Each year, I rethink our portfolio allocations and today I am sharing our Investment Themes for 2024. We don’t time the market, nor do we try to predict how the market will perform. I think this is not only impossible, but also likely to cause more harm than good. We remain globally diversified, use index funds, and maintain a buy and hold philosophy. We have a target asset allocation for each investor and rebalance positions when they drift from our targets.

But that doesn’t mean we are completely passive. No, each year we slightly adjust our portfolio models in two ways. First, we look at current valuations and expected long-term returns (typically 10 years). With this information we add weight to the Core categories which have better valuations and expected returns. And we reduce categories which might be overvalued and have lower expected returns. This is forward looking, rather than looking back at past performance.

The second adjustment we make to portfolios is to annually evaluate Alternative holdings for inclusion in our models. Alternative, or satellite, positions are smaller, more niche investments, which I don’t think merit permanent inclusion as a Core position, but may be appropriate at certain times. We will describe our alternative positions more below.

2023, Better Than Expected

2023 ended up being a great year in the stock market, with the S&P 500 up 24%. This was a shocker. A year ago, 85% of economists were predicting a recession in 2023. But it never happened and the consensus was wrong. A year ago, I wrote that in spite of the calls for recession, the bad news may have already been priced into stocks and that we would remain invested. You can read my Investment Themes for 2023 here. And here are links for my 2022 Themes and 2021 Themes.

Although the S&P 500 and NASDAQ had a great year in 2023, it was aften a frustrating year for investors. Market breadth was poor and performance was concentrated in a fairly small number of Growth and Technology stocks. 2/3 of stocks did worse than the S&P 500 average. And other categories, such as International, Small Cap, or Value, lagged the Mega-Cap names.

It was also a strange year for bond investors. Rising interest rates pushed down the prices of bonds, and detracted from their performance. So, unfortunately, bonds did not add much to the bottom line in 2023. But the flip side of rising rates is that we have purchased very attractive yields which we will hold and profit from for years to come.

Economic Expectations and Stocks

Markets had a great 2023 and the US avoided a recession. But I am afraid this is no guarantee that the economy is in the clear now. The Federal Reserve raised interest rates and has managed to bring inflation down to 3% without damaging the economy or causing higher unemployment – yet. In the past, such aggressive tightening by the Fed has led to a recession. Will they finally be able to engineer a “soft landing” and not cause a recession? The strength and resilience of the US economy in 2023 is truly the envy of the world.

Unfortunately, I think we need to remain cautious and recognize that it is possible that 2023 only postponed a slowdown rather than avoided one altogether. Today the consensus is that the Fed is done raising rates and will start cutting interest rates later in 2024 once inflation is closer to their 2% target. But none of this is a guarantee that a recession is off the table. 2024 could be another volatile year.

And where are we in terms of valuations? US stock earnings grew by 3% in 2023, but stock prices went up 24%. That means that now US stocks are even more overpriced and the expected returns going forward are lower. The returns of 2023 are surprising because they are unwarranted. US growth stocks have become more expensive, not better.

Looking at our core stock categories today, we have the same themes, but only more so. US Value is cheaper than Growth and has a higher expected return. International has a higher expected return than US. Small Cap is attractive relative to large cap. Emerging Markets have strong growth potential. We were already tilted towards Value and International at the start of the year, and this was early. US Growth outperformed in 2023, but the case for Value and International has only grown stronger and more compelling. Our outlook is for more than one year at a time, and sometimes that means we have to remain patient to see a reversion to the mean.

For 2024, we will make a small addition to our International funds, from our US Midcap funds. We use Index exchange traded funds (ETFs) for our Core positions.

Source: Vanguard Economic and Market Outlook for 2024, published December 2023

Interest Rates and Bonds

Interest rates rose steadily through October of 2023. We continued to buy individual Investment Grade bonds. Our core bond holdings are laddered from 1-5 years and we generally hold to maturity and reinvest. 2023 offered the best yields available in the past 15 years. We wanted to lock in some of these yields for longer, and so we had extended duration in 2023, adding some longer term 10-15 year bonds.

Interest rates peaked in October with the 10-year Treasury briefly touching 5%. Since then, the 10-year has fallen to 3.9%, a massive move in a very short period of time. (This high demand for bonds, and inverted yield curve, is a red flag for stocks and the economy.) We’ve seen a lot of Agency bonds getting called and refinanced to lower rates. And so it is possible we have seen the peak interest rates for this cycle already.

I am glad we were buying when we did and that we extended duration. Today, it is less attractive to buy longer bonds, and our purchases in 2024 will return to being on the shorter end of the yield curve. We will not be adding to bond holdings in 2024, just aiming to maintain our 1-5 year ladder as bonds mature or are called. But there is a good rationale for holding bonds. Real yields (after inflation) are attractive. We have purchased yields which are comparable to the expected 10-year return of US stocks. And so, the 60/40 portfolio at the start of 2024 looks better than it has in years. And if we have a Bear Market in stocks in the next couple of years, the bonds will be defensive and give us the opportunity to rebalance and buy stocks when (not if) they drop.

Alternatives

Bond yields have been so good in 2023 that the appeal of alternatives is less. Why take on a volatile, complex investment if T-Bills are yielding over 5%? We will not be adding to any alternative or satellite categories in our 2024 models. We have several existing positions, which we will continue to hold.

TIPS (Treasury Inflation Protected Securities) were added in 2022 and they have given us a good inflation hedge. Our largest TIPS holding will mature in 2027 and at this point the plan is to hold to maturity. Inflation is less of a concern now, but our TIPS are still paying a decent yield.

Last year, we trimmed our holdings in Preferred Stocks, which sold off as interest rates rose. Today, they have started to bounce back and offer yields over 6% while often trading at a 30% discount to their Par value. The current 6-8% cash dividends we receive from Preferreds is above the expected return of common stocks. I’m happy to have that cash flow for retirees or to have cash to reinvest throughout the year. There is some potential for price appreciation in the next rate cutting cycle, but I am happy to hold these for the dividends and ignore any price volatility.

Our third satellite holding is a small position in Emerging Markets bonds. We use a Vanguard fund and ETF, which offer low cost diversified access to this high yield sector. I’ve seen that this category often bounces back well after a difficult year. And after being down in 2022, our fund was up nearly 14% in 2023. The fund begins 2024 with a 7% yield.

Staying On Course

We look each year to make some minor changes in our allocations, and communicate these ideas in our “Themes” letter. But, I think the real key for investors is to think long-term and be willing and able to stick with the process. There will inevitably be ups and downs and the markets often surprise us and don’t do what we expect. We have done well to stick to the basics: Don’t try to outsmart the market. Buy and Hold index funds. Keeps costs and taxes to a minimum.

If you have questions about our Investment Themes for 2024, please reach out. Even with these themes, we still have different investment models for our clients’ individual needs, risk tolerance, and time horizon. 2023 was a year full of surprises, and we will have to see what is in store for 2024!

At the start of each year, I discuss our investment themes for the year ahead. Today we share our Investment Themes for 2023. 2022 was a lousy year for investors, with a Bear Market in stocks (a loss of more than 20%) and double digit losses in bonds. And to add insult to injury, 9% inflation increased our cost of living even as portfolios shrank. War in Europe, supply chain problems, and political drama added to the uncertainty.

The Federal Reserve is committed to raising interest rates to slow the economy back down to 2% inflation. Economists are predicting a recession in 2023. With all these problems, it is easy to feel pessimistic about 2023 as an investor.

However, there are reasons for optimism. The call for a recession is so clear that it may already be somewhat priced into the market’s expectations for 2023. Many stocks are down 20%, 30% or more from their peaks and more fairly valued today. The large losses in international stocks were driven by a 17-20% increase in the value of the dollar to the Euro and Yen, and that headwind may be turning into a tailwind as the dollar starts to decline.

Today, we have very attractive rates in the bond market, 4.5% on short-term bonds and 5.5% on intermediate investment grade bonds. Bonds look better in 2023 than they have since the Global Financial Crisis in 2008.

My annual investment themes are not a prediction of whether stocks will be up or down this year. We don’t believe anyone can time the market or predict short-term performance. Instead, our process is to tilt towards the areas of relative value, with a diversified, buy and hold portfolio. Here is how we are positioning for the year ahead.

(And if you want to look back, here were our Investment Themes for 2022 and 2021.)

Stocks

In 2022, the Growth / Value reversal became widely acknowledged. For over a decade, growth stocks had crushed value stocks, but that leadership came to an end last year. Now, value stocks are performing better and growth stocks could have further to fall. We are using Value funds across markets caps – large, medium, and small.

International stocks have lagged US stocks, but today offer a better value. These stocks are cheaper than US stocks, have a higher dividend yield, and offer a hedge against a falling dollar. International and Emerging Markets are attractive today, and we are maintaining our international diversification. There are now more low-cost Value funds and ETFs offered in International stocks, and so we have replaced some of our Index Funds with a Value fund.

Overall, we have not made significant changes to the holdings within our stock allocations. What has changed is the expected return of stocks versus bonds. Over the next 10 years, Vanguard has an expected return of 5.7% return on US stocks. Yields have risen in A-rated bonds to where we can get a similar return from bonds. So, we are moving 10% of our stock allocation into individual bonds, 5-7 years with a yield to maturity of at least 5.5%. We are buying AAA government agency bonds (such as Fannie Mae or Freddie Mac), and some A-rated corporate bonds. These are offering a similar return as the expected return from stocks, but with much, much less risk and volatility. We aren’t giving up on stocks, but if bonds are going to offer similar potential, then we are going to add to bonds.

Bonds

Our core approach to bonds is to buy individual A-rated bonds, laddered from 1-5 years. We buy Treasury Bonds, Agency Bonds, CDs, Corporate Bonds, and Municipal Bonds. Yields are up and we want to lock-in today’s yields. For clients who are retired or close to retirement, our laddered bond portfolio will be used to meet their income needs for the next five years.

We use a “Core and Satellite” approach. The 1-5 year ladder represents our Core holdings today. For 2023, we decreased our Satellite holdings in bonds. Last year, we had a large position in Floating Rate Bonds. And these ended up being the best performing, most defensive category within Fixed Income in 2022. They worked exactly as hoped, protecting us during a year of rising interest rates. For the year ahead, though, they are less attractive. These are smaller, more leveraged companies. A year ago, their debt cost them 3%. Today, those companies are facing a recession and their debt now may cost them 7%. Floating Rate bonds have become more risky and more likely to have losses. We have sold Floating Rate and added the proceeds to our core 1-5 year ladder.

At the start of 2022, our focus was to minimize interest rate risk by keeping bonds short-duration. Yields have risen so much that in 2023 we want to extend duration and lock-in higher yields. Unfortunately, with an inverted yield curve, it is more challenging. Still, today, we are looking to add 5-7 year bonds to our ladders when cash is available and we can find attractive bonds.

We continue to own a small position in Emerging Market bonds. These have always been more volatile than other bonds, but history suggests that selling after a down year is a bad idea. The yields going forward are attractive, and many of these emerging countries are actually more fiscally sound than developed nations.

Alternatives

We are always looking for other investments which offer a unique opportunity for the current environment. We want returns better than bonds, but with less risk than stocks. If we can add investments with a low correlation to stocks, it will improve the risk/reward profile of our portfolio.

We purchased commodities early in 2022 with inflation spiking. Although they had a good Q1, commodities fared poorly for the rest of the year. We sold most of our commodities in October, and replaced them with TIPS, Treasury Inflation Protected Securities. The price of TIPS fell dramatically through the year, and by October, we could buy 5-year TIPS which yield 1.7% over inflation. TIPS are now a more direct inflation-hedge than commodities, which are frustratingly inconsistent. (If Gold doesn’t do well when there is 9% inflation, when will it shine?) Today, TIPS also offer a better yield than I-series US Savings Bonds.

Preferred Stocks were down in 2022 and we are trimming those positions to add to our Core 1-5 Year Ladder. Still, there are some good opportunities as many Preferreds are now trading at a 30% discount to their $25 par value. Preferreds with a set maturity date should be held to maturity. Perpetual Preferreds (those without a maturity) now offer 6-7% current yields or higher. While volatile, that is a decent level of income, plus the potential for price appreciation if interest rates fall in the future.

Overall, Alternatives are less attractive in 2023 because we now have such compelling bond yields. When we can buy risk-free T-Bills with a 4.5% yield, there is a higher bar for what will make the cut as an Alternative.

Summary

No one has a crystal ball for the year ahead, and our Investment Themes for 2023 are not based on a 12-month horizon. Instead, we are looking for assets that we think will be good over the next 5-10 years. We remain very well diversified, both in size (large, medium, small) and location (US, International, Emerging), as well as in Bonds and Alternatives. We diversify holdings broadly, with 10-12 ETFs, and each fund holding several hundred to several thousand stocks.

Although 2022 was an ugly year for investors, I wouldn’t bet against the stock market after a 20% drop. Historically, the market is usually up 12 months later. The expectations for 2023 are low and I would certainly caution investors to assume a volatile year ahead. Still, in these difficult periods, the best thing for investors is to stick to a good plan: diversify, keep costs and taxes low, and don’t try to time the market.

We take a patient approach and tilt towards the attractive areas, including Value stocks and International. Bonds finally offer a decent yield today and we have increased our core bond holdings and are looking to extend duration. We are making more changes in the bonds and alternatives than to our stock holdings. In 2022, we added more value on the bond side of portfolios, relative to benchmarks, than we did in stocks. So, as boring as bonds may seem, we focus a lot on bonds because we think there is an opportunity to add value for our investors.

Investing isn’t easy, but thankfully, it can be simple. We don’t need a lot of complexity to accomplish our goals over time. Years like 2022 are an unfortunate reality of being an investor. For 2023, we are making small adjustments but focused on staying the course.