Key takeaways

• The fourth quarter of 2023 was an emotional roller coaster for investors. October brought the start of another war and, with it, more tragedy and geopolitical uncertainty. By late October, bonds were in negative territory for the year and the global stock market was in an official correction, more than 10% below summer highs.
• Moderate inflation results during the quarter helped spark a robust “everything rally.” All major asset classes rallied, perhaps most notably bonds. Those with diversified stock and bond portfolios were generally rewarded handsomely for assuming the extra volatility relative to those holding pure cash.
• The “dot plot,” a visual representation of Federal Open Market Committee (FOMC) member expectations, indicates three rate cuts for 2024. Based on current bond prices, the market is expecting even more.
• Sentiment on China is dour. As frustration with stock valuations mounts, Beijing may choose a more investor-friendly approach. There is a strong chance that reality ends up better than feared. If so, the opportunity is significant.
• At the outset of last year, falling prices and FTX’s dramatic implosion called into question whether cryptocurrencies would survive. Some did not, but Bitcoin and several major peers joined in 2023’s risk rally, posted significant gains, and regained relevance.
• While small company stocks did lead in Q4, for equity markets overall in 2023, the AI backdrop provided a narrative allowing domination by the seven biggest U.S. tech-related stocks: Apple, Microsoft, Alphabet, Amazon, Nvidia, Tesla, and Meta Platforms.
• U.S. capitalization-weighted indexes are more top heavy than we have ever seen, which means they are increasingly reliant on a group of stocks priced to meet very high expectations.
• We believe everyone should maintain a thoughtful emergency fund. However, holding too much cash beyond emergency funds or short-term needs can be dangerous. At the highest level, it can lead to significantly less wealth over time.

Q4 brings an emotional roller coaster for investors

October brought the start of another war, and with it, more tragedy and geopolitical uncertainty. The downward trajectory in stock and bond prices from the third quarter continued. By late October, bonds were in negative territory for the year and the global stock market was in an official correction — more than 10% below summer highs.

Then, just as investor sentiment seemed especially dour, encouraging inflation data spurred expectations for interest rate cuts coming sooner. The U.S. consumer price index rose 3.2% in October and 3.1% in November. More recently, the core PCE price index, favored by the Fed, showed core inflation was just 1.9% over the last six months.

The moderate inflation results helped spark a robust “everything rally.” All major asset classes rallied, perhaps most notably bonds. In the end, 2023 ended up being a strong year for patient investors who avoided mistakes. Cash-like investments yielding close to 5% attracted lots of dollars during the year, but those with diversified stock and bond portfolios were generally rewarded handsomely for assuming the extra volatility.

The Bloomberg U.S. Aggregate Bond Index gained 6.8% in Q4, finishing up 5.5% for the year and outpacing cash products. U.S. stocks posted double-digit gains in the quarter (+11.9%), bringing the full-year total to 27.1% and extending a lead over other asset classes. International stocks rose 9.8% in the quarter and 16.2% for the year.¹ Global stocks have now effectively recouped their losses from the 2022 bear market.

Unlike earlier in the year, gains in U.S. stocks were widespread in Q4. The Russell 2000 Small Cap Index outperformed, including a 12% jump in December that sealed its biggest monthly outperformance relative to the S&P 500 since 2000. Smaller company stocks had been shunned for much of the year due to concerns that they would be more negatively impacted by higher interest rates. More recently, the potential for rates to start to decline likely acted as a catalyst for the group. The biggest U.S. technology-related stocks were about in line with the broader market for the quarter.

As expected, the Fed kept rates unchanged at its December meeting. In a change from previous meetings, comments suggested that additional hikes are no longer in focus.

Lower interest rates for longer maturity bonds

In an inverted yield curve, longer maturity bonds are paying lower interest rates than shorter maturity bonds.

Historically, these situations have been correlated with pending recessions, in part because they discourage bank lending. For now, however, overall access to credit seems to remain open for both consumers and businesses. Private credit, or loans from private investors rather than banks, has become an increasingly important source of capital for small and mid-size companies.

Fear and greed are always present. On one side, it is easy to get caught up in the narrative of artificial intelligence and unlimited growth possibilities for U.S. technology leaders. But market cycles come and go, and trends shift. Growth stocks do not have a monopoly on big gains. Historically, small-value stocks have produced the best results over time. Many of last year’s best-performing stocks had been among the worst in 2022.

There was also plenty to be nervous about in 2023. A combination of rapid interest rate hikes, an inverted yield curve, geopolitical risks, and slowing growth in China created an intimidating mix. At times, it appeared safer and wiser to sit on the sidelines, but the fourth quarter demonstrated the benefits of avoiding market timing and instead staying invested in a diversified portfolio.

While it is too soon to declare victory on inflation or conclude that the rate hikes of the past two years will not lead to recession, Fed Chairman Jerome Powell recently summed up the current situation nicely:

“Inflation has eased from its highs, and this has come without a significant increase in unemployment. That’s very good news.”²

Read more: What causes inflation?

As of the end of November, the trailing PE of the MSCI All-Country World index was 19.2, implying an earnings yield of 5.2%. The MSCI USA index has a trailing PE of 23.9, or an earnings yield of 4.2%. Treasury bond yields currently range from 3.9% to 5.6%. It is not unusual for stock earnings yields to be comparable to or lower than bond yields because earnings tend to grow over time. Importantly, short rates are likely to come down this year, which should provide support for equity valuations. Still, U.S. stocks remain moderately expensive in our view.

The earnings yield on international stocks is a more attractive 6.9%, reinforcing the potential benefits of a global approach. And in the U.S., growth stocks are trading at a higher-than-usual premium compared to value.

Sentiment is hard to gauge right now, in part because it has been shifting rapidly. Anecdotally, investors grew particularly dour in October, which was logical given the Q3 pullback in stock prices and depressing events around the world. From a market perspective, spirits have been lifted by the strong rally over the past few months. The VIX, sometimes referred to as the fear index, finished Q4 near a three-year low.

We typically view sentiment as a contrarian indicator. An overall feeling of complacency heading into the new year makes current sentiment a slightly bearish factor, in our view. As evidenced by valuations, enthusiasm for international and value stocks remains absent, potentially creating greater opportunity.

At the start of 2023, many on Wall Street were predicting a big year for Chinese equities, fueled in part by an expected post-COVID reopening boom. Instead, the MSCI China Index fell about 15% last year and is down well over 50% from a 2021 peak.

By breaking tradition to take a third term and purging many of those who may have opposed him, Xi Jinping has assimilated close to absolute power in China. Xi and President Biden met in October in San Francisco and managed to strike a cooperative tone despite Xi’s insistence that Taiwan will soon be part of China. Many U.S. and European companies are repositioning or diversifying supply lines away from China to reduce the risk of getting stung by geopolitical issues. Regardless, the global economy remains highly dependent on China.

While technology leaders in the U.S. have seen valuations and influence expand, the opposite has happened in China. A few years ago, Chinese tech companies were worth comparable amounts to their U.S. counterparts. Now, most have seen their stock prices gutted. Leaders such as Alibaba and Baidu trade at lower price-to-earnings multiples than most U.S. value stocks. In Q4, Tencent, China’s most valuable technology company, was hit by a crackdown from Beijing on video-gaming policies.

Much about China feels dour. From a market perspective, however, what matters most is the outcome relative to current perception. As frustration with stock valuations mounts, Beijing may choose a more investor-friendly approach. The problems in China’s real estate market are extremely well known and anticipated. There is a strong chance that reality ends up better than feared. If so, the opportunity is significant.

At the outset of last year, falling prices and FTX’s dramatic implosion called into question whether cryptocurrencies would survive. Some did not, but Bitcoin and several major peers joined in 2023’s risk rally, posted significant gains, and regained relevance.

Once again, Bitcoin displayed its two primary characteristics: extreme volatility and resiliency. It finished the year at roughly $42,221, up over 150% for the year, although still well below highs reached in 2021.

The biggest catalyst for gains seemed to be applications for spot Bitcoin ETFs by major players such as BlackRock and Franklin Templeton. Currently, the only ETFs allowed in the U.S. are based on Bitcoin futures as opposed to direct holdings. A decision on allowing spot ETFs could come as soon as the end of January. In August, Grayscale won a court appeal overturning the SEC’s rejection of its ability to offer an exchange-traded product. Grayscale currently manages a Bitcoin trust with over $25 billion of assets, which it says it would like to transition to an ETF.

It is somewhat ironic that ETF adoption has become a bullish driver for Bitcoin since much of the original appeal for the currency was the ability to sidestep major financial institutions.

We do not include Bitcoin in client portfolios because we don’t know of a good way to derive what a fair or fundamental value should or could be. That would be guessing, and we don’t believe it is our role to speculate in that manner with our clients’ assets. High volatility also creates challenges. None of that will quickly change with the introduction of a low-cost spot ETF, but we acknowledge the passion that many people hold for Bitcoin, as well as its rugged ability to survive and attract new capital.

Read more: Your ultimate guide to EFTs

The impact of new technologies

New technologies are rapidly helping individuals and companies learn more quickly and be more efficient.

One of the biggest events of 2023 was the viral growth of ChatGPT, a large language model that interacts in a conversational way. ChatGPT represents an exciting breakthrough in generative AI and inspired people to imagine amazing possibilities for the future. Different forms of AI are driving advances in healthcare and helping create and maintain software code.

Given all the hype, we suspect less will change in the next few years than many are expecting. But the overall rate of change in how humans live and do business should transform more dramatically in the next 25 years than it has in the 25 years since internet usage became widespread.

We continue to believe that some of the biggest changes will come from deployments in the physical world. While known for bold statements, Elon Musk was quoted last year as saying he is confident that Tesla’s Optimus robot line will prove more valuable than its cars.

While small-company stocks did lead in Q4, for equity markets overall in 2023, the AI backdrop provided a narrative allowing domination by the seven biggest U.S. tech-related stocks: Apple, Microsoft, Alphabet, Amazon, Nvidia, Tesla, and Meta Platforms. Collectively, the Magnificent Seven (M7) accounted for more than half of all gains in U.S. stocks last year.

For investors chasing the AI narrative, the biggest tech companies were the most obvious targets. Only time will tell if they were the right ones. Developments in AI will increase competition among technology providers and companies that use it, which will be almost every company. While we expect AI advancements to continue increasing wealth and living standards, it is likely that AI will also accelerate single-stock volatility. Those more adept at using emerging technologies should be able to grow rapidly and displace competitors more quickly.

Each of the M7 firms is a strong company with its own unique advantages, but we don’t believe any of them are irreplaceable. Of the 10 largest stocks at the beginning of 2000, many viewed as the biggest beneficiaries of the internet, only Microsoft remains on such a list. Competition is fierce.

The M7 now represents a quarter of the value of the total U.S. stock market. Perhaps more astounding, they also represent about 16% of the MSCI All Country World Index, which is greater than the sum of Japan, China, Canada, France, and the U.K. combined.

In part, their eye-popping 2023 results were due to timing. Growth stocks had performed quite poorly in 2022, but a style rotation happened right around the turn of the calendar year. In 2021-2022, three of the seven stocks remained in negative territory, and only Nvidia posted double-digit annualized gains. Still, U.S. capitalization-weighted indexes are more top heavy than we have ever seen, which means they are increasingly reliant on a group of stocks priced to meet very high expectations.

In theory, the stock market is efficient, and companies are valued fairly based on their assets and prospects. In practice, stock prices are driven by supply and demand, which are controlled by people. People are often wrong. Earnings for most of the M7 were up last year, but stock prices were up far more. This set the bar very high and will make for an interesting 2024.

There will always be cycles. We believe the odds favor more diversified approaches over time, especially when rebalanced in a disciplined way. Fundamentally, we actively desire more meaningful exposure to small-cap stocks and the smaller sectors than capitalization weighting provides. Small caps have a long history of outperforming. Such performance comes with a little more volatility, but we don’t think the premium is dead.

High allocations for cash and cash alternatives

After years with almost no return on cash, higher yields have tempted many to keep a high allocation in cash or cash alternatives, such as CDs or short-term Treasuries.

We believe everyone should maintain a thoughtful emergency fund. However, holding too much cash beyond emergency funds or short-term needs can be dangerous. At the highest level, it can lead to significantly less wealth over time. High cash allocations are subject to:

• Lower returns
• Inflation risk
• Reinvestment risk

Bonds have moderately more risk than cash and tend to generate moderately more return. Stocks have meaningfully more volatility than cash and can generate meaningfully higher returns. While the future is uncertain, blending stocks and bonds, especially if globally diversified, allows an investor to reduce risk and customize expected levels of return. Over time, extra returns compared to cash alone compound to be very important.

Read more: 3 risks of too much cash

Growth of $1 — last 30 years (ending 2022) 

The primary allure of cash is safety. While you won’t lose dollars holding cash, you can lose significant spending power, which is what matters in the end. Inflation is a greater destroyer of wealth than bear markets. Many assets, like equities, can benefit from increases in the money supply and resulting inflation. Cash is victimized.

Despite the opportunity for higher returns and the risks of inflation, some may feel current yields on cash are good enough to support their goals. A potential pitfall can be reinvestment risk. Existing interest rates on cashlike instruments may not be available for long. Most economists, and even most members of the Fed, expect short-term interest rates to decline starting in 2024.

If rates drop significantly, those with heavy cash allocations will be faced with a choice of again losing to inflation or reinvesting in stocks and bonds — quite likely at higher prices. Since 1928, stocks have had a positive return in 59% of months and 73% of years. Those are very difficult odds to bet against.

Higher yields can be great, and for various reasons, it may make sense for some to hold higher cash allocations. For most, money that is not intended to be used for a long time should be invested in a thoughtful, diversified portfolio of mostly stocks and bonds.