US Stocks closed the year with their best quarter since 2020, up 11.7%. Although the largest stocks led the market for most of 2023, the late November/December rally was broad and inclusive of asset classes that previously struggled to keep pace.

The S&P 500’s gain in 2023 marked the fourth positive year of the past five, and was a sharp turnaround from 2022’s negative result. The index produced an above average 26.3% return, a stark contrast to the prior year’s 18.1% decline. Combined, the S&P 500 average annualized return over the last two years was 1.7%.

Looking out further, over the past five years the US stock market is up an annualized 15.7% — despite high inflation, 550 basis points of interest rate hikes, the global pandemic and associated recession, and geopolitical unrest including war in Ukraine and the Middle East — if you stayed invested through these issues, globally diversified portfolios rewarded investors with positive returns.

Returns greater than 1-year are annualized. Indexes used are as follows: US Large Cap Equity, S&P 500 TR; US Small Cap Equity, Russell 2000; International Equity: MSCI ACWI Ex-US TR Net; Preferred Stocks, S&P Preferred Stock Index; Core Fixed Income, Bloomberg US Agg Bond; Money Market, Bloomberg 1-3 Month T-Bill.

US Large cap technology stocks grabbed headlines throughout 2023, with the hype surrounding generative artificial intelligence (GenAI) becoming mainstream. We see immense opportunities long-term but the near-term risks related to this disruptive technology are difficult to quantify. Although GenAI will be transformative and its applications are expected to change the way we work and live, it’s not possible to determine which companies will emerge with durable competitive advantages.

It’s been a wild ride for the GenAI darlings—coined the “Magnificent Seven”—Apple, Microsoft, Alphabet, Amazon, Nvidia, Meta and Tesla. Their outperformance throughout 2023 relative to the S&P 500 was impressive. Yet despite combined average returns more than triple the index in 2023, three of the seven were priced below their 2022 highs at year-end (two-year annualized returns of Alphabet, -1.3%; Amazon, -4.5%; and Tesla, -16.0%). The volatility associated with these stocks has been gut-wrenching, and in the case of Alphabet, Amazon and Tesla, it’s been a bumpy ride to nowhere over the last two years.

The chart below emphasizes how much the largest stocks—which include the Magnificent Seven—dominated the market throughout the year. There is a marked disparity when you compare the top ten stocks of the S&P 500 by market-cap weight with the rest of the index’s 490 constituents.

The chart on the left shows the price return of the top 10 stocks in the S&P 500 for 2023. The 62% return (green line) significantly exceeded the 8% return (blue line) of the remaining 490 stocks by a stunning 54%. From a valuation perspective, these mega-cap names ended the year 157% more expensive on a relative basis.

The charts on the right show the weight of the top ten stocks by size and their contribution to earnings. While index concentration is not new, the diminishing contribution to earnings combined with significant price appreciation, suggests a potential mis-pricing in capital markets. The tailwinds associated with these large companies hasn’t dissipated, but looking forward, the landscape for the remaining 490 looks more favorable.

A wide valuation gap between the leaders and the rest of the market indicates there are opportunities for active investors. We favor strategies where the underlying fundamentals are priced attractively for future growth prospects and see valuation risk in pockets of the market-cap weighted S&P 500.

In the bond market, as reflected in the chart below, the 10-Year Treasury yield had a volatile year.

The rise above 4% in the first quarter reversed suddenly when three regional banks failed and concern of further contagion in the banking sector was widespread. By the end of the second quarter, banking issues were in the rearview mirror and the focus returned to inflation and monetary policy. Rates hit 5% in October, but then dropped sharply late in the year. The benchmark rate ended 2023 close to where it began, relatively unchanged at 3.88%.

For an asset considered “risk free”, it was a roller coaster ride for fixed income investors. We expect continued volatility in long term interest rates until there is more clarity regarding the economy, inflation and monetary policy.

At the December FOMC meeting, Fed officials expressed increased confidence in the outcome of a soft landing and Chairman Powell publicly discussed the potential for rate reductions in the new year, sending stock and bond markets into a state of euphoria. Interest rate futures currently imply six 0.25% rate reductions in 2024, beginning in March, while Fed officials are projecting three.

We think the Fed is likely to exercise caution and wait for further evidence that inflation will be sustainable at or near 2% before easing monetary policy. Today’s rates remain restrictive and inflation has shown immense improvement, but it is not necessarily an indication that all risks (sticky inflation or an economic slowdown/recession) have been eliminated.

Fed projections estimate we will reach inflation and neutral interest rate targets by year-end 2025. Data suggests we could get there sooner, so it seems we are on the right track.

Inflation continued its downward trajectory while real wages remain positive. After reaching 50-year highs, inflation eased to 3.1% year-over-year last November, well off the peak of 9.1% in June 2022. The chart below outlines the underlying components, their contributions to the Consumer Price Index (CPI) and the progress towards reaching the 2% target.

Core services related to transportation remain an issue, but the majority of CPI’s underlying components continue to improve. Core goods prices declined as supply chain disruptions waned and volatile components like energy and food prices slowed due to softening demand. Shelter inflation, which makes up 1/3 of CPI, is also declining as the lag associated with market rents flows through to the underlying data.

Barring an unexpected supply shock or spike in commodity prices, achieving 2% inflation by mid-2024 without a recession is feasible. If the data continues to unfold as projected, it should provide confidence for the Fed to ease monetary policy.

History suggests that once the Fed begins reducing interest rates, the pace of reductions may be more aggressive than their initial projections (currently stair-stepped down over the next two years). This often occurs due to unexpected economic weakness resulting from the lag effect of monetary policy combined with the Fed’s focus on current and sometimes backward-looking economic indicators.

It’s that time of the year when our inboxes are flooded with 2024 forecasts. It’s critical to recognize that any attempt to predict what will happen over the next 12 months is an exercise in futility. Although interesting, annual forecasts can be misleading and somewhat unproductive for long term investors, especially for assets like stocks and long-term bonds, which have inherently longer investment horizons.

At the beginning of 2023, over 80% of economists expected the US would experience a recession at some point during the year. Expectations were for negative job growth, rising unemployment and single digit S&P 500 returns. As you’ll see in the chart below, the gap between what experts expected and what actually occurred was very wide.

And while forecasters had a relatively dim outlook a year ago, today the opposite is true. According to a December survey from the National Association for Business Economics, more than three-fourths of economists — 76% — indicated the probability of the US falling into a recession over the next 12 months is 50% or less.

We ended our letter a year ago stating the following:

Globally, the majority of economists expect a recession both in Europe and the US sometime in 2023. We will not be surprised if they are right. We also won’t be surprised if they are wrong.

Once again, we will not be surprised if they are right about 2024 and we also won’t be surprised if they are wrong.

Regardless of the accuracy of these forecasts, we expect positive real returns for globally diversified portfolios over the long-term. We remain committed to compounding capital for our clients based on their circumstances, return objectives, and ability to tolerate risk.

On a final note, we recently lost one of the greatest investors and personalities of the last century, Charlie Munger. In honor of his passing and influence on our portfolios over the decades, we will close with some of our favorite Mungerism quotes.

“Knowing what you don’t know is more useful than being brilliant.”

“Spend each day trying to be a little wiser than you were when you woke up. Day by day, and at the end of the day, if you live long enough… you will get out of life what you deserve.”

“Those who keep learning, will keep rising in life.”

“When you borrow a man’s car, always return it with a tank of gas.”

“Take a simple idea, and take it seriously.”

“Assume life will be tough, and then ask if you can handle it. If the answer is yes, you’ve won.”

“Opportunity comes to the prepared mind.”

And last but certainly not least,

“Choose clients as you would choose friends.”

We are grateful for your trust and confidence, and further wish you a healthy and prosperous 2024. Please let us know if you have questions, would like to discuss your financial plan or review your investment portfolio in the new year.


The JRM Investment Counsel Team
Jack, Phil and Lauren