Another year is in the books, with results exceeding most forecasters' expectations, and again, patient investors were rewarded.  The anticipated recession never happened, and the U.S. economy continued its strong growth despite the Federal Reserve’s rapid increase in interest rates that were initiated in March 2022, adding another 1% to the Fed Funds in 2023, topping out in July at an upper target of 5.5%. In the face of higher rates, our dynamic economy is poised to conclude the year with an estimated 2.4% GDP growth.  Despite October's volatility clouding the prospects of a traditional Santa Claus rally, a retreat of interest rates and a convergence of economic data fueled a rally of the major equity markets in the last two months of the year, with the large-cap S&P 500® index closing 2023 with an impressive 26.29% return, surpassing global and small-cap counterparts, as the Russell 2000® index returned 16.93%.

Looking back, as 2023 began, pessimism was pervasive.  The Federal Reserve's rapid rate increase aimed to curb inflation, which exceeded 5.0% in September 2022 by their preferred measure, the U.S. Core Personal Consumption Expenditure Price Index (Core PCE).  The S&P 500® closed 2022 with a -18.11% return, consumer sentiment was historically low, and small business optimism was on a downward trend. These factors contributed to a forward price-to-earnings ratio (P/E) of 17.6 times  (17.6x), dropping from 20.86x a year earlier, indicating broad anticipation of a recession in 2023.

As 2024 begins, there seems to be broad optimism that the Fed can navigate the economy through a “soft landing” where growth and inflation moderate without dipping into a recession while keeping employment relatively stable.   In support of this, the most recent minutes from their December meeting indicate a likely scenario of “higher for longer,” though also a bias towards lower rates as inflation is moderating. Employment data continues to be historically strong, the Core PCE continues to moderate and is currently 3.2%, financial conditions appear to be easing, and Artificial Intelligence (AI) is seen proliferating throughout the economy, driving innovation and improved productivity, which should benefit corporate profits, the ultimate driver of stock returns. 

Given these factors, the S&P 500® forward P/E starts the year at 19.7 times (19.7x) next year's forecasted earnings. While lower than the 22x peak in the post-pandemic euphoria of 2020, it marks the highest valuation since 2001-2002. A significant driver of this valuation increase is the leadership of mega-cap tech companies, often referred to as the Magnificent Seven. These companies gained 107% in the past year, constituting approximately 28% of the total S&P 500® index, with a forward P/E of 27.5x to begin the year.

In our previous commentary, we noted parallels with the Dot-com Bubble of 2000 and the Nifty Fifty period of 1972. However, today's top names exhibit greater profitability and cash flows than their counterparts from those earlier periods.  Yet, similarities with the peak of 1972 emerge. Household names like IBM, Exxon, GM, Sears Roebuck, and General Electric dominated then, comprising around 34% of the total index with a trailing P/E of about 42x. Today's top 10 companies make up 32% of the index (having recently peaked at 34%), with an average trailing P/E of 63x. The market's historical pattern suggests that a broadening ultimately occurs when such a narrow group of companies is favored. Rapid growth is challenging for large companies to maintain, leading to expanded opportunities and improved performance for companies outside this favored group, including smaller companies.

As we begin the new year, many anticipate a Goldilocks scenario. Inflation is moderating to the Fed's target, and employment data indicates a more balanced supply and demand reminiscent of pre-pandemic normalcy, and declining mortgage rates, along with improved approvals from October lows, are observed. The ISM Services PMI® Index suggests moderate growth in the services sector, and the ISM Manufacturing PMI® Index, although below 50, appears to have bottomed and is recently trending higher. All these factors underpin expectations for corporate profits to continue growing in 2024 - the ultimate driver of equity returns. Additionally, consumer sentiment is on a solid upward trend as the reality of lower inflation and economic strength becomes more evident.

As the old adage goes, the market climbs “A Wall of Worry,” and today, it includes an overstretched consumer, geopolitical risks, China’s softening, delayed impacts from interest rate rises, and a possible contentious U.S. election.

Against this backdrop, we remain vigilant, closely monitoring indicators that may influence the direction of the economy and markets. Our portfolios are carefully balanced with offensive and defensive holdings, and we are actively seeking to capitalize on the opportunities a potentially broadening market presents. Our investment approach always focuses on companies with solid fundamentals over time and reasonable valuations.

We are grateful for the trust and confidence you place in us. Should you have any questions or if there is anything we can assist you with, please do not hesitate to reach out.  Your satisfaction is our top priority, and we look forward to continuing to serve you.

Sincerely,

Peter J. Connors, CFA

President

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