Published January 10, 2024.
Hello, and welcome to Quarterly Perspectives, fourth quarter 2023.
My name is Alex Kluesner, and I'm a member of the Investment Strategy team at Buckingham Strategic Wealth. I'll be your host for this presentation.
This presentation details quarterly equity and fixed income performance along the framework of absolute returns, relative returns, and future expectations for market performance. We will then go on to discuss recent interest rate movements and inflation expectations.
Last, we examine how different asset classes contributed to an overall portfolio return. We hope you enjoy today's presentation. Now let's get started.
Quarterly Performance Overview
We begin our discussion with a high level look at a collection of major asset classes.
As we can see from the illustration, US developed international and emerging market stocks were up during the fourth quarter. Reversing the negative trend from the prior quarter.
Returns for bonds were also up for the quarter and the year both domestically and internationally.
Next, I'll draw your attention to the upper right hand portion of the graphic.
The US dollar was down 4.6% for the quarter and also down 2.1% over the trailing twelve months.
Now let's take a little deeper look at what was driving the returns of both stocks and bonds.
We'll start by taking a look at how global equities performed for the quarter. And will isolate the performance between US and developed international stocks.
The two charts show the performance of different investment styles between the US and international stocks. The bright blue bars represent the performance of different investment styles, and the dark blue bars represent the total market performance for the region.
US returns are measured with Russell indexes and international market returns are measured with MSCI World X US index series.
Which represents global developed market performance, excluding the US.
As we can see from the dark blue line on the chart on the left, The US market was up 12.1% in the fourth quarter compared to up 10.5% for developed international markets on the chart on the right.
Small cap stocks and large growth stocks on average outperform the market in the US.
Small value stocks continued to lead the pack domestically, which continues the trend from the last quarter on a relative basis.
Internationally, growth stocks tended to outperform the market with international large growth stocks posting the best performance for the quarter among the international development regions.
But no matter the recent trends, it's important to remember that we shouldn't make longer term projections based on short term performance.
Long-Term Performance Analysis
Now we take a longer view to see how different investment styles have performed for standard periods ending December 31, 2023.
Looking at annualized returns in the US, we can see that markets have shown resilience, especially over the trailing one year period. When faced with significant headwinds. Such as renewed outbreaks of war in the Middle East, uncertainty surrounding the future path of interest rates, paired with an apparent disconnect between where markets believe rates will go and what the Fed is actually projecting, and growing dysfunction on Capitol Hill. Despite these potential issues, US markets returned 26% during 2023 and have been nearing or exceeding 10% per year during longer time horizons.
Large growth stocks had the best performance for the trailing one year period gaining 42.7%, which beat the US market by 16.7%.
We can also see that small and value stocks have generally been out of favor during these time periods.
Consequently, we expect that portfolios that have a small value till such as those that we typically design for clients will have underperformed portfolios that are market cap weighted or tilted to large growth stocks at these longer investment horizons. Keep in mind that the very long term evidence demonstrates that on average, small stocks outperform large stocks, and value stocks outperform growth stocks.
But size and value factors can still go through extended periods of underperformance, like those shown here.
Turning to international markets, we see that large cap value stocks have led the pack over the one year period. At the longer time horizon, we see varying performance among different styles, with value stocks, large cap stocks, and growth stocks, each posting leading performance or the trailing three, five, and ten year periods respectively.
And relating to the prior slides, we see that international markets have underperformed the US market by 8.8% during the last twelve months, as well as at the longer time horizons with the three, five, and ten year performance trailing by 4.8%, 6.9%, and 7.1% respectively.
It's also worth noting that the US total stock market has had an exceptional ten year run. With the bulk of it being driven by richening valuations and strong corporate real earnings growth. And a recent AQR research paper suggest that to expect a repeat of this performance over the next decade. Even with an aggressive increase in earnings growth, investors would have to continue to bid up valuations far above where they were at the height of the tech bubble.
Nonetheless, given the higher US return over longer time horizons, we expect portfolios concentrated in US stocks to have outperformed the globally diversified portfolio.
And as we'll see on the next slide, These relative performance numbers aren't reason enough to abandon international stocks.
Thus far, we've discussed quarterly performance on a relative and absolute basis. Now let's take a look at current stock market valuations and how they relate to future expectations and market performance.
Stock Market Valuations
The charts on this slide show how expensive stocks are by measure of the price to earnings ratio, a very common metric used to value equities.
The higher the ratio is, the more expensive the asset class is overall.
Thought of another way, these values depict how expensive one dollar of earnings is. For example, as we can see in the chart on the top left, the average dollar earnings for the total US stock market costs roughly twenty one dollars. Internationally, as we can see in the chart on the top right, earnings are cheaper at just over thirteen dollars per dollar earnings on average.
The values represented here used historical fund and ETF data to establish the price ratios, and the average PE is reflected by the dotted line on the chart. These averages start in the first quarter of 2004 for US measures and in the fourth quarter of 2006 for international stocks.
Noting the strong market performance during the last twelve months, we see both broad US and international markets are now trading close to or above their recent historical averages. We can also see that small value stocks in global developed markets appear cheap relative to their recent historical averages.
All else equal we'd like to pay less for a dollar of earnings. These valuation ratios aid in setting expectations about the future.
Low evaluations today imply higher future returns and vice versa. The recent strength of broader US market performance means that it's reasonable expect lower returns than in the past when valuations were below their long term historical averages.
The opposite is true for international markets and small value stocks globally.
It's reasonable to expect higher returns than in the past when valuations were above their long term historical averages.
I'll emphasize that this is a long term relationship and that short term outcomes will likely be dominated by unexpected market forces.
Here we have the same analysis, but isolating US equities so we can see how valuations compare across different styles. Recalling the annualized performance slides, we know that large growth has had an exceptional ten year period.
We can see that the growth in prices has exceeded the growth in earning as the PE ratio has climbed to 31.8 to close the quarter, which is above its average since 2004.
Small value on the other hand, even with its outperformance to large growth, during the last quarter, still has a PE ratio of only ten. And remains under as average since 2004.
Although many investors may be interested in chasing the returns of large growth companies, We would point to these valuation charts as one reason to stay the course in a diversified portfolio, tilted to small, relatively inexpensive companies.
Next, we'll take a look at fixed income performance, the shape of current yield curve, and how the market is currently pricing inflation.
Fixed Income Performance
The charts on the screen show the average performance of different bond maturities and the segments of the fixed income market that we commonly track.
We typically prefer investing in bonds that are shorter maturity and higher quality compared to the broader market. In the chart on the left side, we see that bonds of all maturity ranges had positive performance, but markets favored longer maturities relative to short or intermediate maturities with the ten to twenty year segment posting largest gains because of their increased sensitivity to falling interest rates.
The chart on the right shows the performance of different intermediate maturity credit quality bonds.
We see again that all bonds in the credit qualities listed were up for the quarter, with investors favoring corporate and municipal debt relative to the other credit segments.
Next, we'll look at the treasury yield curve and what it means for returns going forward.
Here we plot the yield curve to show the current yields for treasury bond at different maturities.
The light blue line represents current rates. The dark blue line represents rates from the end of the prior quarter. And the gold line represents rates from one year ago.
With the exception of the ultra short term portion of the curve, rates decreased for all maturities during the quarter. As stated previously, this benefited longer dated maturity debt.
Looking forward, expected returns for fixed income remain elevated relative to the pre pandemic era due to the Fed's rate hike program. For long term fixed income investors, this is likely to be a net positive as new money and maturing bonds are reinvested into higher yielding bonds.
The yield curve remains inverted as it was at the end of last quarter. Although less so than earlier this year. When this happens, particularly between the two year and the ten year points on the curve, it is widely regarded as one of the precursors but not as a guarantee to an impending recession.
Finally, we plot the market's forecast of inflation by taking the difference in yield between US treasury bonds and TIPS at different maturity levels.
Like the last chart, the bright blue line represents current inflation expectations. The dark blue line represents inflation expectations from the end of last quarter, and the gold line represents inflation expectations from one year ago.
Current market estimates for future inflation have been little change compared to the prior quarter and this time last year.
Even though inflation readings have continued to moderate, the Federal Reserve has been persistent in its stance that it's too early to declare victory over inflation.
Because its 2% inflation objective has yet to be met, and it will need to show evidence that inflation is able to stay at that target in a sustainable manner.
To that end, future rate hikes have not been completely ruled out as of their December meeting.
The Fed will be watching growth in the Economy Service sector, which is less sensitive to interest rates, as well as the housing sector, which has been showing signs of picking back up as mortgage rates fell from recent highs.
As these expectations continue to change, it's important to remember that these levels of inflation are baked into prices today. The markets are pricing an average inflation rate of approximately 2.1% per year for the next five years.
And the market collectively expects inflation to similarly outpace the Fed's 2% over the next 30 years.
Not only are these expectations baked into bond prices, but they're also baked into equity prices.
Making a bet on higher inflation would mean that we expect inflation to exceed the current forecast.
Next, let's take a look at how some major asset classes contributed to a 60/40 index mix this quarter. And how that index makes behave during recent history.
On this slide, we look at the absolute impact of different asset class returns on the quarterly return of a sample 60% stock, 40% bond index mix. With stock and bond markets moving jointly upward this quarter, we can see that all asset classes contributed to the overall increase of the index mix.
US large cap stocks were the largest contributor for the quarter. While emerging market stocks have the smallest contribution to overall return. Divisifying stocks across geographies and investment styles. As well as allocating to bonds, help avoid undue portfolio concentration risk, while allowing for ample growth this quarter. This resulted in the 60/40 index mix achieving a return of 8.2% versus the US total market return of 12.1%. The portfolio is able to achieve 68% of the stock market's return, while only being exposed to 60% of the stock market's risk.
Here we see a collection of major asset class calendar year returns displayed on a quilt chart. Looking at year to date returns in the right most column, we see that all asset classes posted positive performance. With the S&P 500, a popular headline index primarily tracking US large growth company performance, gained the most value at 26.3%. We can also see that performance of each individual asset class tile shows no predictable return or relative ranking from one year to the next.
A diversified index mix, such as the 60% stock 40% bond index mix shown in the white tile tends to stay away from the extreme returns, both positive and negative on a yearly basis and over time. While also dampening the volatility of returns.
This is an example of one of the potential benefits of a well diversified portfolio.
It also helps us as investors to stay in our seats through any given quarter of market turbulence and not take away from our our ability to prosper from the many quarters to come. And with that, we've reached the conclusion of today's presentation.
Thank you for joining us, and we'll see you next quarter.
Beacon Hill Private Wealth is an independent, fee-only, fiduciary investment advisor providing evidence-based wealth planning solutions that simplify our clients' financial lives. Founder Tom Geoghegan, CFP®, CIMA®, CPWA®, RMA® is also a member of the National Association of Personal Financial Advisors (NAPFA).
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