, Australasia, Far East) Index is a free float-adjusted market capitalization index of approximately 900 stocks and is designed to measure equity market performance in 21 developed market countries outside of North America.
The SG Trend Index is a subset of the SG CTA Index and follows traders of trend following methodologies. The SG CTA Index is equal weighted, calculates the daily rate of return for a pool of CTAs selected from the larger managers that are open to new investment.
Swiss Re Global Cat Bond Index tracks the aggregate performance of all catastrophe bonds issued offered under Rule 144A. The index captures bonds denominated in any currency, all rated and unrated cat bonds, outstanding perils, and triggers. The index is not exposed to currency risk from non-USD denominated cat bonds.
The Nasdaq Composite Index is a market capitalization-weighted index of more than 3,000 stocks listed on the Nasdaq stock exchange.

Morningstar Growth Index The index is designed to provide consistent representation of the growth segment of the US equity market, with no overlapping constituents across styles. Aligned with the Morningstar Style Box™, the index is underpinned by a 10-factor model that paints a holistic picture of style.

Value: The index is designed to provide consistent representation of the value segment of the US equity market, with no overlapping constituents across styles. Aligned with the Morningstar Style Box™, the index is underpinned by a 10-factor model that paints a holistic picture of style.