Published January 26, 2024
Below we offer a couple of recent summary reports from Delta Research. We hope you find them of interest.
“The S&P 500 returned 26% in 2023 and ended the year just short of the all-time high of 4796. Components of the 2023 return included +6.32% from better earnings, +17.91% from expansion in forward P/E multiple to ~20x, and +2.06% from dividends. Since 1950, the S&P 500 Index is positive the following year 80% of the time. In the presidential election years dating back to 1960, the S&P 500 index has been positive 81% of the time (13 out of 16 years). In up years, the average return is 12.9%. Of the three down years, there was 2000 which was the beginning of the tech bubble popping and 2008 which was the Great Financial Crisis (GFC). One might argue that two of the three down years were outliers.
The chart below shows 2023 stock performance by sector, style and strategy. Large capitalization technology stocks were the stock performance leaders. The S&P 500 outperformed the average large-cap core mutual fund and significantly outperformed fundamental equity hedge funds. For those exposed to Bitcoin, it advanced by 153%.
The fundamental bull case for 2024 is based on rising earnings, GDP growth, falling inflation and lower interest rates. The bear case is based on high valuation — S&P 500 forward 12-month P/E is 19.5x versus 30-year average of 16.6x. Recession fears have mostly evaporated and the bond market is pricing in six rate cuts this year. With the stock market priced to perfection, the bull story must stay on track to support the high valuations.
Like all prior years, there will be unforeseen challenges that arise that will cause downside volatility in stocks. Examples of these types of disruptions include the Fukushima nuclear accident in Japan, the Flash Crash, Covid, Russia invading Ukraine, etc. Generally, these types of events have created buying opportunities rather than sustained bear markets.
For at least the past 40 years, investors have expressed concern about federal deficits and the rising accumulated government debt. So far, government debt has not been a significant problem for the stock market.
The U.S. is up to $34 trillion of federal debt after adding $1 trillion in the past three months alone. In 2024, the U.S. will need to issue $2.4 trillion net of US Treasuries. The federal debt as a percentage of GDP is about where it was at the end of World War 2.
A potential risk to the bull case in the stock market is that market-driven interest rates (e.g., the 10-year treasury rate) may remain higher than expected as higher yields are required to attract sufficient buyers for the trillions of dollars of U.S. debt.
The inverted yield curve and negative Leading Economic Index (LEI) numbers suggest the risk of recession in 2024 is not entirely off the table. Our expectation currently is that the yield curve will regain a positive slope and the LEI will turn positive without a recession this year. It appears that the negative readings are more tied to Covid response distortions rather than the current economic cycle.
Money market funds were at an all-time high of $5.6 trillion as of September last year. Ultra short duration fixed income investments are attractive when yields are above 5% and risk is essentially zero. Because the duration is very short, changes in interest rates do not have much impact on the bond values. What does change as yields decline is the yield on the short-duration “cash” instruments fall as bonds roll-over in a portfolio.
Depending on whether you ask the Federal Reserve or the bond futures market, the expectation is for 3 to 6 fed fund rate cuts in 2024. History shows that in the 18 months after the Fed ended hikes in the last four cycles, yields on cash-like investments decayed rapidly. The 3-month Treasury yield, a benchmark Treasury security with a yield similar to cash-like investments, fell an average of 2.5%.
If history were to repeat itself, money market fund yields would decline, and investors would be better served by extending duration via being invested in longer duration stocks and bonds. The chart below shows the performance of stocks and bonds 1 year and 5 years after the last Fed rate hike. The Bloomberg U.S. Aggregated Bond Index has a duration of about 6 years. One year after the last rate hike during the past four cycles, it has appreciated by an average of 10.1%. The longer the bond duration (number of years until principal is returned to the lender), the more the bond will respond to changes in interest rates. The 3-month U.S. treasury bill (T-bill) was up only 4.7%.
Bond durations are generally thought of as ranging from about a month to as long as 30 years. Very long-duration bonds can be very volatile. By focusing on the “mid-point” of the yield curve (about 4-7 year duration), the balance of potential reward and volatility has historically been attractive at this point in the Fed rate cycle.”
Market Update
Stocks continued their upward climb this week as earnings season kicked into higher gear. Monday brought a resumption of the prior week’s tech-led move higher. Stocks closed Monday +0.2%. Another +0.3% gain Tuesday as earnings from airlines bolstered that group while homebuilder D.R. Horton and industrial conglomerate 3M offered disappointing views. A flat day Wednesday though the Nasdaq continued moving higher as Netflix jumped +11% on optimistic subscriber growth projections. Economic reports showed strength in manufacturing and overall business activity. Thursday brought weakness in Tesla on slowing order growth as electric vehicles face a digestive phase. Also down, medical insurers Humana and United Health suffered under higher medical costs. The offset came from IBM’s +10% gain as its AI platform drives excitement in the company. The larger story was the very rosy broad economic picture with fourth quarter GDP coming in well ahead of expectations at +3.3% economic growth. This growth came while the Fed’s focus inflation measure posted another quarter at the Fed target of 2%, perhaps supporting the notion of upcoming interest rate cuts. The S&P 500 added +0.5% in another record high. Friday delivered weak results from chipmaker Intel but strong earnings from American Express, Colgate Palmolive, and luxury goods powerhouse LVMH. Overall, the market ran in place with the S&P 500 slightly down to end its streak of five straight gains.
The S&P 500 (SPY) closed the week higher by +1.03%. The index has had only ONE losing week in the past THIRTEEN weeks – an astounding run. The Nasdaq 100 (QQQ) posted a +0.62% weekly lift. Smallcap stocks (IWM), which have been much more uneven, found positive ground this week with a +1.84% gain. Next week will bring another mountain of earnings and economic data for markets to consider.
Warm wishes and until next week.