2024 Outlook Letter
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Business Update
2023 was a transformative year for Evolve Investing. Below are some highlights:
Our assets under management increased by 119% compared to the end of 2022.
We helped our clients deploy several million dollars into private companies and venture capital funds.
I attained the Certified Exit Planning Advisor (CEPA®) credential, to help my clients exit the businesses they’ve worked so hard to build in the most tax-efficient manner possible.
We enhanced our fixed income trading capabilities by adding single-name investment grade and high yield corporate bonds, government bonds, and municipal bonds to our platform.
We started working with several new households with respect to both Investment Management and Financial Planning.
As we enter a new year, I remain focused on serving all of my clients as best as possible. To that end, I've enrolled in Yale School of Management's program to obtain the Certified Private Wealth Advisor® (CPWA) certification. This advanced program is focused on the unique challenges faced by high-net-worth households, such as charitable giving, asset protection, estate planning, and wealth transfer.
As always, my goal is to help you grow your wealth, manage your cash flow and liquidity, minimize taxes, and tackle your most pressing problems. You’re welcome to reach out to me directly anytime to discuss your financial plan and your investments.
Reflections on 2023
I entered 2023 with a generally cautious outlook. At the time, I anticipated a mild recession, and was generally positioning my portfolios defensively, with lower technology sector exposure relative to major benchmarks given my expectation for persistently high interest rates. There were several market and economic developments that surprised me in 2023:
1) There Was No Recession. At this time last year, 70% of economists surveyed by Bloomberg and 63% of economists surveyed by the Wall Street Journal anticipated a recession in 2023. The major surprise to these expectations, in my view, was the resilience of the U.S. consumer. Consumer spending accounts for roughly 70% of economic output in the U.S., and given the strength of household balance sheets, personal consumption expenditures generally exceeded estimates in 2023.
Year Over Year Growth in Real Personal Consumption Expenditures
2) The Magnificent 7 Dominated the Market's Gains. In early 2023, I was cautious regarding more interest rate-sensitive parts of the equity market, including higher-growth technology stocks. Starting in early 2023 a small basket of megacap technology stocks including Tesla (TSLA), Nvidia (NVDA), Meta Platforms (META), Apple (AAPL), Microsoft (MSFT), Alphabet (GOOGL), and Amazon (AMZN) outperformed significantly. In fact, on a market capitalization weighted basis these stocks contributed roughly two thirds of 2023’s total return for the S&P 500.
My strategies included positions in Tesla (TSLA), Apple (AAPL), Microsoft (MSFT), Alphabet (GOOGL), and Amazon (AMZN), albeit underweight the sector relative to the overall market. As noted in last quarter’s letter, while the outperformance in the Magnificent 7 was justified to an extent by earnings growth, I was surprised to see the market shrug off several major risk factors affecting these companies.
3) The Fed's Tightening Campaign Ended. Throughout 2023, investors were hoping for the Federal Reserve to shift to a more dovish stance, and to a potential end to their cycle of increasing interest rates. As recently as September, Fed Chair Jerome Powell reiterated that rates would remain higher for longer, which sent equities into a two-month tailspin as expectations for a near-term bullish policy shift were dashed.
Then in December, the Fed pivoted, as officials suggested that its historic policy-tightening campaign would end. Equities rallied into year-end as the markets priced in a series of near-term rate cuts. For many market participants, the Fed’s shift in posture came as a surprise, and several economists questioned whether it was premature.
Outlook for 2024
For 2024, I believe that the direction of risk assets will be largely driven by the actions of the Federal Reserve and how those actions compare to investor expectations.
As I consider the what expectations are priced into markets today, I'm focused on 30-Day Fed Funds futures pricing data. Based on these data, traders are currently pricing in six to seven quarter-point rate cuts for this year, which is roughly double what the Federal Reserve projects. The first rate cut is expected in March 2024.
Taking into consideration these market-implied expectations as well as the recent rally in equities, my sense is that the consensus view is that the Fed will be able to take rates down sharply while avoiding a hard landing for the economy.
It's tempting to fully buy into that consensus view, as it is a scenario that would be supportive for stocks and other risk assets, for economic growth, and for business expansion. And if I fully bought into that narrative, it would be tempting to increase risk across my portfolios by increasing my allocation to equities and other higher-risk assets.
However, my sense is that the market’s current expectation for continued strong economic growth and 6-7 near-term rate cuts is likely to be wrong. These outcomes don’t occur in a vacuum, and I anticipate that steady on trend economic growth would limit the Fed’s ability to implement the three rate cuts it currently forecasts, much less the 6-7 rate cuts the market forecasts. In order for the Fed to cut rates at the trajectory that is currently priced in, we’d have to see a significant economic slowdown.
Moreover, my sense is that in light of the 4Q23 rally, stocks are pricing in very little room for error. As shown in the graph below, the S&P 500’s current forward price/earnings ratio is around 22x, compared to about 17x at this time last year, and near the high end of its range over the last 10 years.
S&P 500 Price to Earnings Ratio and Forward Price to Earnings Ratio
Given these full valuations, I don’t anticipate significant multiple expansion to drive stock market gains this year. Instead, we’ll look to corporate earnings – the denominator of the P/E ratio – to drive stocks.
For the full year, analysts are projecting earnings growth of 11.8% y/y and revenue growth of 5.5% y/y, suggesting an expansion in profit margins. With overall economic growth expected to decline to a below-trend level in 2024, these earnings estimates may be vulnerable to downgrades.
When comparing stocks to other assets, I still find fixed income assets including high yield bonds to be compelling. Over the last year, the spread between the effective yield on BB rated bonds and the earnings yield on the S&P 500 increased by over 100bp, or 1%, to the widest it’s been in over 10 years.
BB-Rated Bond Effective Yield vs. S&P 500 Earnings Yield
How We’re Positioning
Last quarter I shared that most of my managed portfolios carried below average risk, with a lower proportion of equities and a higher proportion of fixed income investments including senior secured loans and corporate bonds.
Relative to last quarter, we did see a shift in Fed policy to a more dovish stance, and accordingly I’ve rebalanced several portfolios, where appropriate, to an average baseline level of risk.
Nonetheless, my sense is that equities are currently pricing in an ideal scenario of ongoing rate cuts and steady economic growth; a scenario which is highly unlikely in my view. I also continue to find fixed income securities to be compelling on a risk/reward basis compared to equities.
Therefore, my approach continues to be more balanced with respect to portfolio construction. I continue to view floating rate loans, higher-quality corporate bonds, and short-duration U.S. government securities as core portfolio holdings for the majority of my clients.
Please reach out anytime to discuss any of the above themes and how your portfolio is positioned. Thank you for your continued support and confidence in Evolve Investing.
Best,
Peter Hughes, CFA, CEPA®