Q4 2023 Market Review
ECONOMIC COMMENTARY
World equity markets continued their downward trajectory at the beginning of the fourth quarter, briefly entering bear market territory (defined by a decline exceeding 10% from the prior peak) but turned around sharply at the end of October when market participants became convinced that the Federal Reserve had not only succeeded in thwarting the inflation threat but had done so without provoking a recession. To be specific, the MSCI All Country World Index[1], the S&P 500 Index, and the S&P/TSX Composite gained 9.38%, 11.55%, and 8.10%, respectively, during the quarter. For the year, the same indices were up 21.61%, 25.67%, and 11.75%, respectively. US Corporate earnings expectations did not improve materially, but market confidence in an imminent pivot in the Federal Reserve policy fueled an increase in the earnings multiple from 20x to 23x between late October and end of December. In contrast to the recent past when equity markets gyrations were dictated by a small subset of large capitalization stocks, the fourth quarter rally was quite broad. For a change, small capitalization stocks also participated in the rally. The only major market left behind was once again China, where aftershocks on an on-going residential property crash were being felt across all sectors.
Fixed income markets came out of their multi-year doldrum at the same time as equities. Specifically, the ICE Bank of America Global Government Bond Index and the ICE Bank of America Global Corporate & High Yield Index returned 5.23% and 7.03%, respectively. In Canada, the ICE Bank of America Canada Broad Market Index rallied 8.23%. For most fixed income market segments, it was the best quarter since the second quarter of 2009. For 2023, the above indices returned 3.92%, 8.83%, and 6.38%, respectively. Thus, fixed income investors escaped the prospect of a third down year in a row for the first time. As interest rates declined more further out on the curve (more than 0.90% lower for Canadian government bonds and more than 1.00% for US treasuries with 10 years to expiry), longer duration bonds outperformed equities. For instance, the ICE Bank of America 10+ Year Canada Broad Market Index returned 14.79% in the fourth quarter, its best quarter since inception in 1992. We have written extensively about the improving opportunity set in the fixed income market in the last few months, and we were thankfully in position to take advantage of this where we had the flexibility. This enabled the portfolios of many clients to continue on their benchmark outperformance streak in spite of being materially underexposed to long duration bonds until late October. That being said, since the yield to maturity on the above index went from 4.89% to 3.89% between late October and end of December, we have already reduced the exposure to this tactical theme.
THE MARKET IS NOT THE MARKET
A lot has been said and written about the Magnificent 7[2], a group of mega-cap corporations[3] which posted an average return of 111% in 2023[4], once again causing great consternation in the active equity managers community. Over the years, many investors have reached the conclusion that the active management of equities is a losing game. To this point, the three most popular US exchange traded funds (the SPDR S&P 500 Index Trust (ticker: SPY), the iShares Core S&P 500 ETF (ticker: IVV) and the Vanguard 500 Index ETF (ticker: VOO)), had combined assets of 1.3 trillion US$ as of December 2023. These three ETFs alone represent roughly 3% of the S&P 500’s value[5], and in 2023 alone, enjoyed net inflows of over 120 billion US$. This is just for 3 ETFs. In aggregate, a 2021 study[6] estimated that passive investment funds held about 16% per cent of the entire US stock market, a proportion that has almost certainly increased since. In fact, another research estimated that, should this trend continue, passive investment strategies in equities would overtake active investment strategies by 2026[7].
“Why bother with stock picking if I can’t beat the market. I’ll just take the market.” We have lost count of how many times we have heard that sentence in the past few years. But the question we ask is: “Is it possible that, while thinking that you own the market, in reality you do not?” To this point, the Magnificent 7 made up roughly 27% of the S&P 500 Index[8] and roughly 16% of the global stock market[9] at the end of the year. The stocks in the group contributed to roughly 70% of the S&P’s 25.67% appreciation in 2023[10]. In contrast, over 300 of the S&P 500 Index constituents represented less than 20% of the index and weighed 0.05% each on average[11]. As it turns out, owning the market effectively means holding a small group of large positions accompanied by a few hundred of insignificant ones. From a diversification standpoint, it is easy to demonstrate how an active manager owning as little as 30 positions in an equally weighted fashion may actually be less risky than the index.
While the market has not always been this concentrated at the top, the US equity market composition that prevailed 50 years ago (1973) resembles the one that we are witnessing today. That was a time when IBM, AT&T, Exxon, Eastman Kodak, and General Motors collectively represented 25% of the market. It was the Nifty Fifty heyday, a period during which several stocks were designated as ‘no brainer buys’ by respected Wall Street institutions such as Morgan Guarantee Trust and Kidder Peabody.
Since the market more than tripled between 1973 and 1992, it does not mean that because the market is highly concentrated at the top that a dramatic fall is imminent. It could mean, though, that active management may not be so bad going forward. Why? Because none of the industrial conglomerate behemoths of 50 years ago carry significant weight in the index today. As such, it means that the index is equipped with an auto-correcting function that progressively reduces the weight of failing companies and increases the weight of those that succeed. The bad news is that this process can take a while when the companies being recycled are exceptionally large. For instance, it is only in 2008 and 2012 that General Motors and Eastman Kodak respectively filed for bankruptcy protection, and AT&T’s approximate 5% weight did not get to its current approximate 0.30% weight overnight. Basically, what we are saying is that the decision to underweight sickly or dying large companies could yield outperformance benefits beyond a few quarters. Of course, we can argue that the industrial leaders of 1973 have little in common with today’s Tech leaders as today’s moats are nearly impenetrable. Perhaps, but in 1973, optimism towards the Nifty Fifty stocks was consensual. In fact, the average stock included in the Nifty Fifty group had an average Price-to-Earnings (“PE”) ratio exceeding 40x at the end of 1972 compared to the S&P 500’s PE of less than 20x. This is barely more than the PE premium that the average Magnificent 7 stock commands relative to the market today. Yet, that did not prevent the average Nifty Fifty stock to decline by 19% in 1973 and by 38% the following year[12] compared to the S&P 500 decline of 14% in 1973 and 26% in 1974 after the Organization of Arab Petroleum Exporting Countries imposed an embargo that strained a US economy that had become dependent on foreign oil.
Currently, the Magnificent 7 appear to be firing on all cylinders, just like the Nifty Fifty group through the middle of 1973. Ironically, every time an investor drops an active equity manager in favor of an index fund or ETF, more dollars get reallocated to the Magnificent 7 than dollars getting reallocated away from them because nearly all active managers remain underweighted Magnificent 7 stocks. As such, active to passive switches translate into dollars leaving the market’s average stock being redeploy incrementally into Magnificent 7 because, as we have highlighted above, the market is not what you think. A lot of passive investors do not care about the composition of exchange-traded funds they own. They view them as a fair representation of the market they are seeking exposure to. That is not always the case.
WISDOM OF THE CROWD OR WISDOM IN THE CROWD
Canada-born economist John Kenneth Galbraith[13] once reportedly said that “The only function of economic forecasting is to make astrology look respectable.” We do not know if Galbraith was more respected for his sense of humor or for his forecasting ability by his peers, but the recent history has sadly given credence to his pleasantry. To this point, in January 2023, most economists were predicting a recession in the United States. That recession has yet to materialize, largely because the models underestimated households’ ability to withstand an interest rate shock. It is not clear why. Additionally, at the same, when the media sought out Wall Street strategists and asked them at what level would the S&P 500 Index end in 2023, forecasts ranged between 3400[14] to 4750[15], with an average of just 4100. The S&P 500 ended 2023 at 4769, besting even the most optimistic forecast of the group. It appears that the strategists did not anticipate that the AI theme would overdeliver or that valuation multiples would remain above the historical average even though long-term interest rates were racing higher.
Yet, despite the science’s numerous shortcomings, we still consider it preferable to pay attention to consensus expectations than to expectations of a singled-out individual, whether he or she is an economist or an astrologer. The principal reason is that the consensus reveals what the average person thinks and why. Indirectly, it points to what will cause the average person to change his or her views and update his or her forecasts as new information comes in that invalidates the information that went into the initial forecast. In that sense, the views of the crowd may not have a lot of predictive value, but it is nevertheless informative. In contrast, we don’t think the forecasts of individuals provide any value, however famous such individuals might be. In fact, we suspect that listening to a portfolio manager or investment guru on television or reading him or her in the specialized press may be the greatest source of missed opportunities for investors. Why? Because both tend to predict imminent market crashes far more frequently than market crashes occur. As such, anyone who ingests their views probably spends an abnormal portion of his or her investment career in cash, which is certainly the biggest source of missed opportunities.
PORTFOLIO CALIBRATION FOR 2024
As mentioned above, 2023 was a humbling experience from a forecasting accuracy viewpoint. It should serve as another reminder to us all practitioners that deep down, we know less about the inner workings of the financial markets than we are willing to admit, no matter how detailed are the models we are using. Still, as we turn the page to face 2024, we cannot resist the temptation to make financial market forecasts. It is a biological need, deeply rooted in our reptilian brain. It commands us to try to make sense of the complex environment around us to better control it and feel safer.
With that in mind, let us oblige. We must confess that we do not have many strong convictions for 2024. What that means is that our views do not deviate much from consensus and from what is currently being priced in. Our base scenario is for equities to advance modestly, with a slight preference for non-US and small-cap stocks. Contrary to 2023, we expect the advance will be driven by earnings growth instead of multiple expansion. With respect to fixed income, we do expect Central Banks’ discount rates to come down by 0.75% to 1.25% in North America from their current levels. At the time of writing this, this is relatively consensual too. We are aware that some market participants are calling for a reduction of more than 2% in the US discount rate, but we believe that outside of a sharp recessionary scenario, the Federal Reserve will want to maintain a meaningful buffer in case it needs to ease. The Federal didn’t have that in 2018 and it affected its ability to stimulate the economy when the pandemic hit because rates were already low at the onset. As such, we think that sub-3.5% short-term rates by the end of 2024 are unlikely. Regarding long-term rates, the normalization trend that started in the second quarter of 2023, when the yield on 10-year government bonds was nearly 2% lower than the 3-month Treasury Bill rate (and only 0.70% lower by mid-October) has nearly completed reversed course by the end of the year. As such, we feel that long-term fixed income instruments won’t benefit much from the anticipated decline in short-term rates. In retrospect, it looks like the window to take advantage of lower long-term yields only lasted 6 to 8 weeks. It is now too late.
When it comes to reflecting about what could cause forecasts to deviate meaningfully from the base scenarios outlined above, we find ourselves more concerned about the downside risks resulting from an expansion of the Middle East conflict than a deterioration of the conflict in Eastern Europe or the escalation of tension between the US and China resulting from the election of the centre-left Taiwanese nationalist party on January 13th. The risk of a contested 2024 US Presidential election is also a concern, but repercussions of such would play out in 2025, if not later. We are also concerned about a pick-up in corporate defaults, particularly in the real estate sector. A lot of stress already seems priced in. Still, we are concerned that consensus may not be pessimistic enough.
In summary, without strong conviction in either direction for any of the major asset classes but with a view that real-world data is more likely to surprise consensus on the downside rather than the upside, our message is to stay diversified with a defensive tilt to retain the flexibility to acquire risky assets at discounted prices, should a reset of expectations take place.
[1] Local currency returns unless specified otherwise
[2] First coined by Michael Hartnett, Equity Strategist at Bank of America
[3] Alphabet (f/k/a Google), Amazon, Apple, Meta (f/k/a Facebook), Microsoft, Nvidia, & Tesla.
[4] Source: Bloomberg, Patrimonica
[5] Source: Idem
[6] Source: Morningstar, Investment Company Institute
[7] Source: Bloomberg Intelligence
[8] Source: Standard & Poor’s
[9] Source: MSCI
[10] Source: Idem
[11] Source: Standard & Poor’s, Patrimonica
[12] Fesenmaier, J, Smith, G (2002). « The Nifty Fifty Re-Revisited.” Journal of Investing 11, 3, 86-90.
[13] (1908 – 2006), author of more than 30 books including the Affluent Society.
[14] Forecast by Greg Boutle from BNP Paribas as compiled by StreetInsider on December 27th 2022.
[15] Forecast by Tom Lee from FundStrat as compiled by StreetInsider on December 27th 2022.