HIBL - Outlook 2024: What To Own In The New Year

2023-12-22 22:20:16 ET

Summary

• No one predicted the positive market performance in 2023, driven by tech stocks and low inflation.
• 2024 will bring a growth scare and a bull market in bonds, particularly zero-coupon US Treasury Bonds.
• Investors should expect the unexpected and be prepared for a number of scenarios.

It is that time of year, when colder weather and holiday cheer fill the air, and financial forecasts fill your inbox. In looking at the market and what opportunities exist in 2024, there are a number of ways for investors to prosper in the new year, but one specific investment stands out. In this piece I want to go through the economic environment and where I believe we are going in 2024. I will then make my case for the single most important asset for investors to own in 2024, and chances are you do not own it at all. Finally, I will go through specific portfolio ideas to take advantage of the environment I believe will play out in 2024 in various asset classes.

No One Predicted 2023

No one predicted 2023 correctly. Most investment strategists believed there would be a hard landing and a drawdown in equity markets. Instead, a Goldilocks environment of excess stimulus, Fed tightening, locked in ultra-low mortgage rates for homeowners, and a stable jobs market created an environment where stocks rallied. Most of the gains coming from the magnificent 7 tech stocks of Apple ( AAPL ), Google ( GOOG ), Microsoft ( MSFT ), Amazon ( AMZN ), Nvidia ( NVDA ), Tesla ( TSLA ), and Meta ( META ), which dominate the market cap weighted S&P 500 Index.

Just compare the 53.66% gain in the Nasdaq vs. the 24.72% gain in the S&P 500 to see the extent to which the magnificent 7 have pushed stocks higher. A recent Barrons article about Apple, asked whether they have the earnings to justify the price of their stock, with one analyst quoted in the story stating, “people aren’t doing the math.” That about sums up this market rally, with a group of 7 stocks accounting for ALL of the gains this year. Eventually, euphoria ends, and people start doing the math and realizing these stocks are worth a whole lot less.

The view across the street seems to say, in a united voice, that next year is going to be a great year for stocks. When everyone gets on one side of the boat call me skeptical. Maybe it is the positive vibes that accompany the end of the year, or the group think of Wall Street analysts, but something does not add up. The end of the year has seen a melt-up rally, in an environment where companies are beginning to tighten their belts, layoffs are beginning to pick up, and deflationary pressures are beginning to reassert themselves.

In fact, many retailers are in outright price deflation. The excess savings that investors built up over the pandemic has been exhausted, home prices are at the worst levels of affordability maybe in history, and consumer incomes have not risen in line with inflation, causing consumer debt to skyrocket. With this as the backdrop to the new year, it is hard to believe all is sanguine.

It seems the bullish stance of Wall Street is assuming that the Fed is going to cut rates, employment will stay at current levels, and all will remain well. I do not believe this will be the case. Nor am I calling for some kind of crash, but I do think we will have a growth scare that is likely to test the resolve of the bulls in the first half of 2024.

2024: Expect the Unexpected

While there is no way to predict the future, given the positive changes in the stance of monetary policy, and the current state of the stock market being back at levels we saw two years ago where high valuation tech stocks dominate the landscape, I am looking for opportunities where few care to tread, the zero-coupon US Treasury Bond market.

The reality here is that while zero coupon bonds underperformed this year, they were never a trade for a single year. In fact, bonds should be a permanent part of any long term diversified portfolio and the sad fact today is that few investors see any reason to own them in any form, including the total bond market ( BND ). Most investors continue to pour into mega cap tech stocks, but opportunities abound in the bond market.

Bob Michele and team at JP Morgan Asset Management believes that core bonds could see returns of 10-15% in 2024. They write :

"A bond market yield of ~5% is a far better starting point today than the 1% yield at the end of 2020. A rally of about 80 bps is all that would be needed to add another 5% return to the 5% yield of the market currently. Given ongoing disinflation and the Fed’s recent dovish stance, it seems reasonable that bond market yields can fall by at least 80 bps – and perhaps a lot more. A rally of about 170 bps would generate a total return of 15%, resulting in the best calendar year for the U.S. bond market since 1995."

My case for the 30 year zero is a magnification of their argument to attain more exposure to duration and convexity as the bond bull market begins. I believe 2022 was a bear market for bonds, 2023 was a stabilization of the bond market and 2024 should see the beginning of a bull market in bonds.

",,,when investors look forward to 2024, asset allocation must reflect a hard-learned mantra: “expect the unexpected.”"

-JP Morgan Asset Management, 2024 Commentary

Turning to a more comprehensive view of where to invest in 2024, I see the market digesting this stock market melt up with a balanced market in the first half, early gains followed by a growth scare that corrects the market and then more gains in the back half as the Fed cuts rates and the economy accelerates. This should provide a reasonable return for the market, with more alpha coming from small cap and value stocks as we finish up the year. Here are three ways to take advantage of this theme in the new year:

1. Avantis US Small Cap ( AVSC ) / Avantis US Small Cap Value ( AVUV )

Avantis is a division of American Century Investments stocked with some of the best talent in the space formerly at Dimensional Fund Advisors. These DFA alums have created some of the best factor ETF's on the market. One such fund is Avantis US Small Cap. Looking at this fund's composition, we see that it is made up of mostly micro-cap stocks.

Currently small and micro-cap stocks trade at a fraction of their large cap peers. AVSC is trading at 10.65x earnings vs 12.39x for the S&P 600 Small Cap Index, and 18.8x for the S&P 500 index. This fund should benefit more than the index if small caps begin to lead the bull market, as many expect for 2024. Tom Lee of Fundstrat says that we could see 50% returns from small cap's in 2024, claiming that the Russell 2000 could rally to 3,000. If he is correct this fund will likely see even better returns as a result of more exposure to the size and profitability factors.

2. Avantis US Small Cap Value ( AVUV )

For similar reasons as AVSC, Avantis US Small Cap Value should be a good investment in a world of higher rates. With large cap stocks trading at lofty levels, small cap value stocks are extremely cheap at 8.84x earnings for this ETF. This fund has a tilt toward value and holds stocks higher up on the market cap spectrum than its micro-cap dominated sibling. Holding both funds should create a powerful core small cap allocation. For those who do not want to take on the risks of a micro-cap dominated holding, AVUV may be a good alternative as long as you are comfortable with the value tilt.

3. Vanguard Value Factor ( VFVA )

The Vanguard Value Factor ( VFVA ) fund is managed by Wellington Management and provides an even exposure to each part of the value spectrum from large to micro-cap. It is a true one fund solution to capturing US value exposure without having to hold separate funds for large cap or small cap, though the fund does skew toward smaller cap stocks.

4. Vanguard Extended Duration Treasury ( EDV )

Many investors do not own any bonds going into the new year, and I believe this is a mistake. On a risk adjusted basis, with equities trading at lofty valuations, investment grade credit and government bonds that make up the largest components of the core bond index, look very attractive.

Even better, the long-term case for the 30-year Zero coupon Treasury bond remains intact. My long-term readers know that I prefer owning real bonds rather than bond proxies, but Vanguard Extended Duration Treasury ( EDV ) is a suitable alternative for those who feel more comfortable with ETF's.

I believe investors had a huge buying opportunity when long term paper hit 5%. At that level I backed up the truck and bought as many zeroes as I reasonably could. Why? For three core reasons.

First, zeroes act as a hedge to equity market risk. I believe inflation is coming down, and we are likely to hit the 2% core inflation target in 2024.

Second, I want to maximize my exposure to duration and convexity as we move back to a bond bull market with the Fed moving from tightening to more accommodative policy stance as we move through 2024.

Third, I believe locking in a 5% government bond for 30 years guaranteed was a no brainer given where I believe rates are going. Capital gains from this move are already in double digits since the October high in rates.

The aforementioned team at JPMorgan Asset Management believe a similar dynamic should play out as we move through 2024.

A Fed Funds rate of 2.75-3% (250bps below the current policy rate of 5.25-5.5%) would put the real rate at 1%, assuming inflation is at the Fed’s 2% target. In other words, as long as disinflation continues, the Fed can reduce the Fed Funds target while keeping the real policy rate restrictive, e.g., at or above the Fed’s estimate of long-term neutral (0.5%). There is every indication that inflation is not as ‘sticky’ as feared. The 3-month annualized run rate on core PCE (personal consumption expenditures) has fallen rapidly from 6.6% in December 2021 to 2.4% in the latest reading for October. Further, supply chains have eased (foreshadowing core goods deflation), gasoline prices have sunk lower as demand falls (foreshadowing commodities deflation) and we continue to see moderation in rents and wages (foreshadowing services disinflation). What should be remarkable about our rate cut prediction is not the magnitude of the easing, but the fact that it is NOT predicated on a recession."

Conclusion

"Hope Smiles from the threshold of the year to come, whispering 'it will be happier'...” -Alfred, Lord Tennyson

The quote above applies far more to bond investors than stock investors. While stock investors saw equities rally this year, bond investors saw a flat environment for both long term bonds and the core bond indexes. The 10-year Treasury bond saw yields rise precipitously, then fall violently, an amalgam of sound and fury that signified nothing, it would seem, ending the year flat.

With every new year, we look towards a new beginning. For investors, 2023's surprise rally made for a prosperous year. As the calendar turns toward 2024, and investors think about how they will position in the new year, I hope this piece provided insights to aid you in your quest to optimize alpha. If events play out as I believe they will in the new year, investors will be in for a very prosperous new year indeed. I wish you all happy holidays and a prosperous 2024.

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