Financial markets rallied sharply in the fourth quarter, as both the equity and bond markets responded to the continued decline in inflation. The Fed’s favorite inflation barometer, the personal consumption expenditures price index (PCE), rose a scant 2.6% sequentially in November, after rising 2.9% in October, and 3.4% in September. Excluding the more volatile food and energy components, the PCE index increased 3.2% from the level of November 2022. Clearly, inflation is receding, and the deceleration has given the Fed compelling evidence that has allowed it to signal an end to rising interest rates, with lower rates strongly implied in 2024. Whether it will be three reductions, as indicated by the FOMC’s “dot plots,” or six, per the futures markets, or something else, remains to be seen.
The welcomed inflation data has been accompanied by surprisingly strong growth in consumer spending, as the National Retail Federation expects holiday spending to rise between 3% and 4% year-over-year. And, while the job market has cooled from the torrid pace of 2022 and early 2023, gains in employment remain strong, averaging 225,000 jobs added per month in 2023, which would suggest that wage growth and retail sales gains will also remain robust.
There is some concern that the hoped for “soft landing”, in which the economy slows to a consensus of 1.4% growth in 2024, actually culminates in a recession. This concern is prompted by some persistently negative leading indicators of economic activity, such as an inverted yield curve and a contracting money supply. The yield curve, negatively sloped since April of 2022, still worries forecasters, even though medium- and longer-term interest rates have dropped sharply:
Usually, a downturn commences within two years from the date of the inversion of the curve, defined as a negative spread between the yield on 10-year vs. 2-year Treasury's. Based on the date the curve inverted, a recession would be expected no later than April of 2024. Yet, as Ed Yardeni of Yardeni Research has pointed out, the US actually met the technical definition of a recession in the first two quarters of 2022, with declines in GDP of 1.6% in the first quarter, and 0.9% in the second quarter.
Yardeni also dismisses the sharp recent decline in M2, a broad measure of the money supply, as a return to trend growth after the explosion of monetary growth from early 2020 through year end 2021. So, while these and other leading indicators bear watching, they are somewhat ambiguous now in terms of their predictive value.
Perhaps more encouraging to investors is the improved breadth of the stock market’s advance in the fourth quarter. For most of 2023, the advance in the averages was almost entirely due to the “magnificent seven” *, which dominated the market capitalization weighted S&P 500 Index. Until October, the other 493 less magnificent stocks in the S&P 500 had virtually no gain. In fact, this disparity can be seen by comparing the S&P 500 itself to the equal weighted S&P 500, which lagged the capitalization weighted index by a whopping 12%.
At this writing, the “magnificent seven” accounts for 30% by market value of the total S&P 500 index. Since 1990, the only period we can point to that is analogous to 2023 is 1998, when a handful of mega cap stocks dominated the index. We were curious as to what stocks comprised the “magnificent seven” of 1998:
Starting with GE and ending with Proctor and Gamble, the “magnificent seven” of 1998 (with the notable exception of Microsoft) did not do very well in the following 26 years. As Warren Buffett has said, “You pay a high price for a cheery consensus”. While we are not passing judgment on the investment merits of today’s “magnificent seven”, we note that in the fourth quarter the performance of the equal weighted S&P 500 actually edged out that of the traditional index for the first time in quite a while. This suggests to us that investing in a broader list of high-quality dividend paying stocks will be rewarding again.
Wishing you a healthy, happy and prosperous New Year, I am,