Quarterly Market Review: Q4 2023

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Stocks had a strong final quarter to the year, with the Russell 3000 Index returning 12.1%. All sectors except Energy posted positive returns. REITs were among the top performing sectors for the quarter, returning 17.1%, after the sector’s disappointing returns earlier in 2023.

In December, the Federal Reserve signaled progress in its fight against US inflation, and fixed income markets posted strong fourth quarter returns as market participants wagered on rate cuts in 2024. Small cap stocks, particularly small value stocks, outperformed the market for the period, exceeding even the large cap growth segment that has had such a strong 2023.

NVIDIA was not the only company to benefit from the recent boom in artificial intelligence. Broadcom, the fifth largest contributor to the Russell 3000, had a strong fourth quarter as it returned 35% for the period. Evidently, Broadcom’s contribution to the quarter’s returns shows that even names outside the so-called “Magnificent Seven” stocks can deliver outsized return contributions. Tesla, which is in the “Magnificent Seven” set, posted negative returns for the quarter, detracting from the overall market’s return.

What Might it Take to Bring Inflation Down to 2%?

History tells us that once inflation reaches high levels, it tends to stay higher for longer. One 2022 study¹ looked at the behavior of inflation across 14 developed economies to see how quickly it would retreat after reaching various thresholds. When inflation crested between 8% and 10%, as it did in June 2022, it took roughly three to four years to get back under 3%.

Headline inflation, as measured by the consumer price index (CPI), is on the cusp of falling below the 3% threshold already. However, core CPI, which excludes the more volatile food and energy prices, remains closer to 4%. The rising costs of both services and shelter have been driving inflation coming out of the pandemic. Given the typical lease period of a year or more, rent adjustments tend to take time to work through inflation, so the fact that rents are growing slower is a good sign. The Fed will continue to watch the cost of services, but policymakers don’t necessarily need prices to fall; they just want to see prices grow slower. Although the Fed has taken a more dovish tone recently, expect the Fed to keep rates higher until there is overwhelming evidence that inflation is fully contained, or the economy is turning downward.

Economic and Market Snapshot

Stock and bond markets rallied in December on the prospect of potential Fed rate cuts in 2024. The Magnificent Seven* stocks, buoyed by the potential of artificial intelligence, now comprise roughly 30% of the value of the S&P 500. Fortunately, the rest of the market valuations are much closer to their historical averages.

In the bond market, yields remain elevated, although down from the middle of 2023. Bonds continue to offer an attractive yield for high-quality income for investors, and for investors concerned about unexpected inflation, Treasury Inflation Protected Securities (TIPS) offer positive real yields.

Where do markets go from here?

Profitability will be important. How companies navigate higher debt-servicing costs, higher wages and any slowdown in economic activity will be important to their profit margins. Expect fewer companies to initiate share buybacks due to worries of recession, a new tax on buybacks, and the higher cost of capital.

Expect tight credit conditions. Companies will have more trouble accessing new capital or rolling over existing loans given the tighter credit conditions. The inverted yield curve, where shorter-term bonds pay more than longer-term bonds, hurts banks' profitability, which further strains their ability to make loans. Private credit will pick up some slack but won’t fully close the gap in funding.

Risk in the Magnificent Seven. The average price-to-earnings ratio (P/E) of the Magnificent Seven stocks is about $50 per dollar of earnings. Although these high valuations are reminiscent of the dotcom stocks in the early 2000s, the good news is that the rest of the market is much closer to historical averages.

What are the investment planning implications?

Expect volatility. We ended 2023 at very low levels of price volatility for stocks. However, between potential government shutdowns, higher costs of servicing Treasury debt, and ongoing geopolitical tensions, prudent investors will expect more volatility in 2024. The forward-looking nature of stock and markets is such that prices quickly reflect new expectations and the more uncertain the outcome, or the more impactful, the more we should expect prices to fluctuate.

Know how geopolitical risks impact your portfolio. We do not recommend making portfolio changes based on political events, elections or escalating international tensions. However, know that as risks flair, prices tend to fall, reflecting more uncertainty. What matters to the performance of your investments is not whether the news is good or bad, but whether it is better or worse than what was already expected.

Consider alternative sources of risk and return. Investors concerned about volatility and downside risk may want to consider investments with unique sources of risk and return that have historically had low correlation with the economic cycle. Although these investments come with their own risks, they have the potential to provide some stability when other markets are struggling.

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Past performance is not a guarantee of future results. Indices are not available for direct investment. Index performance does not reflect the expenses associated with the management of an actual portfolio. For informational and educational purposes only and should not be construed as specific investment, accounting, legal, or tax advice. Certain information is based on third-party data, which may become outdated or otherwise superseded without notice. Third-party information is deemed to be reliable, but its accuracy and completeness cannot be guaranteed. Neither the Securities and Exchange Commission (SEC) nor any other federal or state agency have approved, determined the accuracy, or confirmed the adequacy of this article.

Market segment (index representation) as follows: US Stock Market (Russell 3000 Index), International Developed Stocks (MSCI World ex USA Index [net dividends]), Emerging Markets (MSCI Emerging Markets Index [net dividends]), Global Real Estate (S&P Global REIT Index [net dividends]), US Bond Market (Bloomberg US Aggregate Bond Index), and Global Bond Market ex US (Bloomberg Global Aggregate ex-USD Bond Index [hedged to USD]). S&P data © 2023 S&P Dow Jones Indices LLC, a division of S&P Global. All rights reserved. Frank Russell Company is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes. MSCI data © MSCI 2023, all rights reserved. Bloomberg data is provided by Bloomberg.

Market segment (index representation) as follows: US Stock Market (Russell 3000 Index), Developed ex-US Stocks (MSCI World ex USA IMI Index [net div.]), Emerging Markets (MSCI Emerging Markets IMI Index [net div.]), US Bond Market (Bloomberg US Aggregate Bond Index), and Global Bond Market ex-US (Bloomberg Global Aggregate ex-USD Bond Index [hedged to USD]), Global Stock Market (MSCI All Country World IMI Index [net div.]). Sector returns are derived by Dimensional Fund Advisors LP using constituent data from the MSCI All Country World IMI Index. Returns for specific securities are sourced from the MSCI All Country World IMI Index using daily security returns. Securities without a GICS sector are excluded. Sectors are classified according to the GICS Industry Code. GICS was developed by and is the exclusive property of MSCI and S&P Dow Jones Indices LLC, a division of S&P Global. S&P data © 2024 S&P Dow Jones Indices LLC, a division of S&P Global. All rights reserved. Frank Russell Company is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes. MSCI data © MSCI 2024, all rights reserved. Bloomberg data provided by Bloomberg. Indices are not available for direct investment. Index performance does not reflect the expenses associated with the management of an actual portfolio. References to specific company securities should not be construed as a recommendation or investment advice. This information is intended for educational purposes only and should not be considered a recommendation to buy or sell a particular security.

Chart Data Sources / Disclosure Information: U.S. Bureau of Labor Statistics, retrieved from Federal Reserve Bank of St. Louis (FRED). Core CPI reflects the Consumer Price Index for All Urban Consumers: All Items Less Food and Energy in U.S. City Average. The contribution from Shelter is measured based on Consumer Price Index for All Urban Consumers: Shelter in U.S. City Average, which was rescaled to reflect the relative importance of the category reported on October 2023 (35%). The contribution from Services reflects Services, excluding Rent of Shelter, which was rescaled by importance (27.3%) Everything else reflects the cumulative contribution of all other items in the Core CPI basket. Core CPI: U.S. Bureau of Labor Statistics, Consumer Price Index for All Urban Consumers: All Items Less Food and Energy in U.S. City Average [CPILFESL], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/CPILFESL, Jan. 5, 2024. Shelter: U.S. Bureau of Labor Statistics, Consumer Price Index for All Urban Consumers: Shelter in U.S. City Average [CUSR0000SAH1], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/CUSR0000SAH1, Jan. 5, 2024. Services: U.S. Bureau of Labor Statistics, Consumer Price Index for All Urban Consumers: Services Less Rent of Shelter in U.S. City Average [CUSR0000SASL2RS], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/ CUSR0000SASL2RS, Jan. 6, 2024.

¹Study: Arnott, Robert D. and Shakernia, Omid, History Lessons: How 'Transitory' Is Inflation? (Nov. 18, 2022). Available at SSRN: https://ssrn.com/abstract=4305206. The 3-4 years is the median years it took for inflation to fall back to 3%.