Buckhead Capital – Quarterly Commentary for Fourth Quarter 2023

Highlights

  • Following weakness in October, the S&P 500 returned 11.7% for the fourth quarter.
  • Seven companies accounted for more than 60% of the S&P 500’s 26.3% return in 2023.
  • Small-cap and value stocks outperformed growth and large-cap stocks in the quarter.
  • Falling interest rates led to strong fixed income returns (e.g., the 10-year Treasury’s 6.9%).
  • Core inflation, as measured by the Fed’s preferred index, moved towards the 2% target.
  • Following its December meeting, the Fed indicated that it was finished raising rates.

Equities

Investors’ growing confidence that the Federal Reserve was finished raising rates and would begin cutting them soon led to an impressive gain in both stocks and bonds in the fourth quarter. After beginning the quarter with a loss of 4% through October 27, the S&P 500 rose steadily for the rest of the quarter. Boosted by a significant shift in the Fed’s outlook early in December, the S&P 500 gained almost 16% through the end of the year, bringing its total return for the quarter to 11.7% and accounting for over half of 2023’s 26.3% return. (Unless otherwise indicated, all returns are total returns, including both price changes and any dividends paid.) 

Consistent with the equal weighted index’s outperformance in the fourth quarter, small-cap and value stocks also delivered better results than large-cap and growth stocks. Small-caps provided most of their year’s return in the fourth quarter, outperforming large caps by 3.4%, but trailing large caps by 17% for the year. Similarly, value stocks outperformed growth stocks by 3.5% in the quarter but lagged growth by 7.8% for the full year. The dominance of the so-called “Magnificent Seven” (Apple, Microsoft, Nvidia, Amazon, Tesla, META, Alphabet) faded in the fourth quarter. However, for all of 2023, those stocks averaged an 111% return and provided approximately 62% of the S&P 500’s total return. Not surprisingly, the return of the other 493 stocks in the index was only 9.9%, while the equal-weighted S&P 500 index trailed the market-cap weighted index by 12.5% in 2023. 

Every sector other than Energy contributed to the equity market’s strong returns in the fourth quarter. The strongest returns came from the Real Estate, Information Technology, and Financial sectors, while the Health Care and Consumer Staples sectors posted good, but relatively weak, returns. For the full year, the greatest returns came from the Information Technology and Communications Services sectors, up 61% and 56%, respectively. (Over the last two years, the Information Technology sector has gained 11.2% and the Communications sector has lost 8.0%.) In the fourth quarter of 2023, the Energy sector lost 6.9%, bringing its loss for the year to 1.3%, although in the last two years it has gained 41.4%. The three other poorest performing sectors in the quarter were Consumer Staples, Healthcare, and Utilities, with the last one also being the worst performing sector for the year. 

While “as-reported” earnings for the S&P 500 declined 12.7% in 2022, they are expected to increase only 12.0% in 2023. (“As-reported” earnings include all ‘non-recurring’ charges such as a write-off of an intangible asset.) Despite the impressive 2023 results, the S&P 500 has returned a total of only 3.4% over the last two years, with most of that being due to dividends. As a result of the higher price and lower earnings, valuation multiples have increased since the end of 2021. Based on the index’s as-reported earnings expected for 2023, the S&P 500’s Price/Earnings ratio stands at a daunting 24.7 

Fixed Income 

As investors grew convinced in the fourth quarter that the Federal Reserve would cut rates early and often in 2024, the Bloomberg Aggregate Index (the broadest measure of the fixed income market) returned 6.8%, bringing its 2023 return to 5.5%. The benchmark 10-year Treasury yield fell 72 basis points from the prior quarter to 3.9%, providing a total return of 6.9% for the fourth quarter.

However, over the course of 2023, the 10-year’s yield actually increased three basis points (0.03%), resulting in a return of only 3.2% for the year. Investment grade corporate bond yields declined for both the quarter and the year as risk premiums contracted. As a result, corporate bonds delivered stronger returns than Treasuries, returning 8.5% for both the fourth quarter and all of 2023. Below-investment-grade spreads contracted even more, leading to returns of 7.2% for the quarter and 13.4% for the year. 

The Federal Reserve’s preferred measure of inflation, the core Personal Consumption Expenditures (PCE) price index (excluding food and energy), increased 0.1% in the month of November and 3.2% for the trailing twelve months. This 12-month rate continued the downward trend seen since the beginning of 2023. More recently, December’s Consumer Price Index (CPI) rose 0.3% after coming in at 0.1% and 0.0% in the prior two months. Over the last year, that index has risen 3.4% (compared with a 3.1% annual increase through November) and 3.9% excluding food and energy. 

The easing in the PCE measure of inflation led the Federal Open Market Committee (FOMC) to leave the Fed Funds rate target range unchanged (5.25% – 5.50%) in December, just as it had in September. But, while the FOMC had forecast in September that one more rate hike was likely in 2023 and that rates were likely to be cut by 50 basis points in 2024, the committee indicated in December that it was probably finished hiking rates and that investors could expect it to cut 75 basis points in 2024. This shift in outlook was made even though financial conditions had loosened significantly (stock prices up and bond yields down) since September. When Chairman Powell seemed to accept the market’s view in his press conference following the meeting, both bonds and stocks rallied further into the end of the year. 

Market Environment 

The bond and stock markets delivered robust performance in the fourth quarter as investors grew convinced that the economy was achieving a “soft landing” and that the Federal Reserve would now focus on avoiding a recession. This change in focus marks the end of one of the most aggressive rate-tightening cycles in the Fed’s history. This cycle included 11 rate increases in just over a year, including four increases of 75 basis points and two of 50 basis points. This all came in response to a surge in inflation that turned out not to be so “transitory” and which peaked at 9.1% in June of 2022. 

2023’s equity market was the inverse of 2022. With a new-found love of all things AI (Artificial Intelligence), investors drove up the prices of the same mega-cap technology stocks they had spurned in 2022. With only modest gains in earnings and no meaningful fall in interest rates, the equity market’s return was driven primarily by an increase in valuation multiples. Given the moves in bond yields and equity prices towards the end of the year, it is tempting to ascribe the equity market’s performance to an actual or expected change in interest rates. 

But despite investors’ late-year focus on expected Fed rate cuts, it was not actual reductions that drove the market. Most risk-free yields ended the year close to where they began it or higher, with the 10-year Treasury yield essentially unchanged and the Fed Funds rate up 1.0%. In addition, should the FOMC’s own projection of rate cuts for 2024 prove accurate, the Fed Funds rate would still be higher than where it began 2023. Even if investors’ optimistic year-end expectation of six rate reductions in 2024 proves to be realistic, the rate at the end of the year would be exactly where it was in November of 2022. 

For now, the markets seem to be whistling past the graveyard. The bond market appears determined to ignore the $34 trillion (and growing) burden of Federal debt. Much of this debt needs to be refinanced in the near term and, as we saw in the third quarter, such issuance can lead to higher yields for all bonds. And while the rate of inflation for goods has declined substantially, services inflation remains stubbornly high. So the risk remains that it will be a more difficult path to 2.0% inflation than the market currently expects. 

Meanwhile, the equity market is not worrying about the effect of the higher interest rates on the economy, even though recent credit card data show clear signs of stress among lower- and middle-income consumers. Nor does the stock market seem to be discounting the increased geopolitical risk from wars in Ukraine and the Mideast, or the threat of conflict in Asia involving North Korea or China. Any kind of conflict over Taiwan, which supplies most of the semiconductor chips used by technology companies would not, to put it mildly, be good for equity markets. For now, as they have been conditioned to do since the real estate bust of 2007-2009, both the equity and fixed-income markets remain firmly fixed on anticipating the Federal Reserve’s next move. The Fed may indeed manage to keep the party going and we may well skate by all these challenges, but with valuation multiples close to record highs, there is little margin for error. 

Focusing on Long-Term Results 

These remain challenging times for all investors. Navigating the risks in this market environment requires consistent focus on long-term goals and an appropriate allocation of assets. At Buckhead Capital, we work hard to help our clients clarify and achieve their financial goals. We try to understand the lessons that markets have provided and to use that knowledge in structuring portfolios to preserve and grow our clients’ capital. We continue to emphasize achieving an appropriate return for the risk taken. We do this not only through asset allocation (the mix of stocks, bonds, and cash) but also through individual security selection, sector weightings, and, in fixed income, target portfolio maturities/durations. This attention to risk management has historically produced better risk-adjusted returns over full market cycles. We continue to believe that this market cycle will be no exception. 

Walter DuPre

Walter DuPre

Walter serves as an Advisor and Portfolio Manager on the firm’s Diversified Value, High Net Worth, and Value Equity investment teams. He joined Buckhead Capital in October 1996. Previously, he was the Managing Director of the Southern regional office of Prudential Capital Group, which was responsible for the management of a portfolio of $2.5 billion in private debt and equity securities. Walter received his B.A. in English and American Literature from Brown University and an MBA from Columbia University. He holds a CFA charter and is a member of both the CFA Institute and the CFA Society Atlanta.