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The Brave Report: Market Commentary for Q4 2023

Click here for the .pdf version of this report: The Brave Report-2023Q4

Well, that escalated quickly…. Markets surged rapidly to close out the year, posting back-to-back positive months to finish the year near all-time highs.  The S&P logged its best quarter since 2020, helping to erase many of the losses from last year.  Improving inflation data, dropping rates and optimism around the Fed all contributed to a more bullish stance.  Performance was very top-heavy as the larger tech companies contributed disproportionately to the quarterly gains. These bellwethers were able to avoid a slowdown in earnings within an elevated rate environment and were rewarded for it.  We will need to see an expansion in the number of companies leading the markets if this rally is to continue in 2024.

Market Overview

After a brief pause during the 3rd quarter, the markets surged again in the 4th quarter to cap off a stellar year.  Even in the face of geopolitical unrest around the world and uncertainty around inflation and rates, all three major indices surged to close out the year.  The S&P rose 11.2%. The DOW rose 12.4% and the NASDAQ jumped 13.6%. This allowed the S&P 500 to end the year up more than 24%. This represents a nice bounce back after the drawdown we saw in 2022.  There continues to be uncertainty around the Fed’s next moves, but markets have been pricing in a very optimistic scenario and a softish landing.

On the fixed income side, we saw a massive drop in rates across the entire yield curve as inflation data came in better than expected.  After peaking around 5% in mid-October, the yield on the 10-year treasury dropped more than a percent to end the quarter below 4%. This rapid drop in rates helped to add fuel to the equity markets. The bond market is now pricing in an end to rate increases and is predicting a reversal to rate cutting sometime later this year.  These decisions will be data-dependent but the current trend in inflation seems to support at least a pause in rate increases.

With cooling inflation and a relatively optimistic tone from the Fed, equity markets were able to surge to close out the year.  While the Indices had a great quarter (and year), it is important to look a little deeper at the numbers and what led to such great gains.  What we find is that most of the market’s gains can be attributed to just a small handful of stocks.  Some have dubbed these the “Magnificent 7”. They include Apple, Alphabet, Microsoft, Amazon, Meta, Tesla and Nvidia. These 7 large tech names now make up more than 30% of the market cap of the S&P 500 and saw their valuations surge in 2023.  While the S&P 500 notched a strong gain of 24% for the year, these 7 stocks returned an average of 111% over the same time frame.  Additionally, if we compare the equal-weight S&P 500 with the normal market-weighted average, we saw the biggest margin between the two since 1998.

All these companies have been able to continue to put out stellar earnings numbers and have benefited from the surge in AI-related business.  However, the disproportionate performance between these companies and the rest of the market has painted an inaccurate picture of where the overall market stands.  If the markets are going to continue to outperform in 2024, we will not just need to see these 7 companies perform well, but at some point, the rest of the market will need to contribute.

The main theme we have been discussing over the last year is inflation and how the Fed can bring down inflation without destroying the economy.  So far, they have succeeded in doing so.  I do think the markets are a little optimistic about when the Fed will start cutting rates.  Inflation has come down, but the jobs market continues to remain strong.  For the Fed to start cutting rates, Jobs data will need to weaken a bit or show signs of weakening.  Until that point, I think the Fed will be hesitant to start a rate-cutting cycle.  They will eventually cut rates but the timing of it will be more delayed than many think unless we see some real weakness in the economy.

The hardest thing in the markets these days has been handicapping the Feds’ next move.  I will credit them with staying data-driven and understanding that some of the rate hikes they have done have not yet filtered into the economy.  The economy has been more resilient to the rate hikes than I think most originally anticipated but I fear that this optimism has allowed the markets to get a little ahead of themselves.  I would not be surprised to see a period of consolidation as we wait to get some earnings data which will tell us how much the increased rates are weighing on company performance and guidance.

The other major theme driving the markets this year, especially on the technology side, has been the AI revolution that has seemed to move into the mainstream quite rapidly. I think we are still in the early innings of this movement, but we will start to see how companies can take AI from a fun word to discuss on a conference call to a resource that moves the needle from a company earnings standpoint.  The early winners will be those companies that provide the infrastructure that powers AI.  We have already seen that with the performance of NVIDIA.  The next stage will be companies that can leverage the power of AI to drive business results.

The other big variable I will be watching this year is the election. I am not a huge believer that a President has a large impact on the month-to-month performance of the stock market but historically the market has performed well during the election cycle. The S&P 500 has returned an average of 11.28% during election years and has been positive 83% of the time since the S&P 500 was created. Incumbents like to be able to run on a strong economy and members of Congress don’t want to pass anything that could throw uncertainty into the markets. They will focus more on pro-growth stimulus efforts which can help prop up the economy in the short term.  As the election dynamics become more clear, we will start to see the markets handicap the various outcomes.

Strategy Commentary

With inflation data improving in October and November I cautiously added to some of my equity positions.  This is in no way a full overweight to equity, but I selectively increased some of my equity weightings.  I missed out on some of the runup to close the year but with data improving I felt more comfortable adding to some positions.  I continue to be cautiously optimistic going into 2024 but do expect some consolidation and profit-taking in the short term.  I think we need to see some more certainty around the Fed’s next move as well as some widening of the breadth of the rally before I go fully overweight equity.  The “Magnificent 7” have run so far so fast that I think we will need some other names to lead the next leg higher.

Domestically, I have continued to maintain my overweight to technology and communication services stocks, while also adding to my consumer discretionary allocation.  I have been overweight technology for quite some time now and expect the trade to continue to outperform as we move from the phase of AI just being a buzzword to it adding significantly to company performance.  I do think the large tech names will continue to perform well but expect some other names to start to catch up. Additionally, if rates continue to decrease, we will see small-cap stocks perform better.  Their valuations are much more reasonable when compared to large-cap companies, but they have been held back by high financing costs and uncertainty about inflation.  If we get any directionality from the Fed, then I think small caps will do some catching up from a valuation standpoint.

Internationally, I am still focusing on large, developed economies.  Geopolitical uncertainties still plague many of the developing markets.  If I were to look at some small emerging companies, I would focus on India and some Latin American names as their economies are less exposed to the current geopolitical conflicts.

On the fixed income side, even though rates have dropped, I still think there are some opportunities at the short end of the curve, especially if you are worried about the Fed raising rates again or delaying their cuts.  Money funds earning more than 5% have also been an attractive place to park money without having to worry about price fluctuations.

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