Thoughts for the New Year

It’s the last week of the year, and if you’re old like me (or getting older), it’s become a time of reflection. I look at my daughter getting older (she’s 10 going on 16). I look at my beard getting greyer. I study the past. I think about the future. And I think about what we know and what we don’t know, what has happened and what could happen. I think about friends, young and healthy, and suddenly get diagnosed with cancer. I think about my ex’s grandma who is 91 years old and still be-bopping around town like she’s 50. The world is bizarre like that, and funny, and sad, and exciting, and fun, and hard, and disappointing, and loving, all at the same time. It’s hard to make sense of it all.

At this point in my life, one thing I am sure of, and I can control is trying to “be better” every day and certainly every year. Taking an inventory of your life right now and being reflective on what has influenced your current situation can help you identify ways to improve your life going forward. I know you probably do that already, so shoot me an email with any goals you have to “be better” in the coming year. 😊

Speaking of reflection and uncertainty, markets ended up delivering a result straight out of left field. It was a low probability result for sure, especially in light of the broader data points and early consensus. In many ways, it was a perfect storm of optimism even if dangerous.

Still, I think it is important to consider our outlook in light of such a counterintuitive result. John Maynard Keynes is credited with saying, “When the facts change, I change my mind. What do you do, sir?” So when do we change our minds? Is it because the S&P was up a lot more than anyone expected? Let’s look at some numbers –

The 2023 year-end price target average for the S&P 500 was 4349.78. (see attached chart) Now this is AFTER all the strategists upped their price targets mid-year. (note the latest update was in 10/18/23) Now these are some really smart people with really large resources behind them which is a reminder forecasting is a very difficult game to call, especially in a relative short time frame of 1 year. As I’ve said many times, global financial markets are highly complex where component influences, relationships, and regimes change. But back to Keynes, have the facts around our outlook changed?

Imo, no they have not. Reliable recession indicators continue to point to a recession coming. Even GDP estimates are projected to make a significant decline in 1H 2024. (attached) Again, no need to rehash these as I’ve discussed them throughout the year.

The returns in 2023 were fueled by speculation (AI), the belief in omnipotence of the Mag7, and the belief in a return to ZIRP (zero interest rate policy) by the Fed. These are the exact themes that created the bubble over the last 15 years, supporting the idea 2023 was an “echo bubble” rather than the beginning of a new expansion.

The AI theme could certainly play out over years to come but valuations appear to be already pricing that. (think CSCO in 1999) No companies in the history of the stock market have proven to be omnipotent, obviously. The return to ZIRP is harder as I think it involves the merging of several big, long-term trends. In a nutshell, slower growth from weak demographics (globally) is a headwind for inflation which would allow ZIRP. But, deteriorating geopolitics and the amount of debt and debt payments required could support inflation at higher levels than in years past. The battle between these trends will ebb and flow, especially year to year. (Note: my longer term opinion is that we (and other developed countries) will attempt to print our way out of the debt, as it is the least bad alternative, but it will ultimately end in a coordinated default)

What does all of that mean for 2024?

Well, since the recession indicators are still clearly flashing red, we must respect them. Indeed, even a “soft landing”, means slowing growth and possibly a mild recession. And there’s certainly an argument for a “hard landing” which isn’t remotely priced in currently. The lag effect from interest rate hikes (each hike mind you) is roughly 12-24 months. This means we are past the point where we should start seeing things slow meaningfully. The effects haven’t hit sooner because of Covid stimulus, but it’s unlikely they won’t hit at all. For example, inflation may be “slowing”, but that just means prices are not going up as fast. The aggregate level of prices has increased massively, and wages have not kept up. So an adjustment phase is necessary.

Technically speaking, indexes are WAY overbought given the November “everything rally” (again exactly what happened prior to 2022) and the Fed’s change of heart in December. We are near the 2022 high which is a natural resistance level suggesting more gains could be limited. However, the psychological hurdle of hitting a new high and the fund manager incentive bias means we could see the melt up continue into the new year, just like what happened in 2021.

Interestingly, the most bullish TOP-DOWN estimates for 2024 are for 5200, and the average is just 1.2% higher than where we are now at 4832.89. (attached) BOTTOM UP is at the top end of the range at 5114.06. But note here the “Return Potential” chart in the attachment. There is a very negative correlation between the S&P and the Return Potential. As the gap closes between the current price and the target, Return Potential is lower meaning future gains are limited. Conversely, at wide gaps between current price and target, return potential and future returns are high. Currently, the Return Potential is very low at these overbought levels.

I see caution in these numbers even though the rhetoric in the media and the printed institutional outlooks are very bullish. It highlights the difference in what people actually believe and what they can say in public to keep their jobs. But should we put any faith in them given the discrepancy between forecasts and returns this year?

Yes, we should. The reason is that these estimates represent a wide range of manager/strategist experience, historical data, model extrapolation, and risk management controls. We should see the value in that. It doesn’t mean we can’t have an anomalous result like in 2023. That again speaks to the uncertainty and difficulty navigating global markets. Even so, such estimates are a valuable “guideline” that is worth consideration. And anomaly tend not to be persistent.

In 2024, I think the data will probably continue to slow in 1H as Covid stimulus will not be there for support. But, tbh, gauging market reaction is a wildcard. The whole “good news is good news, and bad news is good news” phenomenon is really disturbing. This is classic bubble “logic” and obviously not sustainable. But it’s lasted longer than many thought possible, which is also classic from Keynes – “Markets can stay irrational longer than you can stay solvent.”

Also for 2024, we will be dealing with corporate debt, commercial real estate, and zombie company refinancing risk. There’s a wild card for you.

Geopolitically, I don’t see the wars being an issue per se. The only one that would is China possibly invading Taiwan, but I just don’t see that happening next year. China has enough on the plate at the moment. More important is the fact that because of China’s problems, they will not be the white knight to bail out the global economy like they did in 08-09. That is an underappreciated risk that will likely come to the forefront should the recession become deeper.

In summary, “the facts” – slowing economic activity, high valuations, lag effects of interest rate hikes, and growing geopolitical instability - have not changed for 2024, even though all of them were basically ignored for 2023. If history is still a guide of any kind, they won’t always be ignored. And likely because they have been ignored, the re-pricing when it happens will probably be faster, hence the higher tail risk probability.

Still, we have to objectively consider the probability of structural changes in the market (ex. Passive inflows from retirement plans) and how markets will move forward. 2024 may be a time where we have to add risk strategically and selectively if prices continue to move higher and the facts do indeed change.