The longest equity winning streak of 2023 is over. Thank a combination of sober comments from Fed Chair Jerome Powell and a poorly received Treasury auction. Treasury bond yields rose by over 10 basis points and stocks went into retreat. Equities, at least for the moment, continue to be slaves to movements in the bond market.
Chairman Powell had every reason to warn that markets since last week’s Fed meeting acted with too much exuberance. As yields on longer maturities moved up to 5%, the pressure exerted on the economy allowed the Fed to pause increases in the Fed Funds rate. The last thing Powell wants is for bond prices to surge, offsetting the impact higher short rates are exerting on the economy. Thus, he properly warned that the war against inflation isn’t over and the possibility of future rate increases cannot be discounted.
But let’s not focus on daily gyrations in yields or one jawboning comment, albeit one from the most important Fed voice. The reality is that inflation is slowing and so is economic growth. Higher rates are having an impact even if the impact is delayed. Thus, while it is possible the October lows will be revisited, the odds of that, at least in my mind, are still less than 50-50.
As we approach Thanksgiving and earnings season ends, except for the retail sector which reports in November, the key question is how does one adjust to what lies ahead? Let me offer some thoughts.
1. Market valuations are full, and forward-looking earning expectations point to modest growth in a slow growth economy. While becoming more optimistic on the stock market, a post-bear market surge is unlikely. First, we haven’t had a bear market. Leading averages barely fell over 10% from peak to valley and have recovered half those losses in less than two weeks. More modest gains are likely.
2. If you are buying stocks, earnings growth is what it’s all about. But valuation also matters. The biggest growth companies are obvious. The market has labeled the leaders the “Magnificent Seven”. But for any stock, even those seven, there is a right time to buy and it isn’t at a moment of euphoria. Just this last quarter we saw quite varied responses when Microsoft# and Alphabet# reported. Companies can’t grow forever. There are always threats to growth whether it be from competition or government regulation. You need to measure these threats even in the best of times.
3. As we approach Thanksgiving and Christmas, tax selling season passes its crescendo. The losers of 2023 have been suffering, but the pain of tax loss selling will abate soon. Some of the biggest losers of 2023 will rebound next year. Some are in permanent decline. Separating the wheat from the chaff can be quite profitable.
4. The opposite is true as well. Investors don’t want to realize big gains late in the calendar year unless they have large offsetting losses. Rather, they will wait until the new year. Look at energy names. They were big winners in 2022 and losers in 2023 even though year-over-year crude oil prices this year are down just a bit over 5%. Many of the big winners in 2022 similarly were duds in 2023. Look at utilities, consumer staples and a host of healthcare names.
Economically, 2024 could start weak, but I would expect momentum to improve in the second half of the year. Most importantly, inflation should continue to decline next year. When will the Fed start to cut rates? I have no better idea than anyone else. But if I were a betting man, I would say it will be before the end of 2024. Thus, lower inflation should keep a floor on long-term rates, and a weaker economy will put downward pressure on short-term rates. If earnings can hold ground and start to improve later in 2024, the year should be one of improving optimism.
As investors, we constantly have to look forward. Where will money flow? Technology is certainly one area, particularly sectors that benefit from what appears to be a rapid adoption of artificial intelligence applications. Second is the likelihood that infrastructure spending will finally start to accelerate. The rapid adoption of GLP-1 drugs for diabetes and weight loss will have all drug companies scurrying to join the party. At the same time, the notion that the world is going to abandon potato chips for tofu is sheer fantasy. As investors, we have to separate hype from reality.
It seems our democratic systems are under constant attack, but innovation thrives better here than anywhere else in the world. That isn’t going to change. Innovation can be Nvidia# chips or Lululemon yoga wear. Find your long-term winners and innovation will always be a key ingredient.
2023 has been a tough year masked somewhat by the emergence of AI as a key investment theme. The impacts of higher interest rates and waning Covid-related activity were offset in countless ways. But as rates stabilize and start to work lower, the benefits from growing population, productivity improvement and innovation should lead us to bluer skies.
As for birthdays, I’ll start with my granddaughter, Olivia Rovner. Today she turns 1. Others of lesser importance include Miranda Lambert who turns 40, and Broadway lyricist Tim Rice, who gave us the words to Jesus Christ Superstar, Evita, and The Lion King, who celebrates 79.
James M. Meyer, CFA 610-260-2220