A year ago, we had a fairly pessimistic outlook on the economy and capital markets. The prospects and implications of inflation, rising interest rates, reckless fiscal policy globally, high stock market valuations, and increasing tensions around the world all seemed to pose significant head winds for future growth and investment gains. We were somewhat wrong of course. Much of what we anticipated came to pass and there was a lot to be concerned about last year, but the economy still hasn’t entered a formal recession and stocks, bonds, and alternative investments all had solid years. At the risk of once again looking foolish, we’re still not jumping for joy.
It is important to note that we don’t change portfolio strategy based on our short-term views of the economy and capital markets. Last year is a good reason why. No one can time the market and forecasts of economic growth are notoriously wrong, worse than coin flipping according to some studies. Rather, we rely on long-term data to build long-term portfolios that should provide market-beating returns with acceptable levels of risk over multi-year periods. That said, we are frequently asked what we think about the state of the world, at least as relates to financial matters, so here are our thoughts for the coming year.
It may lack credibility at this point, but our outlook for 2024 is similar to what we thought going into 2023. We still see potential for financial, economic, and political unpleasantness that could roil portfolios.
The much-anticipated recession of the past couple years has not materialized, but the warning signs are still there. The yield curve remains inverted. Historically that has been almost a flawless predictor of coming recessions in the U.S. Is it different this time? Maybe. But it would not be surprising to see an economic slowdown, if not an outright recession before long. Many of the economic data releases show seemingly positive headline numbers, but if you scratch beneath the surface, the news often isn’t so good. For example, the unemployment and job creation numbers have looked solid lately. However, when you look at the quality of the jobs created, you see that many of them are part-time jobs for low wages. This means that people are taking second or third jobs to keep up with the rising cost of living. That is far less rosy than new full-time jobs with a healthy labor participation rate. There has also been a new wave of layoff announcements in the past couple of weeks from the large technology companies. They have been the stalwarts of growth in recent years, but it seems even they may see dark clouds on the horizon.
Speaking of the rising cost of living, the Fed and other government entities have all but declared victory in the fight against inflation. While it is true that inflation has come down quite a bit from the 9.1% rate it hit last July, it is still running almost twice as high as the Fed’s target. That doesn’t sound like victory to us. We’re also concerned about historical precedent. In the 1970s inflation rose to 5% early in the decade, receded to 2.7% in 1972, then spiked to over 12% in late 1974. It fell again to 4.9% in 1976, but reached an astronomical 14.7% in 1980. Even over fairly short periods, inflation can ebb and flow. Governments globally, and particularly in the US continue to print money and run large budget deficits. Those practices are inflationary, and the Fed often can’t contain inflation by itself. If one arm of government is trying to rein things in while the other still has its foot on the accelerator, it makes the job much harder. We would not be surprised to see inflation rise again in the relatively near term, and we believe that may be the new normal as longer-term demographic trends shift. Population is declining in much of the world, which will ultimately mean fewer workers supporting relatively more retirees. Retirees consume and workers produce. If there is more demand than supply, inflation rises.
Rising inflation also likely means rising interest rates. Yes, the Fed is talking about cutting rates this year, but longer-term rates are set by the markets, not the Fed. The 10-year Treasury rate has moved quite a bit higher the past 2-3 years, and it is not unreasonable to assume it will keep climbing for some time. Historically interest rates have moved in 25–40-year cycles. It seems clear that the last cycle ended in 2020 when the yield was only 0.50%. A new rising interest rate environment for the next couple decades could significantly change the way our economy functions. Businesses won’t be able to borrow at the same low rates they have enjoyed for years, which means lower profitability. That likely means lower valuations for stocks. Mortgage rates may not ever return to the 3% we grew accustomed to, which raises the cost of living for individuals and families. All of that results in a slower growing economy and will likely put pressure on stock market valuations.
Then, there is the election elephant in the room. The nation is historically divided and the two front runners for President bring a lot of baggage with them. Primary season is just heating up, so maybe there will be a surprise before the general election, but if we have another Trump vs. Biden choice, it seems likely the shenanigans will be unprecedented. That creates a lot of uncertainty, which is never good for the stock market. In fact, if you remember in 2016 when it was announced that Trump won the election, the stock market futures were down more than 1,000 points over night. Once the market opened, stocks reversed course and gained 800 points. This election is poised to be even more bitter and partisan, so extreme stock market volatility is a strong possibility.
All of this sets up an interesting backdrop but what makes it worse is the fact that the overall US stock market is still trading at a historically high valuation. There are a number of ways to look at valuation, including the price-to-earnings ratio, the CAPE ratio, price-to-sales, etc. Regardless of the metric used, the S&P 500 looks frothy. The S&P is dominated by large-cap growth stocks, predominantly technology companies. Those stocks, which the financial media now calls the Magnificent 7 (Apple, Google, Microsoft, Amazon, Meta, Tesla, and Nvidia), seemed overvalued a year ago, but continued to move higher. It is possible that will recur this year, but the odds are increasingly slim. I think back to the 1990s during the Dot Com Boom. The market, also dominated by tech stocks then, looked expensive in 1996, but it continued to move higher until 2000 when it ultimately came crashing down. We may not see the same dramatic end to this tech stock rally, but there are signs that the market will at least rotate away from the most expensive stocks, particularly as their growth slows.
In fact, if you strip out the Magnificent 7, much of the stock market appears reasonably priced. Value stocks, smaller-cap stocks, and international stocks all trade at historically low valuations. Many of these stocks don’t look great when viewed in the rearview mirror, but looking forward, it would not be surprising to see a recurrence of the 2000s when large growth companies lost money every year on average for a decade while other sectors performed quite well. We expect diversification will continue to matter again, and if we’re right about economic softness and election nuttiness in 2024, a stock market rotation may not be far off.
We hate to be the bearers of bad news, but it is hard to be overly optimistic in the current environment. Throw in other non-economic issues like our open borders, the war in Ukraine, and tensions in the Middle East, and we have the makings of a tough road ahead. That doesn’t mean it will erupt into a full-scale 2008 type of financial crisis, nor warrant any changes to our long-term investment strategy, but investors should brace for the possibility of a wild ride ahead.