19th Jan 2024 by Damian Barry, CFA

2023: Predictably Unpredictable

Reflection

We are pleased to share Damian Barry, Chief Investment Officer's, year end reflection piece.


At MASECO one of our mantras is that we don’t try to control the uncontrollable. In other words, we can’t control what the market will do from one year to the next, so we don’t second guess what the market will do each year. We focus on what we can control, and what we can control are portfolio risks by making strategic or long-term investment decisions. The challenge for some of our peers who make tactical shifts each year to their portfolios was evident in 2023. Most of the market pundits had predicted a recession in the US, and consequently many peers reduced portfolio risk at the worst possible time. In contrast our asset allocation decisions are more strategic or long term in nature and not influenced by the educated guesses of market pundits.

The main reason the pundits got 2023 so wrong was that they thought higher interest rates would slow the US economy down, but they failed to recognise that most borrowers didn’t have to pay higher rates because they had already locked in lower rates. In addition, US government spending was expansionary and boosted economic growth which admittedly is unusual when unemployment is so low. Lastly the US consumer is in rude health, due to excess savings following the pandemic, higher net wealth and low levels of unemployment.

Traditionally a higher interest rate environment is great for banking stocks. However, at the beginning of 2023 it looked like higher rates might cause a systemic banking crisis. The rise in long-term bond yields put critical pressure on banks which had taken too much duration risk — overloaded on long-term bonds whose price were negatively affected by the shift higher in rates. Silicon Valley Bank was the main casualty of a higher rate environment. However, a wider banking crisis was averted. The main explanation is the creditworthiness of their clients, as higher rates have not brought the expected wave of defaults. In addition, the Federal Reserve decided to lend to banks against the bonds that were burning a hole in their balance sheets which proved successful in mitigating against escalating risks.  Not many pundits were confident in the Fed’s ability to restore confidence.

For many investors, 2023 will go down as the year that generative artificial intelligence (AI) changed everything. Not since the debut of the iPhone has a single product fuelled such powerful hopes and desires for a new digital revolution. By the end of 2023, it had led to a race across the technology industry to bring generative AI from the research lab into everyday use, embedding it in many of the most widely used digital products and services. While the benefits of AI may ultimately extend to many companies, in 2023 only a small number of companies saw their share price benefit from all the AI exuberance. Specifically, seven mega cap US-based companies – Apple, Microsoft, Amazon, Google, Nvidia, Tesla, and Meta (Facebook) –dubbed the “Magnificent Seven” (not to be confused with the 1960s movie or 2016 remake) drove most of the equity market gains in 2023 and our model portfolios benefitted from having some exposure to these companies. Who would have predicted the market pariahs in 2022 would be the market darlings in 2023?



Source: Apollo

We don’t doubt that the Magnificent Seven are in the vanguard of an ostensible AI revolution, but we are reminded of what Benjamin Graham, the father of modern financial analysis once said, “a great company is not a great investment if you pay too much for the stock”. In Q4 2023 the average trailing price to earnings ratio of these stocks is approximately 45 times earnings which seems rich compared to the S&P 500 long-term average of 19 times earnings[1].

It is fair to say the earnings of the Magnificent Seven in aggregate have outpaced those of the broader market. However, their massive valuation premium versus the aggregate market makes the group increasingly vulnerable to earnings disappointments. Moreover, the group’s already large size (these seven companies now account for approximately 30% weight in the S&P 500) making it ever more difficult to continue to strongly outgrow the economy. We acknowledge that these companies are not without exogenous risks. In December 2023, the FT reported that the New York Times (NYT) filed a lawsuit against AI companies, alleging that the companies used millions of copyrighted NYT articles to train their AI models. With hindsight 2023 was the year to have all your eggs in the AI basket but clearly this isn’t a longer-term strategy to managing portfolio risk effectively which is why our model portfolios are more diversified.

In 2023 we were encouraged to see equity and bond markets rebound after a challenging market environment in 2022. Almost nobody predicted the extent of the rebound. In contrast to 2021 and 2022, model portfolio tilts to cheaper or smaller companies were not rewarded in US markets last year. However, similar tilts in international and notably emerging markets performed exceptionally well. In the fixed income portion of portfolios, we made some strategic changes due to interest rates rising to the highest level in over 20 years[2]. We increased our sensitivity to interest rates falling which helped performance most notably in Q4 2023, but the goal is minimising longer term portfolio volatility.

After a 22% rally in global equity markets last year investors are understandably nervous about where markets go from here but they must remember the same market was down 18% in 2022. Geopolitical and political risks are ever present, and the market impacts are as unpredictable as ever. Can the Magnificent Seven leadership continue to drive the equity market higher? 72% of the stocks in the S&P500 have underperformed the index in 2023. This is the highest percentage of S&P 500 components underperforming the index since 1980. Even at the peak of the dot-com bubble, this metric did not break above 70%[3]. In the coming years the important question may well be whether you are invested in the right areas of the market rather than owning the market (eg S&P500 Index ETF) if the market rally broadens. On a similar vein in Q4 2023 we saw US smaller company values surge – contrary to consensus views on smaller companies. If 100 years of history is a useful reference point than smaller companies at current valuations represent one of the most exciting investment opportunities over the coming years. We are confident that our model portfolios will continue to perform well but we humbly admit we have no ability to predict when.

It seems fitting to leave the last word with a titan of the investment world, Charlie Munger of Berkshire Hathaway, who sadly passed away in 2023: ‘The big money is not in the buying and selling but in the waiting’.  We know that if you tried to trade the S&P 500 over the past 20 years and missed the 20 best days you would have turned a 9.8% return per year into 2.9% a year, giving up almost all your profits.  That is because the best days in markets come right after the worst ones, and it is impossible to get them right.

We hope this new year brings health and happiness. As ever we encourage you to reach out to your wealth manager if you have any questions on performance or the outlook for markets.

Sources

[1] Extreme Concentration in S&P 500 Returns - Apollo Academy
[2] https://fred.stlouisfed.org/series/FEDFUNDS
[3] https://apolloacademy.com/p-e-ratio-for-sp7-vs-sp493/
https://www.valuescopeinc.com/resources/white-papers/the-sp-500-pe-ratio-a-historical-perspective/#:~:text=During%20the%20last%20fifteen%20years,the%20average%20of%2019.4x.
https://www.pionline.com/interactive/magnificent-seven-has-market-topping-performance
https://am.jpmorgan.com/us/en/asset-management/adv/insights/retirement-insights/guide-to-retirement/guide-to-retirement-slides/guide-to-retirement-investing/gtr-impact/

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