Both stock and bond markets rallied strongly the last two months at year-end. Even the beaten down small and mid-sized companies finally rallied, too (though they remain well below their all-time highs). Inflation is retreating, and the Federal Reserve has indicated that they will most likely begin cutting the federal funds rate in 2024. Regardless of whether we’ve turned a corner, it seems safe to say that the rate-hiking by the Fed is over.

You and I are following consistent principles while working towards our financial goals. It’s that time of year to recall why we do this and how we’re doing it.

Why We Follow Principles

  • We do not believe the economy can be forecast with much precision. A year ago, nearly every economic expert was calling for a recession in 2023. But the recession never came. Even the Federal Reserve, with over 400 Ph.D. economists on staff, was embarrassingly mistaken on its forecast of “transitory” inflation.
  • Likewise, investment markets cannot be consistently timed. We’re therefore convinced that the most reliable way to capture the long-term return of stocks (over 10% annually) is to stay invested at all times. Stocks have outperformed bonds and cash by a wide margin, especially net of inflation, which has averaged around 3% over long periods of time.
  • Stock ownership is the only asset class that truly captures the upside of human ingenuity and creativity. We know that the engine of wealth building in stocks is the compounding effect. We must never unnecessarily interrupt the compounding by trying to time markets.
  • Individual investors historically have underperformed their own investments because they oftentimes react to current events and make ill-timed investment decisions. Reacting most likely means that our emotions are involved. Unless our goals have changed, there is probably no reason to make significant changes to our investments. As my long-term mentor, Nick Murray, says, “Stocks are returned to their rightful owners during bear markets.” Please remember that for every pessimist/seller, there is an optimist/buyer purchasing that stock being sold by the pessimist.
  • The recent inflation is a good reminder that the only rational definition of money is purchasing power. While inflation initially depresses both stock and bond prices, stocks have historically (since 1926) beaten inflation by around 7 percentage points on an annual basis – which is more than twice the amount earned by bondholders.

How We Do It

  • Planning. You and I are long-term, goal-focused, planning-driven investors. The best way to stay focused – and not react to current events – is to formulate a detailed financial plan and build diversified investment portfolios that match the goals set forth in our plans. We do not develop portfolios based on headlines, what’s “hot”, or some pundit’s view of the economy. A financial plan helps us understand that short-term price movements in markets are irrelevant to our long-term goals.
  • Diversify. We diversify by investing in a variety of stocks that include large companies, small and mid-sized companies, foreign companies, bonds, real estate, and sometimes commodities. Since Covid, diversification has admittedly been challenged at times (i.e., bonds in 2022). But diversification is generally effective because it helps us stay invested by smoothing out the highs and the lows of investment markets.
  • Cash and bonds for short-term goals. We always make sure that we have enough cash (and bonds) for near-term expenses not covered by other (retirement) income. This also helps us ride out the periodic stock market declines.

Current Observations

  • Interest rates. The Federal Reserve seems done raising the short-term rate. This is important for two reasons. First, the Fed is signaling flexibility that they will lower rates if recession strikes in 2024. The Fed has a dual mandate: stable prices and maximum employment. They’ve been deadly focused on price inflation for two years, but if the economy slows and hurts employment, then expect the Fed to lower rates. Second, the risk of the Fed’s strategy in raising interest rates aggressively has always been that the Fed would break something significant. And that would lead to a much larger problem beyond inflation. For these reasons, market participants have cheered on the news of the Fed pivoting.
  • Media. It’s an election year, so consume media at your peril this year. The media is not your friend. As Steven Pinker said, “The news is a nonrandom sample of the worst events happening on the planet on a given day.”
  • Earnings. Earnings in 2023 continued to defy expectations, and estimates remain strong for 2024.
  • Inflation. Nearly all of the inflation numbers are pointing positive. Some numbers might remain “sticky”, but it appears that the Fed’s work is mostly done on arresting inflation.
  • Productivity. This metric is difficult to measure, but it’s arguably one of the most important measurements of how we are performing as a nation. It measures how much more (or less) output we are producing per unit of input. That’s “geek speak” for how efficient we are at work. It’s almost hard to believe, but the Bureau of Labor Statistics reported that nonfarm labor productivity increased a whopping 5.2% in the 3rd quarter of 2023.[1] That’s a big number, and high productivity goes right to the heart of defeating inflation and raising living standards. Perhaps AI and other technological improvements are working their way into the data.
  • Government Debt. This is a problem, and it’s what most observers believe led to the interest rate on the 10-year U.S. government note reaching 5% in October. Auctions of U.S. government debt simply didn’t go very well last year. Therefore, the Treasury had to offer higher interest rates to attract more buyers of government debt. The U.S. Treasury recently switched tactics and is offering more shorter-term securities at auction to remove pressure from longer-term interest rates. For now, it’s working. The 10-year yield has dropped to around 4%. The other good news is that buyers seem to be more comfortable buying U.S. debt now that the Fed has pivoted and should begin cutting the short-term rate in 2024. If excessive government debt causes the 10-year bond yield to rise in 2024 to 5% or beyond, expect turbulence in stock and bond markets again. But the dollar and U.S. Treasury securities remain the gold standard in international finance.
  • Consumer Spending. Consumer spending remains robust, but there are concerns it will slow in 2024. Government “stimulus” payments, removal of student loan forgiveness, Social Security inflation increases, and temporary tax cuts are wearing off. Will this slow spending in 2024? Or will the Baby Boomers, who control more $78 trillion in wealth, continue to spend and power the economy?

Looking Ahead to 2024

As always, surprises can happen, and the world remains a dangerous place. But for now, there is a lot to like about investment markets and the economy going into 2024. Outside of the top 7 or 8 mega cap stocks that outperformed in 2023, stocks still look reasonably priced – especially small and mid-sized companies. Foreign companies have attractive valuations, too. Interest rates are back to more historical averages, and this should allow bonds to play a more constructive role in portfolios. For now, cash is yielding 5%, but expect that to drop as the Fed lowers the short-term interest rate.

The consensus view is that we are in the process of a “soft landing” coming out of this inflation mess – meaning that inflation returns to 2% without a recession. I am always deeply suspicious of the consensus view. But as the data points arrive, a soft landing certainly looks more likely than it did a year ago.

Bottom Line: The broad-based rally in stocks looks sustainable – or at least justified on current earnings estimates and declining inflation. There are always potential problems that could derail things, but the data looks promising. As always, stay patient, stay disciplined, and stay invested.

[1] U.S. Bureau of Labor Statistics, 12/6/2023.