A Year of (Mostly) Good Surprises
Quick Take
This year surprised most all economists, prognosticators, and investors. A welcome reprieve from the challenges of 2022.
The economy remained resilient as inflation moderated, unemployment remained at historic low levels, and GDP grew.
A strong economy coupled with artificial intelligence euphoria led to a strong stock market rally across most geographical markets.
After a difficult 2022, bonds gained and the U.S. Treasury 10-year note took a round-trip.
Well, that was a pleasant surprise. What a difference a year makes.
A group of 45 leading academic economists were polled by the Financial Times about their expectations for 2023. Of those economists, 85% predicted that the United States would experience a recession in 2023. Even more certain, Bloomberg economists put the probability of a recession last year at 100%.
The economists weren’t alone. Professional soothsayers and investors on Wall Street were glum too. Nearly all predicted the economy would inevitably buckle from the fastest monetary tightening cycle in modern history. Consumer sentiment was near levels last witnessed when Lehman Brothers filed for bankruptcy during the subprime mortgage crisis.
By March, it appeared the reckoning had arrived. The collapses of Silicon Valley Bank, Signature Bank, and First Republic Bank ignited fears of a regional banking crisis – the final blow to a teetering economy. But the Federal Reserve stepped in to ease pressures of a credit crunch, restoring a sense of calm. Subsequent political brinkmanship and geopolitical violence further sought to destabilize the economy, but ultimately failed.
And, a recession never materialized. Inflation abated, and the unemployment rate remained anchored at historic lows. The Fed’s data dependent strategy ultimately prevailed for 2023 – walking the fine line of moderating inflation and growing the economy. The U.S. economy achieved real gross domestic product (GDP) growth in the three reported quarters of 2023, and fourth quarter GDP is projected to be 2.5%.
Very few saw the events of 2023 unfolding as they did – forecasting is an increasingly difficult endeavor. But if you were willing to ignore the economic naysayers and focus longer term, the financial markets rewarded you. What got trounced last year, surged this year. What surged last year, didn’t do well this year. Mean reversion triumphed in 2023.
After the now ubiquitous ChatGPT gained popularity, enthusiasm bubbled around a select few mega-cap tech and artificial intelligence stocks. Most of the U.S. large-cap’s 26% return in 2023 can be attributed to these “magnificent seven” stocks, which include Apple, Microsoft, Alphabet, Nvidia, Amazon, Meta, and Tesla.
Nvidia soared 239%, Meta gained 194%, and Tesla surged 102%. Each of these stocks lost more than half its market value in 2022. U.S. large-cap tech and communication services stocks were up over 55% after getting pummeled last year. Energy stocks were down this year after surging 60% last year. Some years the market ebbs and other years it flows.
The top ten holdings in U.S. large-cap stocks have ballooned in size and now account for 32% of the S&P 500 – a historical high. For perspective, the “magnificent seven” stocks are now larger than the stock markets of Japan, the United Kingdom, China, and Canada combined. But these companies have an outsized impact on global economic growth and underlying corporate profitability. Each still serves a useful role in a well-diversified stock strategy.
U.S. extended market and international stocks did well too. After stumbling to start the year, U.S. small-cap stocks surged in the fourth quarter on the resiliency of the U.S. economy. The trendy clothing retailer Abercrombie & Fitch claimed relevancy again by outpacing tech and AI names, returning 285%. German, French, and Japanese stocks all returned over 20% for U.S. investors, but Chinese stocks faltered after coming into 2023 with high expectations.
But, the biggest story of 2023 was Fed policy. The Fed hiked rates four times in 2023 after 2022’s aggressive rate hiking cycle. The mantra “higher for longer” was inserted into the financial lexicon to signal the need for higher rates to work through the economy.
As is often the case, market expectations were more important than the Fed’s actions. The U.S. Treasury 10-year note followed a round trip, starting and ending the year at 3.8%. It briefly touched 5% as stronger than anticipated economic data sent rates higher. But just as fast, the note fell to finish the year at its 3.8% starting point as accommodative future monetary policy became more likely.
The Bloomberg Aggregate bond index returned 6% - a welcome reprieve from the challenges of 2022. The continued resiliency of the U.S. economy caused corporate bonds to rally, finishing up 8%. Bonds now have higher yields as many U.S. Treasury bills of shorter maturities yield above 5% on an annualized basis. The additional benefit is the insurance provided by bonds, which should allow these instruments to serve as a ballast to stock exposure in the future.
What It All Means
What should investors expect after turning the page on an unexpectedly good year? Without a crystal ball – it’s difficult to say. Human psychology causes us to believe that the universal law of gravitation applies to the financial markets too – but that’s not always the case. Bad years do follow good years, but good years can follow good years too.
In fact, looking at stock and bond data since 1928 shows that good years do indeed follow good years. U.S. large-cap stock returns have positive returns in 65% of subsequent years after a 20% gain, with the average annual return being 9%. A similar situation plays out for bond returns too. The U.S. Treasury 10-year note has a positive return in 81% of subsequent years after a 4% gain (the 10-year’s 2023 return). The average annual return being 6%.
But it is difficult to find any certain patterns, and every subsequent year is unique. Financial markets randomly walk from one year to the next. There is no clear indication that accurately predicts any direction of market performance in subsequent years. This is what makes the stock market exciting and infuriating in the short run.
The financial markets reward the patient investor. The average 5-year and 10-year subsequent cumulative return for U.S. large-cap stocks after a 20% gain since 1928 is 60% and 185%, respectively. Longer holding periods show more manageable outcomes.
This year also highlighted the importance of diversification. Historically, a handful of assets drive market returns at any given time. The S&P 500’s 26% return this year would have only been 9% if not allocated to seven, or 1%, of the 500 stocks in the index. Diversification ensures that your portfolio is allocated to the winners at all times while ensuring that one particular asset doesn’t tank your portfolio. The only way to own all the winners is to own the market through a structured, diversified strategy.
Please let us know how we can best help you in the new year.
Contact us at 865-584-1850 or info@proffittgoodson.com
DISCLOSURES: The information provided in this letter is for general informational purposes only and should not be considered an individualized recommendation of any particular security, strategy, or investment product, and should not be construed as investment, legal, or tax advice. Proffitt & Goodson, Inc. makes no warranties with regard to the information or results obtained by third parties and its use and disclaims any liability arising out of, or reliance on the information. The information is subject to change and, although based on information that Proffitt & Goodson, Inc. considers reliable, it is not guaranteed as to accuracy or completeness. Source information is obtained from independent financial data suppliers (Interactive Data Corporation, Morningstar, etc.). The Market Categories illustrated in this Financial Market Summary are indexes of specific equity, fixed income, or other categories. An index reflects the underlying securities in a particular selection of securities picked due to a particular type of investment. These indexes account for the reinvestment of dividends and other income but do not account for any transaction, custody, tax, or management fees encountered in real life. To that extent, these index numbers are artificial and cannot be duplicated in real life due to the necessity of paying those transaction, custody, tax, and management fees. Industry and specific sector returns (technology, utilities, etc.) do not account for the reinvestment of dividends or other income. Future events will cause these historical rates of return to be different in the future with the potential for loss as well as profit. Specific indexes may change their definition of particular security types included over time. These indexes reflect investments for a limited period of time and do not reflect performance in different economic or market cycles and are not intended to reflect the actual outcomes of any client of Proffitt & Goodson, Inc. Past performance does not guarantee future results.
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