When 2023 started, investors braced themselves for what many believed to be a year of pain for equity markets.

 

But a funny thing happened. The expected pain became gain.

 

We look back at the five key catalysts that turned the U.S. investment environment on its head, leading us to be cautiously constructive in 2024.

 

The mantra was “recession, recession, recession” when 2023 began. Following a difficult year in 2022 when the S&P 500 declined 18 %, many economists forecast the U.S. economy would succumb to recession in 2023 due to the Fed’s very aggressive rate hike cycle, and market strategists thought this could prolong the pain for stocks. A recession has yet to pan out, large technology stocks took off, and the S&P 500 ended up posting strong 24.2 % gains for the year (26.3 % including dividends)—well above the 10.3 % average annual price return since 1980.

 

But we think there’s more to the 2023 story than recession avoidance.

 

The “Big 7” AI-themed stocks dominated, but performance broadened out in Q4 The group of stocks commonly referred to as the “Magnificent 7” or “Big 7” trounced the rest of the U.S. equity market in 2023, rising 105 % on average. This group includes Apple, Microsoft, Alphabet, Amazon.com, NVIDIA, Tesla, and Meta Platforms. These are very different companies, but they all have benefited from artificial intelligence (AI) trends (and hype), a transformative technology they incorporate into their business models in one way or another.

 

 

During the first nine months of the year, the Big 7 stocks accounted for about 75 % of the S&P 500’s gains. They represent 26 % of S&P 500 market capitalization, so whether they trade up or down is a major factor in shaping this large-cap index’s performance. The Big 7’s outsized gains are also a key reason why the Nasdaq Composite rallied 43.4 % in 2023 (44.6 % including dividends), as these stocks trade on the Nasdaq exchange.

 

The good news is that market performance began to broaden out beyond the Big 7 in Q4. In addition to the Information

 

 

 

 

Technology sector, the Real Estate, Consumer Discretionary, Financials, and Industrials sectors outperformed the S&P 500 on a total-return basis from late October to year end.

 

The Fed’s Pivot

The Fed’s dramatic change in stance—pivoting from one of the most aggressive rate hike cycles in history to forecasting multiple rate cuts for 2024—boosted the equity market in Q4 and we think it was one of the key reasons that sector performance broadened out.

 

Not only did other large-cap sectors participate, but small-cap and mid-cap indexes also rallied strongly in late 2023.

 

The S&P Small-Cap 600 and S&P Mid-Cap 400 surged 23.9 % and 20.0 %, respectively, from late October to year end. Even dividend growth stocks, which had lagged badly for much of 2023, rose 14.1 % during the same period as measured by the S&P 500 Dividend Aristocrats Total Return Index.

 

Lower Inflation & Bond Yields + Stronger-Than-Expected GDP

This only served to strengthen the soft-landing argument.

 

Consumer inflation dropped from 7.5 % at the start of the year to 3.1 % in November. Treasury yields surged mid-year with the 10-year yield peaking at 4.99 % in October, but it quickly fell back to 3.88 % by year end—just slightly above where it started the year.

 

Economists’ consensus forecast for 2023 GDP growth rose from just 0.3 % in January 2023 to 2.40 % by year end.

 

These major changes, combined with the labor market’s resiliency, led market participants to become more optimistic that a soft landing is possible.

 

While Q4 earnings have yet to be reported, the consensus forecast is for growth to exceed the year-ago period handily, and if it does, we think full-year 2023 earnings growth will rise at least 4.0 % year-over-year once the earnings surprises are factored in.

 

How could the market rally so strongly in 2023 amid tepid, below-average earnings growth?

 

Over short periods of time, the magnitude of market gains and earnings growth are not always tightly correlated. However over the long term, the relationship between the two is tighter.

 

Investors are beginning to look ahead in anticipation of stronger earnings gains in 2024, which is another reason the broader market rallied toward year end. For this stronger earnings scenario to play out, the economy would need to deliver some decent growth with a healthy soft landing.

 

The U.S. Regional Banking Crisis Was Severe and Short

The collapse of Silicon Valley Bank and other troubled regional banks sparked a crisis in March, capturing the attention of investors worldwide. Instead the crisis came and went, and as the regional banking system stabilized, this group of stocks slowly stabilized and then improved.

 

As the Fed pivoted toward a dovish stance and soft-landing sentiment rose, the S&P 500 Regional Banks Index rallied 34.9 % from late October through year end, clawing back part of the year’s losses.

 

Stand Pat

Today’s charts clearly illustrate that 2023 was largely a reversal of poor 2022 performance. Equity returns in 2024 will mainly depend on whether the U.S. economy succumbs to recession or achieves a much-coveted soft landing.

 

The year-end rally seems to be indicating the latter scenario, but there are risks that the lagged effect of the Fed’s aggressive rate hike campaign could at the very least dampen U.S. consumer spending and GDP growth in the quarters ahead.

 

Maintain Market Weight

Positioning in equities overall toward higher quality segments of the market - companies with resilient balance sheets, sustainable dividends, and reliable cash flow generation would be prudent.

 

 

If you have any questions or comments, please feel free to let me know.