January 2024
Market Update

2023 Year in Review

By Jake Eggett

Markets staged an impressive turnaround in the fourth quarter, primarily due to an unexpected shift in the Federal Reserve's stance on interest rates.  This, coupled with robust economic activity and decreasing inflation, led to a significant surge in stock prices, propelling the S&P 500 to its highest levels in over two years and resulting in the best annual return since 2021.  Let's review the key events of the year.

The strong fourth quarter performance somewhat obscures the fact that stocks and bonds started the year under significant pressure. Heading into 2023, there was widespread concern that the economy would slide into a recession; however, it proved more resilient than anticipated. 

Enthusiasm soared for technology stocks following Nvidia's outstanding first-quarter earnings report, driven by the flourishing chip business for artificial intelligence development. However, some investors remained cautious about the market's rally, particularly because it heavily relied on a few key stocks known as the "Magnificent Seven." For much of the first half of the year, almost all the market gains were concentrated in the top 10 largest stocks, certainly not the sign of a healthy market.

In March, fears heightened after the collapses of Silicon Valley Bank, Signature Bank, and First Republic Bank due to substantial losses in government bond holdings. This raised concerns about a potential regional banking crisis and a credit crunch that could lead to an economic decline. The Federal Reserve swiftly intervened to alleviate pressure on regional banks holding troubled bond portfolios, restoring confidence in the stock market

By the end of July, the S&P 500 had rallied 20% to a mid-year high.  Shortly thereafter an unexpected setback occurred, the Federal Reserve signaled that the fight on inflation wasn’t over and that rates would stay “Higher for Longer.” This led to a sharp selloff in the bond market causing the yield on the U.S. Treasury 10-year note to reach a 17-year high near 5%.

Then on October 7th, Hamas soldiers infiltrated settlements in Israel, killing and kidnapping more than 1,200 Israelis in the worst attack on Israel in decades. The market fallout was immediate, as oil prices spiked on fears a broader regional war would ensue between Israel, Hamas, Lebanon and, potentially, Iran. Higher oil prices fueled a further increase in Treasury yields as investors priced in a possible oil-driven bounce back in inflation.  Between July 31 and Oct. 27, the S&P 500 fell just over 10%, entering formal correction territory.

Once again, sentiment shifted, this time as evidence suggested that inflation was decreasing, and job growth was moderating, and the Israeli-Hamas conflict hadn’t spread.  Expectations grew that the Federal Reserve had concluded its interest rate hikes in July and was poised to implement rate cuts. By the time the Fed signaled its shift towards rate cuts in 2024, stocks had already embarked on a 17% rally from the October lows, concluding 2023 at its peak for the year.  Those factors combined with generally favorable seasonality to fuel a welcomed “Santa Claus Rally.” 

In sum, 2023 was a year of surprises for the markets as the expectations for a recession never materialized, inflation fell faster than forecasts, corporate earnings proved resilient and the Fed surprised markets by pivoting to a more dovish future policy. The result was substantial gains for the major averages. 

Market Performance

Stocks enjoyed a broad and powerful rally in December as all major U.S. stock indices posted strong gains. Investor expectations for rate cuts in 2024 were a major influence on markets in December as the Russell 2000 and Nasdaq 100 outperformed, as companies in those two indices are expected to benefit most from a sustainable decline in interest rates. For the full year, however, the dual influences of 1) Artificial Intelligence (AI) enthusiasm and 2) Rate cut expectations drove performance as the tech-heavy Nasdaq 100 massively outperformed the other major stock indices, surging more than 50%. The S&P 500 also logged a substantial gain of over 20% thanks mostly to the large weighting of technology stocks in the index. The less-tech-stock-sensitive Dow Industrials and Russell 2000 also enjoyed strong returns in 2023, but relatively underperformed the Nasdaq and S&P 500.

Notably, the primary theme of 2023 was a reversal of fortune.  Investment styles and sectors that had been the most buoyant during the bear market of 2022 significantly lagged in 2023, while those that took the biggest beating in 2022, roared ahead with big gains in 2023.  That was especially the case with growth and value.  Growth outperformed Value by 35%, which is the second largest margin of the past decade.

Bonds wrapped up the year in positive territory, even though by the end of October, it appeared that they were headed for a third consequence year of declines.  The primary driving force for this unexpected positive turn in the Aggregate Bond Index was the shift in Fed policy.

Looking Ahead in 2024

What a difference a year makes.

At this time last year, the S&P 500 had just logged its worst annual performance since the financial crisis, the Fed was in the midst of the most aggressive rate hike campaign in decades, inflation was above 6% and concerns about an imminent recession were pervasive across Wall Street. 

Now, as we begin 2024, the market outlook couldn’t be much more positive. The Fed seems to be done with rate hikes and has indicated that cuts are on the way. Economic growth has proven more resilient than most could have expected, and fears of a recession are all but dead. Inflation dropped substantially in 2023 and is not far from the Fed’s target while corporate earnings growth is expected to resume in the coming year.

Undoubtedly, that’s a more positive environment for investors compared to the start of 2023, but just like overly pessimistic forecasts for 2023 proved incorrect, as we look ahead to 2024, we must guard against complacency because at current levels both stocks and bonds have priced in a lot of positives in the new year.  Some of those expectations could prove to be incorrect and if so, that could create some additional volatility.

Starting with Fed policy, Fed officials are forecasting three rate cuts in 2024 but investors are currently pricing in six rate cuts in 2024 with the first one occurring in March or May. That’s a very aggressive assumption and if it is incorrect, we should expect an increase in volatility in both stocks and bonds. 

Regarding economic growth, it’s foolish to assume just because the economy was resilient in 2023 that it will stay resilient. Obviously, that’s the hope, but hope isn’t a strategy. The longer rates stay high (and they are still high) the more of a drag they create on the economy. Meanwhile, all the remnants of pandemic-era stimulus are gone and there is some economic data that’s starting to point towards reduced consumer spending. Point being, it is premature to believe the economy is “in the clear” and a slowing of growth is something we will be on alert for as we start the new year, because that would also increase market volatility. 

Inflation, meanwhile, has declined sharply but it still remains solidly above the Fed’s 2% target. Many investors expect inflation to continue to decline while economic growth stays resilient, a concept traders coined “Immaculate Disinflation.” However, while that’s possible, it’s important to point out it’s extremely rare as declines in inflation are usually accompanied by an economic slowdown. 

Finally, corporate earnings have proven resilient, but companies are now facing margin compression as inflation declines and economic growth potentially slows. Earnings results and guidance in the fourth quarter were not as strong as earlier in 2023 and if earnings are weaker than expected, that will be another potential headwind on markets. 

Bottom line, while undoubtedly the outlook for markets is more positive this year than it was last year, we won’t allow that to breed a sense of complacency because as the past several years have shown, markets and the economy rarely behave according to Wall Street’s expectations. 

As such, while we are prepared for the positive outcome currently expected by investors, we are also focused on managing both risks and return potential because the past several years demonstrated that a well-planned, long-term focused and diversified financial plan can withstand virtually any market surprise and related bout of volatility, including multi-decade highs in inflation, historic Fed rate hikes, and geopolitical unrest.

Given the current market trends, our models have us fully invested on the stock side, focused on U.S. Large-Cap and Mid-Cap companies.  As for bonds, we are fully invested with an overweight to floating-rate bank loans that continue to yield 7-9%.  We also have exposure to high-yield corporates and asset-backed securities which are also sporting attractive yields.  We will remain nimble and rely on our models to help mitigate risk of any potential change in trends.

As always, if you are concerned about your risk level, please reach out to us, and schedule a time to review your allocation and financial plan.

Upcoming Events:

Q1 2024 Economic and Market Update – Thursday, February 15th at Noon MDT

Copperwynd Financial is hosting a virtual discussion for our clients to provide insight into the current economic environment and investment trends. The discussion should last 30 minutes with time remaining for additional questions and answers. Please register at the link provided below.

https://us02web.zoom.us/webinar/register/WN_12dwEuPeQx6S1rvbdCaMDA

If you have any questions, please do not hesitate to contact our office at 480-348-2100.

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