Our View

The investment outlook is cautiously optimistic, focusing on moderate growth, declining inflation, and the importance of diversification in a dynamically evolving global economy.

Key Themes

Waning inflation and evolving monetary policy: Inflation expectations have fallen sharply, and the Fed’s battle with inflation appears to be in the rearview mirror

Overbought stock market: Sentiment is increasingly bullish, leaving valuations stretched

Artificial intelligence: AI fervor remains in the limelight

Abysmal market breadth: Concentrated returns make the rally less durable as seven names in the S&P 500 are responsible for 94% of the performance in the S&P 500

Diversification: Investors are prone to a myriad of behavioral biases (e.g., recency bias, familiarity bias, home country bias) thwarting them from maintaining a well-diversified risk-appropriate portfolio

Dislocated markets present new opportunities: A historic rise in global bond yields has reconfigured the investing landscape, leaving investors with more choices in crafting their financial plans.

How to Invest

Cautiously optimistic

Our base view is that the stock market will reach new highs, and several factors will drive the next leg of this bull market. The widely anticipated U.S. recession hasn't happened yet; growth across advanced economies has proven surprisingly resilient; inflation is retreating from multi-decade highs, driving interest rates lower; and the risk of central banks spoiling the party is waning. In 2024, we should see a return to profitability from US corporations, and the market may grow into the current valuations. Other tailwinds that could propel the market higher are the continued potential from artificial intelligence and the fervor around it, as well as investors piling back into the stock market to avoid missing out, which may lead to a euphoric melt-up. For those reasons, we don't want our clients on the sidelines.

But we are emphasizing cautious optimism as several risks remain front and center. We can't brush away the risks investors continue to pile into the stock market to avoid the fear of missing out, and based on past investor behavior, this could lead to a euphoric stock market rally over the next six to 12 months. Unfortunately, these parties usually don't end well. After everyone has had their share of the Kool-Aid, most leave with a stomach ache. Furthermore, the S&P 500 trading at around 19 times forward earnings implies the following optimistic assumptions are already priced into stocks as investors approach the new year:

The Fed is expected to cut rates as early as March for a total of six times in 2024.
Earnings growth is supposed to surge past long-term averages.
Inflation is expected to decline back to the Fed’s target.
An economic soft landing is all but assumed and
Politics won’t cause any additional volatility.

This is a pretty optimistic Christmas "wish list" from investors. So, while it's possible all that does happen and stocks continue to move higher throughout 2024, we think it's important to be wary of complacency in the markets because a lot of positive resolution is assumed by investors, but as we all know, things can go wrong! On the same token, rising real interest rates could harm borrowers, slow growth, and should lead to lower multiples.

These risks argue for a slightly defensive approach heading into 2024.

Stay diversified

“Diversification is one of the most fundamental and important ideas in modern finance. It’s also a practical result of how markets work.” - Cliff Asness, Antti Ilmanen, and Dan Villalon (International Diversification)

Investors can't escape risk; they can only select which risks to take. The fundamental principle of investing, which asserts that past performance doesn't guarantee future returns, remains perpetually valid. Many investors fall prey to behavioral biases, gravitating towards recent or desired outcomes, while neglecting to scrutinize how these past returns were achieved. This lack of scrutiny leaves them exposed when the tide inevitably turns, as history has repeatedly shown. International assets outperformed U.S. assets in the '70s and '80s, with Japanese stocks eclipsing U.S. and other global markets. This led to over 30 years of underperformance for Japanese stocks, with an annual return of just 0.9% from January 1990 to May 2023. This set the stage for U.S. equities to dominate in the '90s, the emergence of a technology bubble, and the outperformance of emerging markets in the 2000s. Now, we're witnessing a similar trend, with U.S. stocks outperforming.

Extended bear markets can inflict more harm on wealth than short-term volatility, especially for investors in the distribution phase of their investment life cycle. While various factors may influence short-term performance, valuations are a critical predictor of long-term returns. The S&P 500 trades at above-average valuations on a price-to-earnings basis, while U.S. mid-cap and small-cap stocks (as well as European, emerging market, and Chinese stocks) all trade at a substantial discount.

In addition, the largest U.S. companies are responsible for almost all of the positive returns in the U.S. stock market in 2023. When few companies participate in the rally, that means market breadth is narrow, and the durability of the rally may be tested, or the remaining names in the index may play catch up. In instances when the top 100 companies in the U.S. stock market make up more than 70% of the total index, this may be a harbinger for subsequent underperformance of the largest companies, and small-cap stocks usually outperform in the 12 months following concentrated returns by an average of 9%.

The key takeaway is to consider diversifying beyond the largest U.S. equity names to mitigate the risk of prolonged bear markets in specific asset classes or countries.

Take the low-hanging fruit

After experiencing the longest and deepest drawdown in 10-year Treasury Bonds: a 22.9% loss over 39 months (10/31/2023) 😱. Bonds now offer some of the best risk-adjusted returns among all asset classes. Ultimately, the thing to keep in mind is that the higher-rate regime gives you more options in crafting your goals-based financial plans. If you aim to limit the potential downside for your wealth and reduce the range of possible outcomes, swapping equity exposure for bond exposure could make sense. But if you aim to capture a significant degree of potential upside, you’ll likely want to hold on to your equities.

At the Crossroads

As we embark on the investment journey of 2024, we stand at a unique crossroads marked by both opportunity and caution. This year promises to be a chess game where strategic moves, grounded in a keen understanding of the evolving economic landscape, will define success. Embracing diversification not just as a strategy but as a philosophy and balancing the allure of bullish markets with the wisdom of defensive play will be key. For most, the best move may be to keep their strategic asset allocations and look forward to the stronger forward-looking returns that we expect.

2024 Investment Outlook