Q4 2023 Commentary
Happy New Year!
It seems most investors are entering 2024 in good spirits, following a year of exceptional stock market returns. The S&P 500 gained more than 20%. The Nasdaq gained more than 40%. The Dow set a new record high.
If the massive market decline in 2022 was all about inflationary pressures and rising rates, then there was good reason for stocks to spend 2023 reversing some of those losses.
At the end of 2022, CPI inflation data showed core prices (ex-food and energy) rising 6% year-over-year, just off of a generational high. Since then, we have seen a steady trend of disinflation, with the latest CPI report showing core prices rising by less than 4% year-over-year. Most encouragingly, the last six months have seen prices rise at a 2.9% annualized rate, closing in on the Fed’s 2% target.
Though the inflation picture has improved since last year, the interest rate picture has not (yet). 2023 began with a Fed Funds rate floor of 4%, and ended with a policy rate of 5.25%. Despite some volatility throughout the year, the yield on the ten-year treasury bill ended 2023 almost exactly where it began.
In general, we feel good about the economic landscape. The domestic economy overcame the worst inflation scare in forty years, and managed to do so without a recession. There was a broad belief among the economic/finance community that aggressive monetary tightening was certain to restrict economic growth and damage the labor market. The most common debate was whether the fallout from rising rates would be mild or severe. Instead, the economy remained resilient, led by strong employment numbers.
There is certainly enough data out there to paint a more dour picture (manufacturing data, employment revisions), but the U.S. economy ended 2023 with solid real GDP growth and a prime-age employment:population ratio in line with pre-pandemic levels – far from the fears touted via financial media.
Our economic optimism is not accompanied by market optimism, however, as 2023 ended with stocks touching an unwelcome milestone. The S&P 500 is beginning 2024 priced at an expensive 24 times peak earnings. Prior to 2016, a multiple above 20 had never been sustainable – always followed by lower prices and lower multiples.
The evidence since 2016 suggests that we may be living in a new era of elevated multiples, though it is truly too early to declare victory (1997s high multiple prices were not wiped out until 2009). If we have been in an era of high valuations, it is largely in part because we have been in an era of low interest rates and an accommodative Federal Reserve (an era that also included some of the most corporation-friendly tax cuts in history). Of the dates that have recently shown high valuations to seem sustainable, all occurred with ten-year yields below 2.5%.
Even for this new high-multiple period, 24 times earnings is a rather steep premium. Valuations this high were only sustainable starting from a very brief window in late 2020. Late 2020 was a time of unprecedented massive global monetary and fiscal stimulus, with ten-year yields below 1%. Capital was cheap, and stocks faced little competition from other asset classes.
Those days are now behind us. The ten-year yield today is four times higher. The Fed is still concerned with inflation. There are no more stimulus checks coming and no more massive corporate tax cuts. This normalization of rates and policy makes it hard to justify abnormally high multiples. Even if we set aside policy effects altogether, multiples above 20 have never been sustainable with interest rates above 2.5%.
Yet, for some reason, we hear very little from the financial media about the return of high multiples.
Perhaps the media optimism could be explained by just how resilient markets have been over the last five years. Despite an ugly 2022, three of the last five years have seen the S&P gain more than 20%. There has been a real cost to investors doubting the ability of markets to climb higher. But this recent strength is less a validation of high multiples and more of a warning sign about the future.
We have seen such clustering of 20+% returns only a few times in history. Each saw no more than one 20+% year in the following five years, with the following five years on average generating negative S&P 500 returns. The best-performing comparable period posted average annual returns of 7% (below the index’s historical average).
Whether we are looking at valuations or price returns, history tells us that equity investors should raise their risk expectations and lower their return expectations going forward.
That is not to say that this type of environment necessitates avoidance of equities altogether. The high-valuation world of the last several years has brought a fair amount of volatility, providing us opportunities to accumulate stocks at relatively discounted prices. We expect markets to continue to provide such opportunities, even if multiples remain high.
It is also notable that not all segments of the market are extremely expensive. High multiples in the largest stocks are skewing the valuation of market-cap weighted indices, but small and mid-cap stocks, in general, remain attractively valued. Unfortunately, however, it is unlikely that valuations in the most widely held names come down without broader impacts.
Valuations do not imply that weakness is imminent. Markets have strong momentum entering 2024. Corporate profits are expected to set new record highs this year. The Fed is expected to cut interest rates as soon as March. There is plenty to feel good about, and good feelings can keep prices rising.
Though weakness may not be imminent, the risk/reward prospects in this market environment continue to encourage us to default to a conservative positioning. After aggressively buying stocks in second half of 2023, the strong year-end rally allowed us to capture gains and decrease our equity exposure once again. Most actively managed accounts ended the year more than 50% allocated to cash and cash equivalents (primarily in money market funds yielding ~5%). We believe that this renewed flexibility will likely be rewarded in 2024.
Wishing you a happy and prosperous New Year,
Robert B. Drach
Drach Advisors LLC