Friday, January 19, 2024
Remember in early 2022 when everyone was criticizing Federal Reserve Chairman Jerome Powell for not raising the Federal Funds rate soon enough because the Fed considered inflation to be “transitory” and would self-correct as the bottle necks in the supply chain worked their way through after Covid? My, what a difference a year makes! I heard a few people recently suggest that Jerome Powell should have been awarded Time’s Person of the Year instead of Taylor Swift. Jerome Powell and his hawkish friends on the Fed have focused on bringing down inflation and the market’s largest increases this year seemed to be around data releases suggesting drops in inflation. Can they pull off an economic soft landing or, as some have suggested, no landing at all? Time will tell. With all of that said, we are not out of the woods yet. As the lag-effect of the Fed interest rate increases continues to work through the US economy, we could see the economy deteriorate throughout 2024. Whether we end in a recession later this year or not is anyone’s guess.
Before we dive too deeply into the possible recession talk, let’s look at our major investment categories to see what worked and what didn’t last year. As you know, when you have a diversified portfolio, you should have some winners and you should also have some laggards. If everything went up all at once, you most likely are not as diversified as you think. Depending upon the size of your portfolio, the securities you hold may differ slightly from the securities mentioned below.
Fixed Income: For most of 2023, our ultra-short bond fund like PIMCO Short-term and money markets like Schwab Value Advantage Money Market outperformed the rest of the bond category. As the longer-term interest rates declined towards the end of the year, all of our bonds rallied – especially the intermediate bonds. For example, from November 15 through the end of the year Dodge & Cox Income was up 6.07% while Metropolitan West Total Return was up 6.56% – that is 1% per week! It goes to show you that should the Fed help by lowering the part they control – the overnight lending rate – the rest of the bond market could quickly follow suit. Should the Fed decide to lower rates this year due to a slowing economy, I could see bond fund returns hit high single, if not low double, digit returns by the end of the year. This area of our model has lagged for a couple of years so the snapback would be well received.
Large-Cap Domestic Equities: There are really two words that summarize the main driver behind the stock market resurgence in 2023: Artificial Intelligence (AI). AI is in its infancy right now, but it will grow to become
a larger part of our lives. For instance, AI is part of Microsoft Word or your texting app – it guesses the word or phrase you are going to type next and pre-populates it without you having to type it. Obviously, investors are hoping for bigger and better things with AI and are bidding up the Magnificent Seven (M7) share prices that are heavily investing in AI: Amazon, Alphabet, Apple, Meta, Microsoft, Nvidia and Tesla stock prices soared in 2023 and with all of these firms making the top 10 holdings of SWTSX, contributed most of the index’s 26% gain last year. My concern is that the M7 stocks are now expensive. The forward price-to-earnings (P/E) ratio is 35 times for M7 stocks while the S&P 500 excluding M7 holdings is 15.5 times – 15.5 is much closer to the long-term S&P 500 average P/E of 15. We will have to see if earnings can keep up with lofty M7 expectations!
Mid and Small-Cap Equities: With M7 dominating the investment headlines this year, mid and small-company stocks seemed to be left behind. Things began to change as the inflation data came in better than expected. This category tends to perform well coming out of a recession. However, what happens if we just have a slowdown without a recession as the inflation data was starting to point to? I believe investors wanted to be ahead of curve and bought up the mid and small-cap stocks while they were cheap. After the run-up at the end of the year, the small cap index we invest in has a P/E ratio of about 14, which is much cheaper than the current 21.7 P/E ratio for the S&P 500. There should be more room to run here, but we still don’t know if we have the all-clear regarding an economic recession. Remember, small-cap stocks tend to lead us out of recessions…not into them.
Foreign Equities: All of our international holdings finished with double digit returns. They seemed to piggyback on the better-than-expected inflation news like our mid/small-cap investments. Dodge & Cox International was up 16.7%, while our more conservative Vanguard Global Wellington and First Eagle Overseas funds were up 12.55% and 10.74% respectively. Foreign stocks continue to win the prize for being the least expensive. All three funds have P/E ratios less than 11 times earnings. I am assuming that is why Vanguard believes foreign stocks have the best return potential of all the categories we invest in over the next 10 years. Vanguard researchers believe we could see 10-year average annual returns of 7-9% per year in the foreign stock category while they believe US stocks will return 4-6% on average for that same period.
Outlook: One of our favorite stock market analysts has been predicting a recession for quite some time. In fact, he started talking about a recession hitting the US economy by the fourth quarter of 2023. He has since pushed his recession prediction to mid-2024. Obviously, no one knows what the future holds. Should the Federal Reserve lower rates this year, that would be favorable to bond prices. It would also be favorable to stocks, but it would depend upon the reason why the Fed was lowering rates. If they were lowering rates because data is pointing to inflation being under control, that is one thing. If they are lowering rates because the economy is collapsing due to the lag effect of the Fed keeping rates too high for too long, that is another. Stocks would rally on the former, but most likely struggle under the latter scenario. Either way, I believe our portfolios will do relatively well. We have 50% of our equity allocation indexed to keep up with M7 stocks along with the next investment theme – whatever that may be – while we have the other 50% in managed securities that focus on value investing (not paying too much for a stock) along with predictable dividend streams. Hopefully the total return we receive from our stock and bond picks will provide a smoother ride than if you were to just focus on index funds or just focus on deep value investments. In 2024, I would be pleased with an 8-10% return for equities and a 5-10% return for bonds. Obviously, no one knows what the future holds.
Thank you for your continued support of American Investment Advisors! CJ and I are fortunate to be working with you! Best wishes in 2024!
Enclosed you will find your Portfolio Holdings statement as of December 31, Performance Analysis and Position Performance summaries and a quarterly Account Management Fee Statement. Please contact us should you desire the most recent copy of our Form ADV Part 2A. In addition, please notify us should your investment objectives or personal financial situation change.
- You can expect to receive your 1099-Composite and Year-End Summary by mid-February from Schwab. Please let us know if you would like us to forward the 1099-Composite and Year-End
Summary to your accountant. - With the new year upon us, this is an excellent time to review your IRA and retirement account beneficiaries to make sure they are up to date. Contact us if you would like us to send you the names Schwab Institutional has on file.
- Please consider contributing to your Roth IRA if you are able. You have until April 15th to contribute a maximum of $6,500 (plus $1,000 catch-up contribution for those over age 50) for tax
year 2023. - For those who can afford to maximize their 401(k) contributions in 2024, please note that the maximum you can contribute is now $23,000. For those over the age of 50, the catch-up contribution
is $7,500. Thus, one could contribute $30,500 in 2024 if they are over 50 and have the means to do so. Please contact us if you need any help with selecting the underlying investments within your
retirement plan.