Market Recap

2023 Market Performance Dominated by 'Elite Eight'

Stocks

The S&P 500 gained over 24% in 2023, erasing losses suffered during 2022’s bear market. For much of the year, relatively few stocks drove the strong returns. Through October 27th, 8 mega cap stocks (Apple, Meta, Google, Netflix, Tesla, etc.), known as the “Elite 8,” gained 50.3%, while the remaining 492 companies lost 3.6%. However, in November and December positive stock returns were broader based as the Elite 8 returned 16.4% while the remaining 492 gained 15.5%.

These early gains for the Elite 8 were not driven by strong current earnings, but instead by a rise in expected future earnings due to rapidly advancing AI technology. The rest of the market was weighed down by concerns that the Federal Reserve would tighten monetary policy sufficiently enough to induce a recession to bring inflation back down to 2% as well as a regional bank crisis that started with Silicon Valley Bank in March.

Despite the efforts of the Fed to slow growth, strong economic data persisted as high consumer spending and a tight labor market drove higher than average growth in the economy, coinciding with a slowdown in inflation. While Fed policy remained unchanged in December, comments by Chairman Powell and dot plots from Fed officials incorporated this reality, indicating that they will likely cut rates in 2024, removing a headwind that held back returns for most stocks since the beginning of 2022.

Bonds

Yields on several different maturities for Treasuries ended the year at the same level as where they started. But the ride throughout the year was anything but boring as 2023 was a very volatile year for bond prices. The US Aggregate bond index was up 5.53% but was down 3.44% as late as October 20th. An 8% turnaround in two months is very unusual. Low quality, high yield bonds were up double digits, far outperforming high-quality bonds for the year.

With moderating inflation, interest rates began to fall during the 4th quarter, as investors seemingly questioned whether the Federal Reserve would follow through with its guidance of “higher for longer.” This fall in interest rates accelerated later in the quarter after Chairman Powell signaled that it was unlikely they would raise rates further and Fed officials implied that they would cut rates in 2024, resulting in a choppy but positive return for bonds in 2023.

Election Year and Corporate Balance Sheets

The course of the last US Presidential election year (2020) ended in a way that no one could have expected at the beginning. In January of that year, we were becoming increasingly bullish as the economy was gaining traction after the slowdown from 2018 and 2019. However, we specifically remember writing about several main risks to 2020, which were mostly focused on earnings, geopolitics, and uncertainty around a US election. One thing that was not on the radar of potential risks was a global pandemic that would result in self-imposed economic calamity.

The way 2020 turned out was a good reminder that even if we believe we have a grasp on the risk landscape, no one really knows an uncertain future. This is why investors should focus on what makes successful investors successful, which is buying companies that are able to maintain solid balance sheets and cash flows, and strong management teams that have a history of making good decisions when it comes to increasing shareholder value.

Choosing solid companies to own is pivotal to investment success, however, what is less talked about but just as equally important is avoiding, or limiting, exposure to stocks that one should not own. These are the companies that must rely on debt to continue operations. We believe that we will continue to see reverberations of the most aggressive change in interest rate policy in history for several years to come.

Corporate Bankruptcies Highest in 13 Years in 2023

The above headlines from very reputable news outlets are eye-catching. On the surface, headlines like these appear to be majorly negative news for stock investors. However, a closer look reveals a more nuanced situation.

A recent report by S&P Global Market Intelligence shows that US corporate bankruptcy filings reached a 13 year high in 2023. While there is a major move up in sheer numbers, the 642 companies that filed for bankruptcy last year was not out of line with the figures from the past 13 years considering the two years leading into last year were very abnormally low. The number of bankruptcies from ’21 and ’22 were historically low due reduced borrowing costs and readily available access to funds. This has led to the emergence of "zombie" companies who boasted exciting ideas and growth opportunities but did not make enough money to cover the interest payments on accumulated debt. Until recently, these companies were able to operate and sustain themselves through readily available low-cost financing. However, as interest rates have dramatically increased, these companies now struggle to continue their pattern of refinancing, leading to increased risk and potential bankruptcy.

However, understanding this issue presents opportunities for educated investors. Many other companies have navigated the recent low interest rate environment wisely by borrowing long-term at near-zero interest rates, not out of necessity, but because it was simply a good decision to buy back shares of stock with inexpensive capital. As a result of taking advantage of low interest rates, corporate interest payments have hit a 45-year low (see graphic below).

We believe corporate bankruptcies will likely continue to rise into 2024 and beyond. Actively weeding out higher risk companies, investors have a greater chance of outperforming market- based indexes.

Portfolio Positioning

Stocks

Short-term: Since our last commentary in December, investor sentiment went from pessimistic to very optimistic by the end of 2023. As a contrarian indicator, very optimistic sentiment has historically been a symptom of overbought conditions. Although the short term is overbought, any pullback in stocks should be viewed as a buying opportunity given strong economic and company fundamentals.

Long-term: In absolute terms, US stocks appear expensive relative to history (but not as much as 2021). As compared to other parts of the world, US stocks are the most expensive region. While this is not an uncommon phenomenon, US stocks are not just marginally expensive, they are extremely expensive relative to the rest of the world. However, the US economy is much more resilient than other parts of the developed world, therefore, we will remain with a US tilt in global exposure for now.

As we have discussed in this commentary, companies that have heavily relied on debt to make interest payments will continue to see major challenges in the year(s) ahead as along as interest rates remain high. In a monetary environment where interest rates are low, investing in index funds can be a very good, tax efficient strategy. However, going forward, it is our opinion that putting in the work to separate the ‘wheat from the chaff’ will be significantly more important for future portfolio returns.

Bonds

Bonds performed very well last quarter as interest rates across many different maturities on the yield curve dropped substantially. Remember, when interest rates go down, bond prices go up because the bond issued with higher interest a few months ago is worth more than current bonds that are issued with lower interest.

Yields on bonds have dropped substantially because most bond investors are betting on the Federal Reserve to cut rates at least 3 times in 2024. However these investors, fueled by persistent optimism, faced disappointment yet again as Jerome Powell signaled no intention for a rate cut in March. While markets are pricing in multiple rate cuts, we are not as optimistic and believe the Fed will be steadfast in their mandate to meet inflation rate goals.

Economic and company fundamentals are overall good, so it is ok to take extra risk with bonds to achieve higher interest payments. If economic fundamentals start to turn, we would be quick to reduce lower quality bonds in favor of high quality.

Opinions expressed in this commentary may change as conditions warrant and are for informational purposes only. Information contained herein is not intended to be personal investment advice for any specific person for any particular purpose. We utilize information sources that we believe to be reliable but cannot guarantee the accuracy of those sources. Past performance is no guarantee of future performance; investing involves risk and may result in loss of capital. No graph, chart, formula or other device can, in and of itself, be used to determine which securities to buy or sell, or when to buy or sell such securities, or can assist persons in making those decisions. Consider seeking advice from a professional before implementing any investing strategy.

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