2023 has turned out to be a much better year than anyone had the right to expect at the start of the year. Through the close last night, the Dow Industrials were up 14%, the S&P 500 was up 25%, and the NASDAQ Composite rose 44%. While the equal weighted S&P lagged the leading averages, which were heavily influenced by the performance of the Magnificent Seven, it still rose 12%, not bad for a year that was expected to be in recession by now. It would seem that it would be an “all smiles” year for equity investors. But here is one sobering fact. Through yesterday, 330 of the S&P 500 components are up for the year while 170 are down, a ratio of roughly 2:1. Clearly, performance depended much more on which stocks you owned than on the performance of the leading averages themselves. I doubt there are many portfolios, for instance, that will match the NASDAQ Composite for the year.
While stocks were doing well, it was a different story in the bond market. Short term rates rose sharply in tandem with Federal Reserve actions to raise the Federal Funds rate. Longer rates gyrated more than usual as investor moods swung from fears of skyrocketing inflation and recession to a tamer expectation of a soft landing and muted inflation. The 10-year Treasury yield will end the year about where it started. Credit spreads narrowed significantly from the start of the year, a sign that investors are more sanguine about the likelihood of a soft landing without igniting significant credit risk.
I noted Monday that 2023 started amid much pessimism. It appears 2024 will start with strong optimism. With fourth quarter earnings still to be reported, it appears likely that 2023 earnings will approximate 2022 results. With interest rates also flat year-over-year at the long end of the yield curve, it would stand to reason that 2023 should have been a relatively flat year for stocks. Flat yields should lead to flat P/Es. Combine that with a flat earnings picture and it’s hard to rationalize a market rising 14-44% depending on which average you are looking at. Obviously, the disparity is answered by the change in mood swings. Not to be totally repetitive, the mood was dour last January and while not euphoric quite yet, it is certainly decidedly optimistic. Consensus forecasts have earnings rising by 8% in 2024 well above nominal GDP forecasts. Thus, margin expansion is built into those numbers. Estimates for 10-year Treasury yields are also favorable with mean consensus suggesting rates fall below 3.5% before bottoming. Some forecast rates once again falling below 2%, particularly if the Federal Reserve cuts the Fed Funds rate by 1 ½ percentage points by the end of 2024.
As I noted Monday, that’s a lot of optimism to live up to. Nominal GDP growth is almost certain to decline in the early part of 2024 as growth slows along with inflation. By definition, low inflation suggests companies will lose pricing power. It’s hard not to see some squeeze on margins. As for the 10-year Treasury yield, I throw up my hands. Slower inflation helps. Treasury’s massive and rising borrowing needs hurt. No politician wants to rein in spending in an election year. The only guarantee I will make is that the Federal government will spend more in 2024 than it spends in 2023. And I am sure I will make the same statement a year from now.
But let’s not get too pessimistic. There are distinct positives. Number one is population. Fewer Covid deaths and a lot more immigrants, both legal and illegal. These immigrants aren’t stealing anyone’s job. There are plenty of job opportunities out there. Second, is artificial intelligence. No one knows exactly what its impact will be, but it will be large, and leaders want to be out at the forefront. So, expect massive spending for computing capacity, semiconductors, and adequate electrical grid capacity. Add in accelerated spending from the 2021 Infrastructure bill, and you have considerable tailwinds.
With that said, let me offer 5 contrarian thoughts for 2024.
1. Americans will take more drugs to lose weight. But it won’t impact the sales of snack foods or all the “unhealthy” foods Americans eat. Maybe 1% of us will seriously use them to lose weight. And if we do, it will be a collective blessing. But we aren’t all going to get diet religion overnight. Remember Beyond Meat and Impossible Meat burgers?
2. Every business student needs to understand cost accounting. Furthermore, they need to understand the short-term leverage of a revenue upside or downside surprise. Businesses react to these surprises after they happen, not before. Lower inflation and slower growth are likely to lead to more revenue misses than usual, especially early in 2024.
3. China is an economic mess, and it isn’t going to be fixed in 2024. In fact, because the state wants to take over and control (hey, does that make Xi a progressive Democrat?), the situation is likely to get worse before it gets better. A key question is how does the population respond to a deteriorating economy? Some will simply leave. Some will protest. It isn’t quite the Cultural Revolution but Xi needs to right the ship. No reason to be optimistic.
4. AI is as powerful today as was the introduction of the PC or the advent of the Internet. The winners and losers are still to be determined. If I look out a decade or more, some of the real winners haven’t been born yet. Only a few of the current Magnificent Seven will live up to their hype over the next decade. But given the enormous expense needed to sustain or attain leadership, there will be significant barriers to entry for those parts of the AI ecosphere that are capital intensive.
5. EVs will evolve as will entertainment streaming. The question isn’t whether Tesla will survive as a leader but whether GM or Ford will survive at all if they can’t ignite consumer EV imagination. Similarly, Netflix will survive, but who else does is open to debate. Take a deep breath. Content is always king. You and I want to turn on TV and watch something original every night. Just a few years ago it might have been a new episode of your favorite sitcom or whodunnit. Today, those choices are still apt but so are short form YouTube or TikTok videos. A year from now, the number of serious streaming services will be significantly less than what they are today. The merger that created Penn Central reminded us that merging two weak companies never works.
So, I will end there. A better second half in 2024 is likely to follow a back and forth first half. Let us wish you all a Happy and Prosperous New Year. 2024 may not match 2023, but long-term investors should be happier a year from now than they are today.
Today, actor Jude Law is 51. Jon Voight is 85. Doesn’t he have an even more famous daughter?
James M. Meyer, CFA 610-260-2220