Fourth Quarter 2023 Market Update

Investment Management

January 30, 2024

“At the end of the day, the macro may deteriorate, political winds will blow as they will, and the global opportunity set may shift.  However, we believe bottom-up opportunities will always exist, assuming one is willing to look.” – International Equity Manager

Fourth Quarter 2023 Market Update

Overall, the fourth quarter of 2023 was particularly strong for capital markets as prices moved higher across asset classes, market capitalizations, geographies, and styles.  The period began with relatively strong economic data released in October, fueling investing skepticism that the U.S. Federal Reserve (the “Fed”) would not be able to start easing monetary policy in the near future (and that interest rates would likely remain elevated).  This caused bond yields to march higher, as the U.S. 10-Year Treasury yield flirted with 5% in mid-October, its highest level in more than a decade.  The rise in yields pushed stocks lower and technically into a “correction” as they were down 10% from their peak in July.  However, investor sentiment shifted quickly and dramatically in November as updated economic data on inflation progress was made available, hopes for an economic “soft landing” were reignited, and constructive comments from Fed Chair Jerome Powell stoked optimism.  Not only did the Fed signal to the market that its rate hiking cycle was on pause (and likely over), but also that it expected to start cutting rates in 2024, marking the “policy pivot” that many had been waiting for.  On the heels of this news, stock and bond prices shot higher (i.e., bond yields plummeted) and assets across the board exhibited positive performance into year-end, in what only could be described as an “everything rally”.

Domestic equity markets, as measured by the S&P 500 Index, were positive for the period, returning +11.7% and capping off a strong year.  On a year-to-date (“YTD”) basis, the index finished up +26.3%.  Over the quarter, interest rate sensitive sectors including real estate (+18.8%) and financials (+14.0%) performed well, as did technology (+17.2%); while consumer staples (+5.5%) and health care (+6.4%) were positive but lagged.  Energy was the only sector that posted negative returns for the period (-6.9%).  On a YTD basis, technology (+57.8%), communication services (+55.8%) and consumer discretionary (+42.4%) led, all posting eye-popping returns of more than 40%.  These three sectors were the worst performing sectors in 2022, posting losses of -28.2%, -39.9%, and -37.0%, respectively, in what has been a stark trend reversal (and an important reminder of the need for portfolio diversification).  Although performance in domestic equity markets broadened somewhat in the fourth quarter, the S&P 500 Index remains historically concentrated.  As of year-end, the top 10 stocks in the index represented 32% of the index (based on market capitalization) and contributed 86% of the return for 2023. 

Mid- and small-cap domestic stocks outperformed during the quarter, however, still underperformed their large-cap peers over the course of the year (small cap stocks returned +14.0% in Q4 and +16.9% YTD as measured by the Russell 2000 index).  While much of this YTD underperformance is likely caused by their increased economic sensitivity versus their large-cap peers, their valuations today look attractive from a relative historical context, trading at a significant (~30%) discount to large caps on a forward price-to-earnings (“P/E”) multiple basis.  As we wrote about in prior letters, small caps experienced a prolonged period of underperformance versus large caps, a trend that was reversed this quarter.  Market participants are watching earnings closely to determine whether a durable period of small cap outperformance may be on the horizon.  International developed equity markets also posted double-digit gains over the quarter, returning +10.4% (+18.9% YTD), as measured by the MSCI EAFE Index in U.S. Dollar (“USD”) terms.  Like domestic markets, equities outside the U.S. also experienced a profoundly positive fourth quarter, helping to buoy returns for the year.  Emerging market equities returned +7.9% for the quarter and +10.3% for the year, as measured by MSCI EAFE Emerging Markets Index (in USD terms).  Stocks outside of the U.S. trade at a meaningful (approximately two standard deviation) discount to their domestic peers (using forward P/E ratios of the MSCI All Country World Ex-US and S&P 500 indices), while also having a significantly higher dividend yield (a premium of approximately 170 basis points or 1.7%).

Fixed income markets finished the quarter and the year in positive territory.  Given significant exposure to interest rates, and after an extremely difficult 2022, bonds remained challenged through most of 2023, heading into the fourth quarter.  However, as the Fed hinted at their potential policy pivot (i.e., interest rate cuts), bond prices jumped and traded up in tandem with stocks.  As measured by the Bloomberg U.S. Aggregate Bond Index, bond markets were up +6.8% for the period, propelling them into positive territory for the year (+5.5% YTD).  On a more granular level across the fixed income landscape, longer dated bonds (U.S. Treasuries and municipals) were some of the best performing assets, given their interest rate sensitivity.  For example, the U.S. Treasury 20+ Year Bond Index posted double digit returns over the quarter (+12.9%).  The performance in the fourth quarter lifted almost all fixed income indices and sub-sectors into positive territory for the year.  Convertible bonds (+13.9% YTD), U.S. high yield (+13.4% YTD) and leveraged loans (+13.2% YTD) were some of the best performing areas of the market, all finishing the year with double-digit total returns.  U.S. investment grade corporate bonds were not far behind with returns of +8.5% YTD.  Municipal bonds finished the year posting returns of +6.4%.  Although there were some oscillations, U.S. Treasury yields ended the year close to where they began, and overall credit spreads finished much tighter.

The Federal Reserve and the Year-End Rally

“On a macro level, the single most important driver of risk-sentiment across all asset classes remains interest rates.  It is our view that the Fed’s efforts to bring down inflation and manage employment will be proven successful in 2024 and will result in cuts to the Federal Funds rate that likely will accelerate toward year-end.” – Private Credit Manager

The Fed’s Open Market Committee left interest rates unchanged at both its October and November meetings.  In December, they continued that momentum by not only keeping rates unchanged, but also indicating through its meeting minutes and comments from Chairman Powell that up to three interest rate cuts may be possible in 2024, noting that inflationary pressures had eased.  What had been a positive, but not extraordinary year, for equities markets quickly turned course as markets screamed higher.  The rally that ensued was truly remarkable, with the S&P 500 soaring 16% off its October lows.  November and December gains marked 9% and 4%, respectively, and included nine straight weeks of market gains.  When all was said and done, equity indices finished the year with annual returns that jump off the page – S&P 500 index (+26.2%), NASDAQ index (+44.6%), MSCI EAFE index (+18.2%), etc. 

Equity assets were not the only beneficiaries of the Fed’s policy pivot and the incremental clarity that it provided on its future path.  Fixed income assets also exhibited a similarly noteworthy year-end rally.  The U.S. 10-year yield peaked in mid-October around 5% (even eclipsing 5% intra-day) before falling precipitously to below 4%, hitting lows of 3.8% before year-end, less than 45 days later.  In the month of December 2-, 5-, 10-, and 30-year US. Treasury yields were all lower by 40-50 basis points.

As economists start to publish their outlooks for the coming year, we acknowledge that things are still not crystal clear from an economic perspective.  While the “soft landing” outcome seems to be a higher probability than it was a year ago, the Fed (and most of the managers we listen closely to and respect) are not necessarily ready to call for an “all clear”.  After the year-end rally, some areas of the stock market are back within striking distance of their all-time highs (e.g., the NASDAQ Index finished the year only 6% below its peak).  Valuation multiples are again back to more normalized levels on a forward basis, however, on a current P/E basis are close to 22x earnings.  As things come into focus for 2024, we think that investors should likely temper expectations, particularly considering what has been priced in during the recent rally.  A research piece that we read recently put it well when they mentioned that what constitutes an “upside surprise” in 2024 is certainly a high bar from where we sit today, which could potentially limit percentage gains in the market to more modest levels.

Market Breadth and the Magnificent Seven

“Sometimes, growth expectations just get too high and/or valuations become extreme.  An important lesson from the Tech Bubble is that overpaying for future growth can be costly to future returns.  You can be right on the business and still be wrong on the investment.” – Domestic Equity Manager

Equity markets today remain historically top-heavy and concentrated.  We have written about this in prior letters, and undoubtedly much ink has been spilled about this topic, however, we think it’s worthy of some additional context and color.  Without question, the major driving force in markets this year was interest rates and the Fed’s path forward.  Perhaps a close second would be the tailwinds and market euphoria around artificial intelligence (“AI”).  Throughout the first three quarters of the year, equity markets were bifurcated between two distinct groups – those that investors felt would be beneficiaries of AI (“haves”), and those that would not (“have nots”) – with significant disparities between the two.  Some of this disparity can be seen in various performance metrics, including sectors, whereas technology stocks gained +57.8% over the course of 2023 as compared to out of favor or “have not” sectors such as utilities (-7.1%), energy (-1.3%), and consumer staples (+0.5%) which lagged significantly.  U.S. large cap growth stocks also handily outperformed U.S. large cap value stocks, by a margin of more than 30%, also largely supported by this AI theme.  Such outperformance between sectors and style is rare from a historical perspective.

The market’s performance during the first 10 months of the year was driven primarily by the mega-cap technology companies that are believed to be some of the largest and most direct beneficiaries of the gold rush in AI, most recently coined as the “Magnificent Seven”, which includes Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia, and Tesla.  The sheer gains during the year for these companies are staggering, including Nvidia (+238.9% YTD), Meta (+194.1% YTD), Tesla (+101.7% YTD), etc.  As of year-end, the market capitalization of these seven companies was almost $12 trillion.  Given their incredible performance, sheer size, and tailwinds over the last few years, these companies today have a dominating effect on driving stock market index performance (e.g., the S&P 500).  However, during the last two months of the year (i.e., after the Fed’s policy pivot), there was a slight broadening of market participation in the year-end rally, with more contribution from the other 493 stocks that make up the S&P 500 index, as noted by the outperformance of the equally-weighted index versus the more often used market-capitalization weighted version.  However, the percentage contribution from the index’s top ten stocks was still the second largest on record, and amazingly, 360 of the 500 companies in the index (72%) actually underperformed the index’s overall return for the year.

Final Thoughts

As the calendar turns to 2024, investors will likely recall 2023 as a year of robust returns across nearly all market segments, almost erasing the disappointment from the bear market of 2022.  Market sentiment seems to have materially shifted over the course of the year from that of fear and caution around an imminent recession, to a more hopeful and optimistic outlook – thanks largely to a year-end holiday gift from the Fed in the form of forecasted interest rate cuts.  Markets showed impressive resiliency over the course of the year and finished materially higher despite several headwinds and negative themes – rapidly rising interest rates, bank failures, a persistently inverted yield curve, and significant geopolitical risk – just to name a few.  While the consensus and outlook heading into 2024 seems to be more positive than the prior year, we acknowledge that there are certain risks that remain.  Market participants will be closely monitoring significant questions that should get answered over the course of the year including a soft vs. hard economic landing, the outcome and implications of an important election year, the Fed’s path forward, etc. 

Although questions remain, the current environment does provide reason for optimism.  Lower interest rates should be supportive of corporate profits and would likely stoke what has been a challenging and frozen environment for both M&A and IPO markets.  Markets seem to be placing an increased emphasis on fundamentals, efficient growth, and thoughtful capital deployment, all of which we believe are positive.  We continue to see attractive opportunities to put capital to work in several asset classes including high-quality fixed income, portions of the equity market where valuations still look attractive, and certain parts of the private markets.  We believe that positioning portfolios for a range of outcomes, namely through diversification and risk management, will suit investors well.

As always, we welcome the opportunity to discuss your portfolio in detail, appreciate the trust and confidence that you have placed in Prairie Capital, and look forward to connecting throughout the course of the year.

Important Disclosures

Past performance is not an indication of future results.  This publication does not constitute, and should not be construed to constitute, an offer to sell, or a solicitation of any offer to buy, any particular security, strategy, or investment product.  This publication does not consider your particular investment objectives, financial situation or needs, should not be construed as legal, tax, financial or other advice, and is not to be relied upon in making an investment or other decision.

Certain information contained herein has been obtained or derived from unaffiliated third-party sources and, while Prairie Capital Management Group, LLC (“Prairie Capital”) believes this information to be reliable, makes no representation or warranty, express or implied, as to the accuracy, timeliness, sequence, adequacy, or completeness of the information.  The information contained herein, and the opinions expressed herein, are those of Prairie Capital as of the date of writing, are subject to change due to market conditions and without notice and have not been approved or verified by the United States Securities and Exchange Commission (the “SEC”), the Financial Industry Regulatory Authority (“FINRA”), or by any state securities authority.  This publication is not intended for redistribution or public use without Prairie Capital’s express written consent.