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Strategy Update

A Goldilocks Rally

The final two months of the year saw a significant rally in both stocks and bonds. A market that
had been extremely thin, resting on the strength of only a handful of companies, broadened to
include a majority of stocks, which was a welcome development for many investors. And after
languishing all year, bonds began to recover. Prior to this rally, 2023 was proving to be another
frustrating year for most investors, save for those whose portfolios leaned on a small basket of
technology stocks. But after the late rally, which included a much wider array of industries and
asset classes, most investors could view 2023 as a successful year.

What investors found so encouraging was both an improvement in the economic data and an
improving narrative around that data. Investors are constantly shaping narratives to fit new
data as it emerges, and often the narratives turn far more quickly than the underlying data.
Stock and bond investors have now settled into a rosy view of a “Goldilocks Economy,” in which
growth that is neither too hot nor too cold avoids the twin risks of inflation and recession. For
the moment, the temperature is just right: employment and consumer spending have improved
slightly, while inflation continues to moderate and the Federal Reserve has begun to talk in clear
terms about interest rate reductions. Looking back, it was this turn in narrative from the Federal
Reserve, in November and December, that allowed investors to develop more positive narratives
of their own. The odds that the central bank can reign in inflation without provoking a recession
are increasing, a scenario that seemed unlikely a year (or even a few months) ago.

There are some dangers to a market rally built on this foundation. Most notably, inflation is still
well above the Federal Reserve’s stated goal of 2%, and the most recent reading of core inflation,
stripping out food and gas prices, was actually a touch above expectations. If the Federal Reserve
has to keep rates at the current level beyond this spring, that would be an unwelcome surprise.
A recession seems like less of a concern at the moment, but investors will want to see a good
economy reflected back in corporate earnings. Many companies were impacted negatively last
year as price and wage increases took a toll on profit margins. Profitability should improve this
year, but so far many executives have been cautious when providing their outlooks for 2024.
One reason for this is that for many large U.S. companies, China has become a very important
market. Demand there is weak and it is hard to forecast an improvement, which cuts against an
improving view of the domestic economy.

Yet these dangers pale in comparison to the fears that gripped the market early last year and
again in the fall: that the economy would topple into a stagflationary mix of recession and
stubbornly high prices. Such a mix is historically toxic for stocks and bonds. Fortunately, we
believe it can be discounted with improving data. The temperature may not be perfect going
forward – and it is quite easy to point to a rally that has gotten slightly ahead of itself – but the
danger of getting badly burned in the near term seems diminished.

Current Strategy

If the temperature stays just right for investors in 2024, it should call for a broadening of the
current rally. It is important to note that the Russell 2000 Index, a basket of smaller companies,
is still 20% below its all-time highs. So, even as the largest tech giants soar to new heights,
a large swath of stocks are still technically in a bear market. This mix of smaller companies
typically carries more cyclicality and volatility, but an improving economic outlook and benign
inflation would be just the mix required to push shares higher. While we find much of the
technology sector to be overheated on premature enthusiasm for AI, we believe this does leave
other parts of the market reasonably priced.

There is an aspect to this market that calls back to the tech bubble of 2000. We have made
this comparison sporadically in recent years, but increasingly there feels like a single path to
investment success. The enthusiasm for tech stocks appears to be sucking oxygen out of the
room for other corners of the market. There is only so much money to allocate to stocks, and
on many days of late, the success of technology stocks is matched by declines in other sectors.
If the economic outlook is improving generally, it would point to success for a diverse mix of
companies and industries. While the rally did start to broaden a bit at the end of the year, a
benign environment should provide ample room for this broadening to continue, with so many
stocks still struggling for any investor attention in the shadows of the tech giants.

The bond market rallied significantly as the Federal Reserve changed its language in November.
Prices climbed, sending yields lower on longer-dated bonds. Yields on much shorter-dated
bonds will fall as well, but only when the central bank lowers rates. The timing of this is up for
some debate at the moment, both amongst investors and amongst the twelve Federal Reserve
members who set policy. But the bank is likely to begin cutting rates sometime in the spring or
summer, based on the consensus view and commentary of its voting members. While short-term
rates will fall, we question whether long-term rates will continue to decline as well. At a certain
point, a good economic outlook should support higher long-term rates. In robust economic
times there is a demand for money, and all borrowers, including the U.S. Government, have to
compete for lenders. This has meant historically that 10-year Treasury bonds often command
yields of 4-5% or higher. A return to normal, both in regards to inflation and economic growth,
would signal that the bond rally has left longer yields in about the right place. If this is true, even
as short-term yields decline for fixed income investors, they will hopefully have the opportunity
to build out a longer-dated bond portfolio at yields that are in line with historical levels.
Critically, we do not anticipate a return to the era of super-low yields for fixed income investors
if the good economic outlook holds in 2024.