Quarterly Edge Webinar: Q1 2024 Market Analysis

Daniel Dusina: Thank you for joining another edition of Blue Chip Partners’ Quarterly Edge. For those of you whom I have not spoken to in the past, my name is Daniel Dusina; I am the Chief Investment Officer here at Blue Chip Partners. The agenda for today is the same as usual. I will walk through what I view as three of the pertinent themes for the upcoming quarter. Given that this is the first quarter of 2024, my outlook can almost be interpreted as a 2024 outlook in general instead of just the first quarter. Just as in quarters past, we will look at one theme that relates to the overall domestic economy, what I view as pertinent points for the domestic equity market, and then finally, we'll talk a bit about fixed income to round things out.

Starting with the economy, I will give you a brief overview of the general thought process; from my seat, this year in the U.S. economy, I expect a general level of slowness to emerge. That doesn't mean we won't experience growth at all. Realistically, I think this is already broadly anticipated by investors and the Federal Reserve. Specifically, I'm citing a level of slowness in the US economy related to the labor market and a slower level of consumer spending.

In the equity market, 2023 was embodied by one of the narrowest markets from a return perspective that we have seen going back to 1998. The short answer is that we think equity returns will broaden in 2024. We believe the risk versus reward construct is skewed in favor of some of those left behind in last year's rally. Just as we touched on the previous quarter in the equity portion of the quarterly edge, in the slowdown phase of the economic cycle, if that does come to fruition as we are expecting, certain types of companies perform relatively better than others, and those types of companies just so happen to be those with very strong balance sheets and that are aggressively returning cash to shareholders. We think broadening out and those high-quality companies should work very well in 2024.

Finally, on the fixed income side of the equation, we continue to believe that the higher quality subset of the bond market offers a tremendous value proposition right now, even after a fairly stark rally in bonds over the final two months of 2023, you still have yields in the higher quality subset of the fixed income market that are above where they have been 70% of the time over the last 20 years. Realistically, the opportunity is still there, and for taking on a marginal amount more risk relative to a money market fund type exposure, you get attractive coupon payments and the benefit of potential price appreciation.

I will dive into the economy section first. Feel free to submit questions using the Q&A function in the GoTo Webinar app. I will address any questions at the end. In terms of why I'm anticipating a slower economic growth environment in 2024, this has much to do with the labor market. Looking back at the course of 2023, we were very encouraged by the fact that the supply and demand dynamics in the labor market got back into balance. Coming out of the pandemic, many corporations and small businesses were trying to fill jobs. They could not, resulting in individuals getting paid a significant amount more, which could stoke inflation, just as we saw.

Looking at 2023, we saw lower job openings and general slowness regarding the monthly jobs added to the economy. As a result of those fewer job openings and fewer people looking to hire, wage growth slowed down a little bit year after year. That is coming off a very aggressive period, that inflationary period. All of this is healthy and is bound to happen in an economic cycle. We want to ensure that we don't overshoot to the downside. You've heard talks of the Federal Reserve potentially becoming more stimulative in 2024; I think they are turning their focus from the inflation side of their mandate to the labor side.

Realistically, I believe that 2024 will be a year where the labor market is heavily in focus. If additional softness emerges on the job front, that will be somewhat problematic in stoking additional fuel for the economy going forward. If we get this kind of softness in the labor market, that impacts the consumer. Recently, if you look at the bulk of consumer spending that has exploded over the last two and a half years, much that has been driven by savings that were pent up above the traditional trajectory throughout the post-pandemic period and the stimulative actions provided by the government.

This chart shows that $2.1 trillion was accumulated over and above the typical savings trajectory in the U.S. So, that savings rate was far above average. Individuals accumulated extra dollars from around March 2020 through the middle of 2021. A lot of the spending over the last two years has been driven not necessarily by extra income but by a drawdown of those excess savings to about $1.7 trillion.

We find ourselves in a position where the consumers have drawn down all those accumulated excess savings. So, if there is going to be above-trend consumer spending growth, it has to come from extra income because those savings are getting very close to being depleted. In the back half of 2023, the income level was not outpacing spending, so individuals continued to draw on those excess savings. My assertion is if you have a slower labor market and individuals who have drawn down their savings and continue to spend above their income levels, that can only go on for so long.

We get higher incomes or a softer level of consumer spending; I see the latter as more likely. This doesn't mean that we're going to a collapse in spending. Consumer spending accounts for roughly 70% of U.S. GDP. Certainly, any movement in consumer spending will be meaningful from an overall economic growth standpoint. All indications point to a relatively softer level of consumer spending as we work through 2024, not a doomsday scenario. This section is titled “Slower, but not stagnant,” I think that is precisely what the economic data will show as it starts to roll in this year.

On the equity side of portfolios, 2023 was an incredibly narrow and top-heavy market. In an environment where the largest companies outperform a capitalization-weighted index like the S&P 500, which gives a higher allocation to the larger companies, that index will perform very well. The level of concentration we saw in performance last year was fairly historic. The chart on the bottom half of the screen shows the percentage of constituents in the S&P 500 index that outperformed that index in any calendar year back to 1990. The brown line indicates that roughly half of the companies in the S&P 500 outperform the index on the median, and the other half underperforms on a median year.

The number of companies that outperformed the S&P last year was roughly 28%, the lowest level of outperformers within the index since 1998. That's another way to think about how concentrated the returns were in the US equity market. To have the index up north of 20% and only have 30% of those companies driving a level of outperformance, more specifically, just seven companies drove returns. This was an absolute outlier and somewhat of an anomaly. It's not necessarily something we would view as indicative of a healthy market or something likely to continue.

We do still think selectivity is warranted. Those quality companies tend to perform best in an economic slowdown if it is as we predict. We see more of a broadening in returns in the equity market in 2024. Here are more numbers that indicate how historic and rare what we saw last year was. On the left side of the screen are the top ten holdings by weight within the S&P 500 index, their average weight throughout the year, the total return, and the contribution each of these companies made to the overall S&P 500 index’s return.

The companies highlighted in green are the Magnificent Seven. The data through December 20, 2023, is shown at the bottom. The average return for these top ten stocks was close to 80% due to the contribution of these top ten names, the largest weighted names having a high total return. Almost 65% of the return in the S&P 500 was driven by just seven names.

To have almost 15% of your portfolio in two names, which is essentially what would happen if your entire equity allocation was just the S&P 500 index, is not a risk that I would view as prudent for most individuals. In years like last year, when the most prominent companies dominate the market and perform well, it can work out very well for a portfolio. In years like 2022, being concentrated in stocks that could have been down 30% or more is very challenging for individuals. Even though stocks like Meta and Tesla were up monumentally last year, they were both down south of 60% in 2022. Realistically, 2023 was getting back above water, and they didn't even accomplish that.

If you look back to 1990, the outperformance for a capitalization-weighted S&P 500 versus an equal-weighted S&P 500, the latter gives an equal share to each company in the index; 17 out of 34 years, the cap-weighted index is outperformed. The equal-weighted is outperformed in 17 out of 34 years, a very even split. To have a return spread between the two of nearly 13%, meaning the S&P 500, a traditional cap-weighted index, outperformed the S&P 500 equal-weighted index by almost 13% last year, which is very much an outlier. You have to go all the way back to 1998 to find that level of outperformance for a cap-weighted S&P versus an equal-weighted S&P. We envision a broadening out of equity returns in 2024, and we specifically prefer those types of companies that perform best in the slowdown phase of the economic cycle.

Finally, on the fixed income side, we have been optimistic about the traditional high-quality fixed income subset over the last few quarters. We think the setup is all right from a macro perspective, with the Federal Reserve potentially becoming more stimulative, which certainly bodes well for bond prices—the last two months of 2023 indicated what is likely for the bond market if we get more assurance from the Federal Reserve regarding rate cuts and more stimulation. The question that we were getting through the end of last year and the first couple of weeks of 2024, due to how bond prices have moved and yields came down dramatically during the last two months of 2023, is, “Did I miss the boat? Am I too late?” I answer no because you are still getting paid in these high-quality fixed-income instruments; I'm talking about U.S. treasuries, investment-grade corporate bonds, and municipal bonds.

You're still getting paid a coupon level above where those securities have yielded 70% of the time over the last 20 years, and in the case of U.S. Treasury, 84% of the time in the previous 20 years. So you're still getting compensated at a well above-average rate. Suppose you get this environment where yields are starting to be pressured to the downside. In that case, you can also get price appreciation out of these securities as well because these securities become a lot more attractive if rates start to move down and you've already got higher rates locked in. To take money out of your equity exposure and shift it into fixed income is not necessarily what I'm recommending; I suggest that individuals start to consider paring back what have become relatively large money market exposures.

Money market funds can be great, especially when rates are as high as they have been. Looking back at November in the bond market, municipal bonds in the U.S. essentially gave you the entire year of money market return in just one month. Municipal bonds were up north of 6%. The value proposition from money market funds is stability and consistent income. You can get those elements from the traditional bond market subset, treasuries, investment-grade corporates, and municipal bonds. But you're also getting the benefit of potential price appreciation as well. It is more about paring back those money market allocations and taking advantage of these high yields available in high-quality instruments today. Remain optimistic on the traditional fixed income subset.

I'm going to take a look at the questions that have been submitted. The first question is, “How many interest rate reductions are priced into mid-long-term bonds?” I haven't looked at the numbers over the last two days because, strangely enough, our Bloomberg terminal malfunctioned the other day. At the end of last week, FEDFUNDS futures were pricing in seven rate cuts for 2024, which is not necessarily what the actual bond market is pricing in. The bond market, with a ten-year treasury of around 4.1%, does not imply seven rate cuts, but I think it is somewhere between zero and seven currently priced in by the FEDFUNDS futures. I don't think you have to get seven rate cuts for bonds to be attractive right now. Technically, you don't have to get any rate cuts for bonds to be attractive. A more realistic scenario, and where the bond market is right now, is closer to three rate cuts, potentially four, depending on how economic data develops over the next few months. I think that's a fair assessment. You are still getting value in bonds right now.

I would say this is a situation where bad economic news is good news for bonds. Bad economic news, whether it is bad manufacturing data, bad employment data, or anything of the sort, can be interpreted as generally bad news for the economy but good news for the bond market. If there is bad news for the economy, the Federal Reserve will likely have to be more stimulative, meaning lower yields and higher prices for existing bonds.

The next question is, “I think interest rate reduction expectations are built into homebuilder stocks. Will there be a time this year to get into builder stocks like D.R. Horton Toll Brothers, etcetera?” This is a challenging one because homebuilders had a fairly significant run.

What people are wrestling with right now is the fact that there are competing forces at play. Yes, the recent short-term focus has been challenging for the housing market based on where interest rates have been. At the same time, there is still a secular demand for homes from millennials, who are now the largest demographic in the U.S. but are historically underrepresented from a home ownership perspective. This secular demand is still there, but when does that start to come online? I think a big part of it for home builders is getting a bigger offering base because, historically, home builders haven't focused on building starter homes. They can make more money on that 2500 square foot house instead of the 15,000 square foot house; I think that is a big opportunity for home builders.

Regarding timing, I haven't done the valuation work on them specifically, but I would have a hard time believing that more than three or four rate cuts would be priced into home builders right now. Suppose you do get an expectation or indication of more significant economic deterioration than is currently expected. In that case, I think that could be a reasonable time to look at home builders. It sounds counterintuitive because you think the economy is slowing down, and people have less money to spend. Realistically, the individuals buying a home will probably have that money locked up in safe instruments. Therefore, some economic deterioration might not make a massive difference for them. It's tough to say because we don't follow the home builders that closely because they don't screen great from a quality perspective, given some of the dynamics within their business. I think there could be a time this year when you get a good entry point on them, especially if people overreact to potentially hotter economic data.

Those are all of the questions I'm seeing. I'll give you all one last chance to fire anything in before I give you a few minutes back here.

I'm not seeing any more questions, so I will take this time to round things out. Thank you for attending another edition of the Blue Chip Partners Quarterly Edge. Be sure to follow us on LinkedIn and stay up to date with our website via our blog for all the most recent happenings at Blue Chip and perspectives on the market and financial planning. You can also download a full copy of my quarterly outlook, the topics we covered in the Quarterly Edge today, through the website in the resources section and click on the blog. Thank you again for joining; I will talk to you again soon.