Reflection on the Fourth Quarter

By Hightower Omaha on January 5, 2024

January 5, 2024

Stocks usually benefit from a decline in interest rates, and that’s exactly what we saw in the fourth quarter. The yield on the 10-year Treasury peaked at a little over 5% on October 19 and began a plunge to the current yield of 3.99%. Just one week later, on October 27, the S&P 500 bottomed out and began a climb that would produce a total return of 16% by year end. The rally in stocks was driven by multiple expansion, from about 17.2x forward earnings at the beginning of the rally to the current 19.6x. Earnings estimates have barely budged, and that makes me a bit nervous. 

The strong equity performance in 2023 was also heavily concentrated among large technology companies that stand to benefit from the development of artificial intelligence. In fact, only about a quarter of the companies in the S&P 500 outperformed the index for the year, which is the lowest percentage in over three decades and is well below the long-term average of close to 50%.[1] It’s worth noting that valuations have become quite rich for many of the 2023 outperformers, while valuations for many rank-and-file stocks that did not keep up in 2023 remain quite reasonable.

The industry sector benefiting most from the rapid decline in interest rates (and the Fed pivot) in the fourth quarter has been the banking sector. The KBW Bank Index, which is comprised of 24 large U.S. banks, also bottomed out on October 27and has since produced a total return of over 35% in a little over two months. Not many people were expecting that kind of move from the banks. You may remember a long time ago in a galaxy far, far away, there was a banking crisis. Well, that actually happened in March, but it seems like an eternity ago. The crisis was caused by the cumulative impact of Fed interest rate hikes, which led to huge paper losses on the banks’ bond portfolios, deposit flight in search of higher returns and the possibility of a spike in loan losses as maturing loans must be refinanced at higher interest rates. 

The recent drop in interest rates is a lifeline for many banks that made bad bets on interest rates. But the banks are by no means out of the woods as interest rates remain well above the averages over the past 10 years. The most obvious vulnerability for banks is their exposure to commercial real estate. In March, the Mortgage Bankers Association estimated that almost $2.7 trillion in commercial real estate loans will mature by 2027, with nearly half of those loans on bank balance sheets. While much of that exposure is held by smaller, regional banks, there are other headwinds that will negatively impact the sector more broadly. Rising deposit costs, weak loan demand and increased capital requirements are likely to continue pressuring profits. At the very least, investors in bank stocks will need to be highly discerning following the surprising fourth-quarter strength in that sector.

The gathering pressures on the consumer, combined with the delayed impact of interest-rate increases, continue to justify a more defensive posture for stock investors. And there is pretty clear evidence that the global economy is slowing down, to include the sharp declines in inflation, interest rates and commodity prices (especially energy). The deceleration in growth could put earnings estimates for 2024 and 2025, both of which translate to about 12% growth, at risk of downward revisions. And if earnings estimates do begin to head lower, it would be much harder to justify the current premium valuation for the S&P 500 (19.6x forward earnings compared to a long-term average of 16.4x). A focus on quality companies with rock-solid balance sheets, many of which haven’t fully participated in the recent market strength, could help weather any storm that may come.

Bond prices have been spiking too as interest rates have dropped, and more gains could be in store. The reason is that long-term interest rates remain fairly high relative to inflation expectations, leaving inflation-adjusted (or “real”) interest rates relatively high as well. The current 10-year “real” yield is about 1.78%, which is down from a recent high of about 2.5% in October but otherwise is higher than any time since 2010. The Fed views “real” interest rates as a proxy for how restrictive its monetary policy is. So given its recent “pivot” towards a more neutral policy stance, it would make sense for the Fed to reduce some of that policy restriction if it wants to help avoid a recession.    

Peace,

Michael

[1] Source: Blake Millard of Sandbox Financial Partners. As of November 21, 2023.