Always Expect the Unexpected
Jan 25, 2024Looking back at 2023, one thing we can reflect on is the winding road we navigated along the way. The last several years we’ve had alternating results and abnormal returns. In 2020, the S&P fell more than 33% before recovering before year’s end to finish up 18%. In 2021, the market was up 29%. In 2022, it fell more than 18%. Last year, it jumped more than 26%.1
For most indices, we sit fairly close to where we were two years ago. In other words, in most areas of the market we have done nothing in 24 months. Of course, as noted above, the path here has been anything but flat. At times, it has felt like skiing a double-diamond.
The Impact of Behavioral Biases on Your Investments
As we review portfolios, we are reminded of the behavioral biases that can play a fundamental role in portfolio management. Investors, of course, are human (for the most part). And human emotions have an uncanny way of controlling and dictating behavior. In the last two decades, researchers have spent an increasing amount of time on behavioral investing psychology as an integral driver of returns in the world of finance.
There are two fundamental realities that tend to be forgotten by many market participants:
- You can have the greatest conviction in a thesis with tons of evidence to support it, however, markets are infamously unpredictable and don’t care (you can’t time the market).
- Financial markets and risk assets do not move in a linear fashion (a straight line). Not when they are moving up, nor when they are falling.
While these are simple concepts, they are often ignored thanks to the human emotion that tends to force us to challenge them. Recognizing these biases is the first step in making a rational, informed decision, especially when grounded in the reality that we may be right in the long run but wrong many times along the way.
2023's Financial Shake-Up
Last year was a great example. The Fed began tightening monetary policy in March 2022 but really only entered restrictive territory in the first half of last year. They raised the Federal Funds rate 400 bps (+4.0%) in 2022 and another 150 bps (+1.50%) in 2023 before stopping last July.
In the first part of 2023, the impact began to really be felt. An extremely fast run-on deposits at Silicon Valley Bank (“SVB”) left them insolvent. The headlines were dramatic:
- “Silicon Valley Bank Fails in Largest Bank Collapse Since 2008 Crisis” — The Guardian, Mar 2023 2
- “It’s Crystal Clear Now: More Banks Are Going to Fail” — Business Insider, March 2023 3
- “The Banking Crisis Has Only Just Begun” — Forbes, July 2023 4
One might have thought that it was a catastrophic year for banks and that another 2008, or worse, 1929 was upon us. Instead, the S&P Financial Sector SPDR ETF (XLF) finished the year up over 12.0%.5
Many also thought that since the banks that failed mostly dealt with California and start up technology firms, that it would spillover into the technology sector. Instead, we had the Nasdaq return 44% on the year.6
The geopolitical environment didn’t disappoint either. There was the ongoing Ukraine war with Russia plus a new one with Israel being attacked by Hamas.
Often, we see oil move markedly higher when geopolitical events occur, especially in the Middle East. While it did move higher initially, it ended the year lower by 10%. In addition, the volatility index was cut in half during the year.
Market Volatility & the Power of the Magnificent Seven
The S&P 500 returned ~26% in 2023 but it did not do so in a straight line. We experienced two corrections (peak to trough of -10% or more). We had many more -5% pullbacks. However, the catalyst for most of the returns was the last-in-the-year pivot by the Federal Reserve who announced that they were ‘on pause’ from their quantitative tightening (“QT”) program.
We did not expect the S&P 500 to return so much in 2023 and that departure of our expectations from reality is a great illustration why maintaining a set of defined risk parameters set by principals is so important. Actively trading on headlines would have proved detrimental to returns.
Additionally, we saw just seven stocks contribute the majority of that return. The ‘Magnificent 7’ as they have been dubbed (Apple, Microsoft, Google, Amazon, Meta, Tesla, and Nvidia) soared during the year. Since the S&P 500 is market capitalization weighted, meaning the larger the company, the larger the weight in the index, these seven stocks account for nearly one-third of its weight. That is the highest in over 30 years.7
Source: Pring Turner & StockCharts.com, as of 01/25/2024. Graph illustrating 2023 Price Performance of the Magnificent 7 and remaining stocks in S&P 500.
Since all seven of these stocks performed strongly in 2023, they contributed an outsized amount of the return the S&P 500. The average return of the Mag7 stocks was a whopping 111%.8 Yes, you read that correctly. The rest of the 493 stocks were up about 12%. And for most of the year, the 493 were returning less than zero. But since those seven stocks are weighted so heavily, they moved the total index return from 12% to 26% for the year.
This led to some “FOMO” (the fear of missing out) as investors piled into technology names like it was 1999 all over again.
Our fundamental principles are simple: We want to invest client money so that it allows them to achieve their goals, objectives, and dreams while being able to sleep at night when volatility inevitably spikes higher.
The Danger of Chasing Big Stock Gains
Swinging for the fences with individual stocks can be very rewarding but more likely, damaging to one’s portfolio. An investor who is easily swayed by emotions or their own cognitive bias, is likely to depart from the fundamental principles that provide guardrails around their portfolio to ensure they stay on the right track. Retirements and legacy wealth are just too important for gambling-type of bets in the markets. This is especially true if it is not necessary to reach the stated goals of the capital.
In the last 15 years, the S&P 500, largely on the back of a handful of stocks, has massively outperformed nearly every major stock market on the planet. In fact, it hasn’t been pretty. The S&P has trounced the MSCI EAFE (an index of 21 developed country stock indices) 380% to 97% over the last 13 years.9
Source: Noble Wealth Management, powered by YCharts, as of 01/25/2024.
However, there have been times when it was the other way around. When international stocks consistently beat US stocks. The chart below shows that. Whenever the bar is ‘negative’, that is when the EAFE index outperformed the S&P 500. I have highlighted those sustained periods in red.
Source: Investment Moats, as of 01/25/2024. Graph highlighting Cumulative Rolling Return Differences.
With the S&P 500 being led by a handful of stocks, largely from the same sector, there is a higher than average chance we could see a reversal and those stocks enter a bear period of sustained declines. However, no one can predict the future.
This is why we stick to our guns and maintain that discipline of adhering to our principles. Risk management can be far more important than any other consideration when building a portfolio.
The Key to Market Success
The key is maintaining that discipline by attempting to be emotionless with the markets. Deviating from those principles even in the face of newsworthy, global events, can be the most difficult lesson to learn in investing. Succumbing to triggers that produce a knee-jerk reaction rarely delivers the results our emotions tell us to expect, and our response rarely improves the likelihood that we will meet our long-term objectives.
This year is an election year and not allowing those headlines or personal preferences to infiltrate your thoughts will be imperative to maintain that discipline. Long-term investing and fundamental analysis often serve as the foundation for portfolio allocation decisions. All that means is we focus on the data – financial metrics and economic indicators – that provide the foundation for our assessment of risk versus return.
While fundamentals will likely dictate asset returns over the long run, results can and will run counter in the short run. We must be okay with the fact that even if we believe strongly that our assessment of fundamental analysis is correct, the market will often disagree, sometimes by a wide margin, and perhaps for a long time.
When 2023 began, investors were largely pessimistic about the year ahead. As usual, the market caused the most amount of pain for the greatest number of people by doing the unexpected. The pendulum has shifted dramatically judging by sentiment surveys. Investors today are largely ebullient about the future and there is little fear today in the markets.
No pricing in of a recession remains in the market. As of now, they look to be right but that can change quickly. It is possible that the market is now ignoring some of the significant risks that are lurking under the surface.
We remain vigilant and adhere to our steadfast beliefs of not letting emotions or personal bias infiltrate our thinking and the managing of portfolios. Risk controls are paramount to everything we do. Our unwavering firm commitment is to aid every client in successfully navigating both predictable and volatile markets, ensuring they accomplish their unique investing objectives.
Sincerely,
Mark Asaro, CF
1 https://www.morningstar.com/etfs/arcx/spy/performance
2 https://www.theguardian.com/business/2023/mar/10/european-markets-spooked-by-us-bank-shares-sell-off
5 Calculated on yCharts using the XLF ticker, Dec 31, 2022 through Dec 31, 2023 and a total return price calc
6 yCharts calculation using the Nasdaq index from Dec 31, 20222 to Dec 31, 2023 – total return price
9 Calculated with Noble’s yChart subscription (see chart)
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