In 2023, the economy, stock market, and bond market all performed well.

This was a very different year than 2022, which had negative stock returns, bond returns, and high inflation. Many economists  predicted those bad times would continue, with a recession in 2023.

Luckily, that did not happen. The year did get off to a rough start, with three big bank failures: Silicon Valley Bank, First Republic, and Signature Bank. These were three of the largest bank failure in US history:

What also served as a headwind was the Federal Reserve raising interest rates. They did so four times in 2023 in order to mitigate the risk of further inflation.

Largely as a result of a declining inflation, resilient consumer demand, and a competitive labor market, no recession occurred. As we’ve seen before, investors who remained disciplined were rewarded with favorable returns.

Tech of the Year: AI
A notable theme of the year was AI, which was highlighted by the launch and popularity of ChatGPT. Despite AI’s decade-plus presence (Siri was launched in 2011), this felt like a catalyst for the industry.

Side bar: It’s interesting to think about what other technology is available today, but not yet at its full potential. 3D printing?

Back to AI, Nvidia showcased the sector’s strength by being the top performer in the S&P 500:

Nvidia’s excellent year also serves to highlight the difference between 2022 and 2023.

Below, we see how “The Magnificent Seven” – the 7 largest stocks in the S&P 500 (all tech) – performed in 2022 (poorly) versus 2023 (very well):

Fourth Quarter Economic Highlights

• Economic Growth: The economy continued its impressive performance, exceeding expectations with GDP growth of approximately 2.5% in the 4th quarter, more than double the analysts’ initial forecast.
• Inflation: The Federal Reserve’s preferred measure of inflation decreased to 2.6% in November, down from 7% in 2022.
• Interest Rates: Due to declining inflation, the expectation is that interest rate hikes are behind us, with potential rate cuts in 2024.

Stocks – Fourth Quarter Results:

• US Stocks: US stocks rose 12.1% during the quarter and 25.9% for the year. November through December was the 12th best two-month period for US stocks since 1950, with a gain of 13.9%. A historically good quarter.
• International Stocks: Developed international stocks (e.g., Japan, Germany, Australia) rose 11.1% during the quarter and 17.7% for the year.
• Emerging Markets: Emerging market stocks (e.g., India, Philippines, Brazil) rose 6.5% during the quarter (largely pulled down by China’s weaker performance) and 9.0% for the year.

With a year of 20%+ returns behind us, I found this stat interesting:

Bonds
After a volatile year for interest rates, the US 10-Year Treasury – an important benchmark for lending – ended 2023 almost exactly where it started. Despite briefly reaching 5%, the 10-Year yield started and finished the year just under 4%.

This decline in interest rates drove the rally in bonds during the quarter.

Over the past year, hedged international bonds showed the benefits of global diversification, as they outperformed US bonds.

For investors in tax-sensitive portfolios, municipal bonds have been one of the strongest sectors over the last year, with even better relative results when compared on an after-tax basis.

Parting Thoughts – Large Tech Stock Valuations
With all the fanfare around AI, I thought this analysis from Larry Swedroe was informative:

As always, please reach out if you have any questions or would like to connect.

The third quarter usually provides the worst returns of the year. This year, it lived up to its reputation, with stocks and bonds both down modestly.

These negative returns followed one of the strongest starts ever for the stock market. In the first two quarters, the S&P 500, representing the 500 largest stocks in the US, experienced its 13th best start to a calendar year on record.

After what felt like a long Q3, most investors are probably looking forward to winter. Historically, the fourth quarter has been the best performing, up 4.2% on average, and positive 79.5% of the time:

Economic Summary
Looking at the economy, we’ll start off with the good news: the economy remains in surprisingly great shape. So much so that The Economist recently compared it to the Energizer Bunny. It just keeps going and going:

To add to this impressive list:

• GDP growth for Q3 is projected to be 5.1%. This would be the highest GDP reading since Q4, 2021.
• On the labor market front, September’s nonfarm payroll numbers, which encompasses employment data for approximately 80% of the US workforce, rose by 336,000. This surpassed economists’ expectations by double and exceeded the average monthly gain of 267,000 over the past 12 months. Moreover, employment data for July and August saw upward revisions, totaling 119,000 more jobs than previously reported.

These positive outcomes occurred despite the Federal Reserve’s interest rate hikes, a move that typically slows the economy.

The concern now is that, with the economy remaining resilient and generally doing well, inflation may persist if consumer spending remains high. That could prompt the Federal Reserve to keep interest rates elevate for longer than was originally planned.

Oddly enough, good economic news can end up being viewed as bad news. Positive results end up causing concern about the future.

The primary worry is that if high interest rates remain they could dampen consumer spending through high rates on mortgages (currently 7.6%), auto loans (currently 8.3%), and credit cards (currently 21.1%).

Additionally, there are several other potential risks to keep in mind:

• Inflation has declined and is now under 4%, a decrease from last year’s high of 9%. However, this is still higher than the Fed’s target of 2%. In simpler terms, prices are still rising, but the rate at which they’re going up has slowed. This can be seen at the gas pump, where prices have increased 12.9% over the last two months.
• There remains a looming threat of a government shutdown.
• Student loan payments just resumed, and it’s unclear how much that will affect overall spending.
• Last but not least, the two wars between Russia-Ukraine and Israel-Palestine seem to be intensifying, each with their own unique geopolitical risks.

Risk is an ever-present part of investing (more on that at the end of this newsletter). But it’s usually the risks that nobody sees that end up causing the most damage.

Housing Market
Before diving into the stock and bond market returns, I wanted to touch on housing.

With interest rates at 7.6%, the cost to purchase a home is high. In fact, interest rates haven’t been this high since 2000:

As a result, the housing market has stopped booming, which feels odd given all the activity in recent years.

House prices rose dramatically during Covid, as many white-collar workers moved while interest rates were low. Then inflation rose, interest rates followed, and home prices stopped going up (but they’re still currently at all-time highs).

As a result of the run up in home prices and interest rates, home affordability is at an all-time low, as demonstrated by the following screenshots:

However, housing is unique because most people aren’t affected by it. Over the past few years, many people moved or refinanced, and are content sitting still for a while. As a result, there aren’t many sellers, which is limiting supply.

All in all, the market has slowed dramatically, with very few people refinancing, selling, or buying.

Economic textbooks would show that an increase in interest rates would lead to a decrease in home prices, but it’s not always that easy. Just another example of how predicting the future is hard.

US Stocks
After a strong run for the prior three quarters, US stocks fell modestly during the third quarter, down 3.3%, while they are up 20.37% over the past 1 year:

During the quarter, energy was the best-performing sector, up 11.4%, as the result of higher energy prices.

The worst-performing sectors were utilities (think of companies like PG&E and Duke Energy), and real estate, down 10% and 9.7%, respectively.

As mentioned at the beginning of this post, it’s the long-term investing outcome that matters. As shown below, the longer your investing time horizon, the higher the likelihood of achieving a positive return:

International Stocks
Developed international and emerging markets stocks performed similarly to US markets for the quarter, with developed markets down 4.1% (as measured by the MSCI EAFE) and emerging markets down 3.0% (MSCI EM).

Over the past year, developed international markets (think of companies located in countries like Germany, Japan, and Canada) outpaced the US, gaining 25%. Emerging markets (think of companies located in countries like India, Mexico, and Taiwan) gained 11.7%.

Bonds
Bond performance was negative across all sectors during the quarter. This was largely attributable to investors weighing recent economic data and Federal Reserve guidance. During the quarter, investors appear to have priced in a higher probability that the Fed may hold rates at higher levels throughout much of 2024.

Over the past year, returns for fixed income investments have been modestly positive. More credit-sensitive sectors, like corporate bonds, have generated the highest results for the period.

For investors in tax-sensitive portfolios, municipal bonds have been one of the strongest sectors over the last year, with even stronger relative results when compared on an after-tax basis.

Parting Thoughts – Investing During Major Geopolitical Events
Ryan Detrick from The Carson Group recently provided a table depicting the performance of the S&P 500 in response to geopolitical events.

Looking at this extensive list, we see everything from the Pearl Harbor Attack to the Cuban Missile Crisis to the Kennedy Assasination, 9/11, and much more.

The lesson I take is that market sell offs have generally been limited. And while some extended periods of weakness have occurred, the market typically recovers swiftly.

This is because stocks reflect earnings over time, and companies persist in pursuing growth.

If history is any guide to the future, we can learn that despite terrible and tragic news, the stock market consistently bounces back and rewards patient investors.

As always, please reach out if you have any questions or would like to connect.