Vertigo3d, a Market Breadth Report by Scott Glasser, Michael Kagan, and Stephen Rigo, CFA
Market Breadth Broadens as Rate Regime Shifts
Market Overview
The S&P 500 Index’s (SP500, SPX) mid-year malaise reversed emphatically in November and December. After a third consecutive monthly decline in October (-2.1%), the S&P 500 roared back, jumping 14.1% from November 1 into year end. When all was said and done, the S&P 500 returned 11.7% in the fourth quarter (its best quarterly performance since the fourth quarter of 2020) and 26.3% in 2023, leaving the benchmark within an earshot of January 2022’s all-time highs.
During the quarter, 10 of 11 sectors advanced in absolute terms, with real estate leading the way as investors began to price in a Fed not only done raising interest rates, but also likely to cut them in the first half of 2024. Technology shares also outperformed meaningfully as artificial intelligence (AI) growth opportunities continued to excite investors. Technology led all sectors in 2023, returning a whopping 60.8% and marking the ninth year out of the past 10 for tech relative outperformance (with 2022 being the outlier).
Although the tech-heavy communication services sector advanced roughly in line with the index in the fourth quarter, it finished the year as another notable outperformer, returning 56.4% in 2023. Energy, the lone sector to decline in the fourth quarter, was down 7.0%. Energy also has the notable distinction of being one of only two sectors to decline on an absolute basis in 2023. Utilities — the other — was one of two sectors to underperform the benchmark in every calendar quarter of 2023, sharing this distinction with consumer staples.
The powerful market rally to end the year was driven by a precipitous decline in interest rates as sustained disinflationary trends created an expectation that not only is the Fed finished raising rates, but rate cuts would also begin sooner and be more numerous than previously expected. The proverbial punch bowl was spiked post the December Fed meeting where Chairman Powell’s dovish press conference added to the soft landing narrative given strong current GDP growth, full employment, and a Fed pivot in sight. As a result, the 10-year Treasury yield, which peaked at nearly 5% in October, ended the year below 4%, while federal-funds futures priced in six interest rate cuts in 2024.
Given the current economic backdrop and market valuation, the soft landing narrative has seemingly become consensus for equity investors. Coming into the year we anticipated the Federal Reserve’s rapid withdrawal of liquidity would keep pressure on equities and ultimately lead to a recession. We continue to forecast at least a mild recession, as many of the key indicators we track still point in that direction. The Conference Board’s basket of leading economic indicators (LEI) has declined sharply over the last two years (Exhibit 1) and remains disconnected with GDP growth. In addition, the yield curve has been inverted for over a year, a duration consistent with where economic weakness should become more evident (the curve tends to un-invert at recession onset). Finally, the average stock had been mired in downtrend while index gains were largely driven by the Magnificent Seven mega cap technology stocks (Alphabet, Amazon.com, Apple, Microsoft, Meta, Nvidia and Tesla). Highly concentrated equity markets tend to be unhealthy. As such, we’ve been hesitant to declare the “all clear” signal for equities.
However, the market’s powerful year-end advance was broad-based and included small cap participation — healthy attributes that were missing from the rally in the first half of the year. Although it would not be unusual for markets to correct or consolidate after the impressive year-end rally, we view current internals as more supportive of a sustainable uptrend than the highly concentrated market of 1H23. To us, this suggests any recession is likely mild and dealt with by equity investors via a buyable correction. That said, we believe investors should anticipate historically average equity market returns from here (high-single-digit total returns) versus the heady 20%+ gains seen in three of the past four years, as valuations suggest the market is already pricing in the soft landing.
In the past, we’ve pointed to various valuation metrics to support a subdued total return environment, such as a 12-month forward P/E ratio and the Buffett Indicator (a ratio which measures total equity market cap as a percentage of GDP). Both of these sit over one standard deviation above their long-term average. However, the valuation measure that stands out today is the Fed Model, which compares the S&P 500’s earnings yield (the inverse of its P/E ratio) to the 10-year Treasury yield. For the first time since the financial crisis, the risk-free yield is competitive with the earnings yield offered by the stock market. Said another way, for the first time in over a decade, stock market investors have competition from less risky alternatives (Exhibit 2).
Outlook
While we believe investors remain too complacent regarding corporate profits and the economy, our prior forecasts underestimated the impact of fiscal stimulus on the U.S. financial system during the COVID years. Huge fiscal spending programs, both at the state and federal levels, materially boosted GDP this past year and their impact continues to help counteract the effects of tighter monetary conditions. In addition, structural changes in employment, again partially resulting from COVID, have made corporations reluctant to cut employees, keeping labor markets tight. As a result, consumption, which accounts for two-thirds of U.S. GDP, remains at higher levels than might be expected during more traditional tightening cycles. That said, consumer savings are now back at pre-COVID levels, the housing market is both slow and unaffordable and employment is likely to deteriorate as employers attempt to maintain margins in the face of slowing demand. Although a recession remains our base case, we believe that the odds of a significant economic downturn are lower as the lingering effects of fiscal spending are helping cushion the impact of monetary tightening. Layer in the potential for proactive interest rate cuts ahead of lagging employment data, and the potential for a soft landing seems viable.
Historically, at the start of a new bull market, small and mid cap stocks tend to lead the way in performance, and participation is now robust across the spectrum. The improving breadth and small cap participation evident in November and December may indeed prove an early signpost for a durable expansion. While we are optimistic about the long-term benefits generative AI will have on workplace productivity, aggressive assumptions need to be made to justify current valuations. We are positive on much of the health care sector as market expectations for medical device and life science/tool companies have come in markedly, while we find the noncyclical nature and modest valuation of pharmaceutical companies appealing. We are positive on select cyclicals such as rails and logistics companies where expectations are low and sustained economic growth would create upside. We believe easing financial conditions and the potential for rate cuts and a steeper yield curve will benefit select financial companies such as banks and other mortgage-exposed institutions. We do not expect the top-heavy market of 2023 to continue, and we believe a diversified portfolio with investments focused on durable growth at attractive valuations is best positioned in this transitioning interest rate regime.
Conclusion
Although we have become more constructive on the medium-term outlook, we believe total return expectations should be closer to long-term trend (high single digits or low double digits) versus the larger swings that have become common in the post-COVID environment. We are long-term investors. Rather than trying to project near-term earnings trends, we believe it is better to look out two to three years and make investment decisions based upon our assessment of a company’s longer-term, sustainable growth rate relative to what’s implied in today’s share price. Although we prefer certain cyclicals with moderate expectations today, as out year expectations moderate for growth stocks we would be comfortable adding risk to the portfolio.
Portfolio Highlights
The ClearBridge Appreciation Strategy underperformed the benchmark S&P 500 Index in the fourth quarter. On an absolute basis, the Strategy had positive contributions from 10 of 11 sectors. The…
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