Investment Concepts

4.9% real GDP growth

5% interest rates

3.1% inflation

3.7% unemployment

S&P 500 up over 20% on the year

Reading these numbers, you could easily think they belong to a bygone era when the US economy was soaring and good times were rolling, perhaps the roaring 1920’s, the post WWII expansion, or the mid 80’s and 90’s boom years. Yet, the figures listed above are official data as of the end of 2023, stellar numbers by most historical standards, but you would have no idea how good things are judging by the depressed mood among investors and the general public that prevailed throughout most of 2023. 

Growth is back, we’re operating at full employment, inflation is only modestly higher than the Fed’s target, and long suffering savers can finally enjoy some returns on their hard-earned cash. Yet investors have spent most of 2023 trapped in an endless cycle of recession worries, fearing the imminent start of the crisis so many market commentators had last year’s Walkner Condon outlook I had warned about this negativity bubble, and the extreme bearish positioning.

While economic improvement and continued earnings strength are finally getting some recognition, we started the year in such a gloomy state that perhaps it’s taken until now for people to start questioning whether things really were as bad as they were told. In a recent podcast, the New York Times referred to this disconnect as an “enduring mystery” and questioned ”Why do Americans feel so bad when the economy is so good?” (a topic my colleagues Keith and Clint had already covered with much more panache in their own podcast. The Tik Tok sphere, I am told, even has its own “silent depression” viral trend, purporting that we are in fact in the midst of deep economic despair, there just haven’t been enough social media posts about it for people to notice.

We’ll never fully grasp the reasons for this ongoing negativity, but it’s worth mentioning that we have all been conditioned for doom and gloom in the last decade or so. After all, ever since the great financial crisis, we are supposed to be living in the “new normal”, a term coined by Mohamed El-Arian in 2009 to describe the low-growth post-crisis environment, and which has since become entrenched in investor parlance to describe the quantitative easing (QE) era: this strange experimental world where old dynamics no longer apply, where the gyrations of monetary interventionism have replaced business cycles, where low rates act as a form of ongoing subsidy, where any sign no economic weakness is met with drastic fiscal measures, and where none of this even matters anyway, because inflation is dead.

Through the lens of the “new normal”, it’s hard to picture an economy driven by ongoing labor market strength, consumer spending and innovation. Yet one of the more surprising positive developments of the year, to me, has been the increase in labor productivity growth. In technical terms, labor productivity is defined as total output of an economy divided by the total number of labor hours. In essence, it should simply capture how good we are at making stuff: if our business environment, policies, laws, financial conditions, labor practices and technology are conducive to growth, each unit of labor should be producing more. As such, labor productivity growth has the potential to be a sort of master economic number, through all the noise and if we’re moving in the right direction, the only piece of data you’ll ever need.

In practice, things are a bit more complicated, in part because labor productivity is very hard to calculate, prone to wild swings and statistical noise. With that said, ignoring the COVID distortions in the chart below, the Q3 2023 productivity reading of +4.7% was the highest quarterly increase recorded in over a decade, and followed an already very respectable 3.6% in Q2. If this trend can be sustained, it has profound implicativons for growth, and for the fight against inflation. To understand its relevance to inflation in particular, simply think about one of the most popular definitions of inflation: too much money chasing too few goods.

If, in aggregate, the economy becomes better by making stuff, the money has more goods to chase, and inflation abates… This improved productivity on the part of US workers and businesses has no doubt had a role to play in the recent improvements on the inflation front, though I’m sure central bankers will naturally take all the credit for it (I once attended a conference where a retired official described central banking as the world’s greatest self congratulation society, I don’t think he was kidding). Growth, meanwhile, has also started increasing fairly significantly in recent months, as evidence in the 4.9% third quarter estimate:

For these improvements to happen now, after a massive increase in interest rates, at a time when we are finally experiencing positive real (inflation adjusted) interest rates for the first time since the early 2000’s (see chart below), and while growth is rising (labor productivity often rising in recessions), is a clear sign that the “old normal” is new again, and that we’ve just experienced a streak of very successful economic performance which many may have thought out of reach in our generation. In short, we are back, and, economically at least, the fu- ture may be starting to look like the good old days of a not so distant past. Perhaps we are even re-discovery the merits of an old normal rate policy, where higher cost of capital pushes businesses to be more efficient, starting with a purge of zombie businesses and bloated profitless startups we witnessed in 2023.

These gains in productivity and growth are ultimately the only “good” way to beat inflation, the only alternative to the standard central bank modus operandi: crushing the economy enough to kill inflation.

Another possible reason why it’s been so hard for investors to get excited about the economy and markets is the notable lack of breadth in this year’s rally. For most of the year, while markets did remarkably well overall, that performance was driven almost entirely by a small handful of large cap US stocks (now dubbed, they “Magnificent Seven”). Through October 2023, they had rallied over 50%, while the other 493 constituents of the index barely moved.

Not that this type of market behavior is really anything new, we’ve seen many periods of highly concentrated market trends in the past. After all, when the first Back to the Future movie came out in 1985, the world was in the midst of one of the greatest asset price bubbles in history: the Japanese stocks and real estate bubble. An episode that would see Japanese stocks grow to represent 42% of global markets and average Price/Earning ratio of 60 (for perspective, Japan stocks now account for about 5% of global markets and a PE ratio of 16.

While not as extreme, one may even find vague hints of that era in today’s extreme US-centric positioning. Of course, Marty McFly and Doc Brown could have propelled themselves into the late 90’s for a taste of the internet stock craze, or gone back in time to the 60’s and experience the “Nifty Fifty” era (12), a blue chip stocks frenzy not unlike today’s mega cap tech obsession. Launching the DeLorean time machine all the way back to the roaring 20’s would have allowed an even wilder ride: an era dominated by exhilarating new technologies that saw the share price of RCA (The Radio Corporation of America) grow over 200-fold, outpacing even Nvidia’s performance in the last decade.

For the most part, all of these episodes were underpinned by genuine economic strength, but that did not prevent asset prices from becoming grossly overinflated, and for a crisis to eventually emerge. Current investor negativity, or at least skepticism, has the merit of keeping expectation in check, and valuations somewhat realistic. Sentiments are fickle and can change on a dime. As I’m typing this on the last trading day of 2023, markets are hovering around all time highs, and a further breakout would surely lead to a deluge of enthusiastic headlines. As of late, we also witnessed a broadening of the rally, with small cap and dividend paying stocks beginning to catch up with the magnificent 7. Even much hated bonds have rallied as interest rates fell.

If this trend continues, even the most hardened of bears may have no choice but to throw in the towel, and the goldilocks narrative could easily start to take hold take hold: imagine a magical place in the not so distant future where AI revolution meets falling rates and inflation, and where recession fears have morphed into soft landing realities. What’s not to like? With just a little bit more patience this future may well be within reach, even without a DeLorean.

With all that said, I certainly don’t think we are out of the woods when it comes to central bank induced recession risk. As impressive as the streak of economic strength has been, betting on its indefinite continuation would be betting on something that has never been achieved at any time in the 100 or so years of the central banking era: strong, consistent growth that lasts. Indeed, all prior periods of economic strength mentioned in this article ultimately had one thing in common: they ended in distorted asset prices and in some form of a crisis, one way or another.

One of the more absurd sounding things I told my colleagues in private office discussions last year (which was absolutely never meant to leave these walls) was something along the lines of “bank collapses are bullish”. This pronouncement was made in response to worries that the SVP bankruptcy was going to trigger the next crisis. As flippant and ridiculous as it sounded back then, in hindsight, I was right.

I didn’t mean to imply that business failure was, in itself, a good thing, but that if it triggered central bank easing, it may actually be an upside catalyst. While it might be easy to imagine that bank failures, higher rates, and central bank balance sheet reduction would cause severe tightening of financial conditions, the NFCI index actually indicates the The More Things Change opposite: financial conditioned in the US have been constantly loosening over the course of 2023 (13)

This counter intuitive development may be explained in part by short term liquidity measures put in place in response to SVB collapse, such as the ever popular Bank Term Funding Program in the US , and various liquidity supporting measures by central bank counterparts around the world (the Chinese’s central bank’s asset have grown $600B in the last 4 months: All perhaps cumulating to what macro analyst Matt King calls “Saying QT but doing QE”.

Meanwhile, as if these loosening financial conditions weren’t enough, the market is now pricing in an aggressive succession of rates cut in 2024. Market derived odds apply the highest probability outcomes to no less than 7 rate cuts over the course of 2024. With the term funding program now set to expire in March, and with plenty of strong economic data to support a higher-for-longer Fed policy stance, one might wonder how much longer the goldilocks conditions of loosening liquidity and aggressive rate cut expectation s might last. For economic strength to persist, it may need to survive a tighter than expected financial environment, and it may also have to deal with one of its main ongoing challenges: continued tight labor supply.

While full employment conditions are generally seen as a positive, they also have a dark side to them. In the short term, tight labor markets have supported wage growth and spending, contributing to growth, but they also create a difficult equilibrium for businesses: a combination of higher costs, and difficulty in planning future expansion.

Some of the positive developments on the labor productivity metrics discussed earlier are certainly rooted in business response to having to do more with less, with fewer staff, but how much more can we squeeze out our existing workforce? At some point, businesses may need to start scaling back their plans or delaying expansion until conditions improve. If hiring slows and financial conditions tighten, it would not take long for the goldilocks environment to shift to much, much more challenging conditions. 

Over the course of 2023, I have repeatedly told skeptical clients that I believed the rally that started in October 2022 had legs. As we enter 2024, I still believe this to be the case. Strong economic data and earnings, still tepid investor sentiments, shift in rate policy and slower inflation are likely to continue to support the current bullish momentum. At the same time, while all the talk of recession that dominated headlines at the beginning of the year has financially started to subside, recession probabilities have, in my view, increased compared to the same time last year. As prices go up, there is always a temptation to believe that this time will truly be different. AI is already emerging as a justification for ever expanding valuation in a small subset of the market, but a look at our past may very well provide clues to what the future holds. If history is any guide, 2024 could be both fantastically exciting, and dangerous.

By: Syl Michelin

I have a lot of nostalgia for the 1980s and watching the “Back to the Future Trilogy” with my wife and my kids to this day remains a mental time machine back to my own high school days (when the trilogy started). 

One thing that I enjoy about watching the future “Hill Valley” in BTTF Part II is how much some of the more “creative” minds were influenced by their present (1989) when bringing this future to life. It’s actually quite instructive to look at this depiction of 2015 from our current 2023 perspective. On the one hand, flying cars obviously haven’t quite come to fruition, but, on the other hand, many aspects of that future seem to be tethered to an ‘80s cultural perspective. For example, the sneaker fashion of the 1980s included such innovations as velcro laces and the Reebok “pump” to tighten the fit.  From the lens of 1989, Marty’s 2015 Nikes with “power laces” seemed a logical progression (not to mention the auto-sizing “Members Only” jacket!). And, of course, who can forget the holographic shark that attacks Marty in the promotion of “Jaws 19”!  Sadly, the film doesn’t show the people walking the town square blindly fixated on iPhones or any drones buzzing about, Tesla robots or any internet references (kids apparently still played outside in the 1989 version of 2015). My point here is that the future is particularly difficult to predict or imagine because our minds are tethered to the things we know best:  the present and the recent past!

Which leads me to the troubling conundrum of investing in foreign stocks. Behavioral finance would suggest that there are several behavioral patterns that are conspiring to make international diversification almost entirely unpalatable to U.S. investors as we move into 2024. One of these powerful patterns or traits that lead U.S. investors to overinvest domestically is certainly not specific to the current market environment as it has endured throughout market history:  equity home bias.  This bias is really just a subspecies of “familiarity bias,” meaning that investors tend to be more confident in investing in things they know better or have more contact with than things that are more distant. This leads to local geographic overconfidence and causes investors to ignore the benefits of geographic diversification.

But equity home bias plays a secondary role to another bias that’s been around longer than that old broken clock tower. I’m talking about a behavioral force well known in the field of behavioral finance that is perhaps more “heavy” than the earth’s gravitational pull, Doc Brown:  

RECENCY BIAS!!! 

Recency bias is that special fabric in our neural programming that can dominate investing choices and horribly skew what we forecast about the market’s future as our imaginations are captured by the market climate of yesterday and today. It is the fuel that powers the herd ever forward, plowing more and more money into what has been performing best in the unwavering belief that outperformers will continue to do so well into the future. Recency bias basks in that part of the mind that is so confident in the obvious trend that we literally start to believe that we are betting like Biff with the Gray’s Sports Almanac (I guess the newer 2000-2050 edition) curled up in our back pocket!  

Since the moment the stock market’s deep dive brought on by the Great Recession bottomed out in early 2009 – almost 15 years ago now – recency bias has continued to support the same behavior as home equity bias — buy American stocks! Two powerful behavioral biases supporting one self-evident conclusion that the herd has happily and prosperously embraced again and again in recent history. U.S. stocks have led the rebound charge from the abyss of the housing crisis, once again in the Spring of 2020 even as C-19 lockdowns gained traction, and yet again this past year as U.S. stocks powered out of the toxic storm of ever-rising interest rates and inflation into a the spectacular market rebound of 2023 as the prospects of a soft(er) landing for the economy grew more probable. 

It’s been a market recovery dominated not just by U.S. stocks, but particularly by a group of “special” innovative mega cap U.S. growth stocks that Michael Hartnett, a pundit’s pundit from Bank of America, coined in 2023 as the “Magnificent Seven” (oh lord, another movie reference that we’re stuck with – thanks a lot Mikey!). I’m not going to list those seven stocks here, lest I further fuel the biases, and you probably own them all anyway. I actually hope so, because these seven stocks currently constitute well above one quarter of the S&P 500’s total value and over one-half of the total value of the Nasdaq 100. As a believer in holding core positions in index ETFs, I’m not suggesting that you shouldn’t own these seven companies, but you should not own them to the exclusion of other investments that are essential to a well-balanced (i.e., diversified) investment diet.

But recency bias is the flux capacitor fueling our greediest instincts and naturally draws investor attention to the jaw-dropping performances of the Magnificent Seven and all stocks within their collective orbit. Just look at the cumulative five-year performance (2019-2023) of these mega cap growth stocks (not naming names here):

Chips to power the future as far as the AI can see:  1,354%

Elon’s E Carz:  1,073%

Still Cookin’ with Tim on the Job(s):  419%

Close the Gates after you let in that Nadella fella:  269%

Great Googly Moogly:  163%

He (the creepy) Man & The Masters of the Metaverse:  156% (despite the Metaverse)

Doctor Evil in his Prime:  93%

Those gains obviously had a favorable impact on overall U.S. large cap performance over these past five years. It’s been good to buy America and even better to supersize your order when doing so, with five-year returns looking more than respectable, despite the most recent bear market packed into the middle of it all. Here are some five-year returns from popular US large cap index ETFs:

SPDR S&P 500 Index ETF:  88.3%  

INVESCO QQQ Trust Nasdaq 100 ETF:  162.1% 

Vanguard Information Technology Sector ETF:  192.3%

The more Mag7 the merrier for your index returns. Just out of curiosity, do you know of any non-U.S. trillion dollar companies?  Me neither. So let’s take a peak at how international stocks performed collectively during that five-year period:

Vanguard Total International Stock Market Index ETF:  20.4%

Vanguard FTSE Developed Markets ETF:  26.4%

iShares MSCI Emerging Markets Index ETF: 1.3% (wuff!)

Those are incredible disparities over the past five years – go home team! Recency bias is that constant whisper in our ear telling us that 1, 3, and 5 year returns not only matter, they’re the only returns that matter, that have ever mattered and, quite possibly, that will ever matter! This investing business is pretty easy, right?!?! It feels like it’s high time to sell those toxic Chinese Biffcos and get yourself some more USDA prime tech stocks to ride the AI wave to a future of opulence free of financial worries, right?!?! Fair questions, I suppose, when the good times roll and we feel the Power of Love. But hold on there, Huey Lewis, before you spread more recency biased “news,” remember how the old adage goes: THERE ARE NO FREE LUNCHES (nor Pepsi Free, Calvin Klein). Despite all recent evidence to the contrary and that constant whisper of more to come, no one has a Gray’s Investment Almanac 2000-2050 edition … yet. 

For example, that flat five-year return for emerging markets obscures a less-recent, but not so distant, track record when emerging markets, and foreign stocks in general, ran circles around U.S. stocks. In Chapter One (2000-2009), that almanac will reveal that U.S. large caps finished that initial decade in basically the same place as they collectively started (the Mikeys of that era cleverly coined it the “lost decade”). Hopefully, your draft of those first chapters in Gray’s Investment Almanac 2000-2050 has some helpful graphics courtesy of the Callan Institute, namely their Periodic Table of Investment Returns. The Callan periodic table breaks the investment universe into nine general categories:  Developed ex-US Equity, Emerging Markets Equity, Global ex-US Bonds, High Yield Bonds, Large Cap Equity, Real Estate, Small Cap Equity, U.S. Bonds, and Cash Equivalents.

As these tables can take a while to be published or readily available, let’s for now break the past twenty years of available market data into two 10-year periods: 2003-2012 and 2013-2022. To make things simpler (as this discussion is about stocks) we’ll focus on the larger stocks in the three categories discussed above:  U.S. Large Cap, Developed ex-U.S. Stocks, and Emerging Market Stocks.  In the more recent decade not including 2023 (2003-2012), U.S. Large Cap Stocks were the best performing asset class of all nine categories three times and finished second twice. U.S. Large Caps outperformed Developed ex-US stocks in every year but two (2017 and 2022). In each of those instances, U.S. Large Cap was the next asset class under these foreign blue chips. U.S. Large Cap stocks bested Emerging Market stocks in nine of the ten years. The only exception was 2017, when Emerging Markets was the top performer (37.28%), Developed ex.-U.S. stocks finished second (24.21%) and U.S. Large Cap stocks finished third (21.83%). Though the markets have had plenty of bumps along the way, I would describe the most recent decade as “consistently comfortable” to be a USA-only stock investor.

But moving back to the prior ten-year period (2003-2012), such USA home bias came at a terrible cost.  During the 2003-2012 period, U.S. Large Cap stocks never finished first. In fact, there were only two years in this period that U.S. Large Caps outperformed both Developed ex-U.S. stocks and Emerging Markets stocks:  2008 and 2011. 2008 may still bring back painful memories for domestic and global investors alike, as U.S. Large caps beat the foreign stock categories yet still lost thirty-seven percent of their value, while 2011 was the only year where U.S. Large caps gained and both international stock asset classes lost ground.  In contrast, Emerging Markets over the 2003-2012 period provided investors with Doc Brown’s requisite 1.21 jigawatts of investing power (and volatility)!  The emerging markets asset class outperformed all others in 2003, 2005, 2007 and 2009, while finishing second in 2004, 2006, and 2012.  Sounds unstoppable, right?  Oh, I forgot to mention it finished dead last in 2008 and 2011. Emerging market stocks were clearly the cryptocurrencies of the new Millennium there for a while – Great Scott! 

Just looking at the first five years of this Callan Periodic Table of Investments (2003-2022), the cumulative outperformance of emerging markets stocks and developed ex-US stocks looks suspiciously familiar to the absolute rout that U.S. large cap stocks have put up against those foreign stocks in the most recent five years, as described above:

This is especially true of emerging markets stocks, because of the symmetrical degree of outperformance against U.S. large cap stocks in 2003-2007 and underperformance in 2019-2023. Bringing 2023 back into the discussion and looking at the last five market years, there are eerie and troubling similarities. For example, note that Emerging Markets finished 1st in the first, third and fifth year of the 2003-2007 5-year time period and it appears that U.S. Large cap has pulled off that same feat over the last five years, finishing first in 2019, 2021 and once again in 2023.  Given that emerging markets proceeded to lose 53.33% the very next year following its stretch of dominance, should you be comfortable holding only (or even mostly) U.S. large caps in 2024?  Hellooooooo McFly, anybody home???

I’m not suggesting that U.S. stocks are doomed to a similar fate in 2024. That would imply I have access to the 2024 data in that Almanac, and I do not. But, as we move into 2024, I wouldn’t bet it all on that U.S. large cap horse, lest your portfolio  run the risk of colliding into a trolley cart of horse manure returns. Don’t Biff around with your nest egg! These trends always reverse eventually and the stronger the trend of one asset class above all others, the greater the potential strength of that reversal to underperformance.

I could make a more multi-factored argument against holding only U.S. large caps and ignoring foreign stocks entirely.  I could pull out some socio-economic Jenga pieces that include the high valuation of the U.S. dollar, relative valuations, political uncertainty, the national debt, the 2024 elections, etc., etc. I could cleverly stack each of those Jenga pieces as I mention them only to eventually slap them right off the table. But that’s a different movie entirely. More importantly, none of those Jenga pieces are going to influence the herd because they simply don’t have the gravitational pull on investor psychology that recency bias holds. 

I’ve also noticed that very few “pundits” are coming out as we turn the page from 2023 to 2024 with any predictions that don’t sound eerily similar to what’s been working. This isn’t a retail investor problem, it’s a flaw in the human condition. And the fact that recency bias is absolutely blinding everyone from seeing a future where foreign stocks reward investors relative to U.S. stocks is the single strongest argument that 2024 could very well be your watershed  opportunity to keep more of your domestic gains from the last decade and shift the future timeline of your retirement for the better. There are really only two key ingredients for this:

1. Diversification across asset classes AND geographies

2. Time in the market, NOT timing the market

There are special tools at the disposal of your investment advisor, such as direct indexing strategies that utilize tax loss harvesting to defray some tax costs of gaining more geographic diversification. But the key benefit of independent, fee-only financial advice just might be the objectivity of an experienced professional that has shepherded clients through different markets and understands the dangers of recency bias. The danger is real and frankly more so because it is invisible in the glowing bright light of 2023’s spectacularly strong finish. Overcoming your recency bias is the ultimate challenge to reaching that better future – like overcoming the fear of rejection or the fear of being seen as a coward when confronted with a risky proposition. 

As Doc Brown tells Marty and Jennifer at the conclusion of the trilogy, “the future is unwritten.” Avoid the seductive temptation to believe otherwise and embrace the concept that not knowing the future does not mean that we should fear it. Without that investment almanac of the future, we should continue to take calculated risks, while always hedging the larger positions. U.S. large cap stocks, which make up around one-half of the investment wealth in the global stock market, have been and forever should be a significant position in need of responsible hedges. 

By: Stan Farmer