INVESTMENT THEMES January 2024

Emphasis on Long-Term Cycles:

Unlike typical annual forecasts in investment newsletters, we remain focused on long-term cycles and trends as short-term market predictions are notably unreliable. That said, while common valuation measures such as the P/E ratio have no predictive value over a one-year period, they do explain a significant portion of investment returns over the next decade. According to Berkshire Hathaway’s Charlie Munger, “The big money is not in the buying and selling but in the waiting.”

Current extremely high valuations of the top seven technology stocks (often referred to as the Magnificent Seven) suggest limited long-term returns. In contrast, the broader market, with more moderate valuations, is poised for reasonable returns, though likely slightly below historical averages.

10-Year Asset Class Return Forecasts: Our long-term projections align with Vanguard’s, as presented below, favoring international and smaller value stocks over domestic large growth stocks, as well as forecasting solid bond returns in line with historical norms.

Diversification Rationale: The market currently is highly concentrated in major U.S. firms, paralleled only in 1932 and 2000, as shown below.

Coupled with the disproportionate valuation surge in 2023 for the top seven technology stocks (shown below), this degree of concentration underscores the need for diversification. Those 7 stocks are valued higher than all 5,000 public European companies, despite the latter’s combined revenues being nearly 5 times greater. RBC Global Asset Management estimates the Magnificent 7 companies need to grow their earnings by 37% per year over the next decade to justify their higher valuations, twice their growth rate in recent years. The valuation gap to the U.S. market is highlighted as follows:

Short-Term Market Trends: While longer-term market trends are more predictable, short-term trends remain relevant. Stock market responses have been mixed historically post-Federal Reserve rate hike cycles. After fourteen rate-hike cycles, the market was down over the next 12 months eight times, and six times it was higher, with many of those higher instances being in more recent decades. The average 12-month return of 1.8% after all rate-hike cycles over the past century is well below normal.

Additionally, quality stocks, which we favor in our portfolios, have performed well following rate hikes over the past thirty years.

While the short-term returns following rate-hike cycles have been mixed, stocks in election years of first-term presidencies have had an average total return of 15.5% and have gained 100% of the time since World War II, regardless of whether the incumbent president was reelected or replaced.

Bond Market Insights: Over the past thirty years, bonds of all types have shown strong performance in the year following the final Fed rate hike, as shown below. However, a potential complication to following this pattern could be that while the Fed may reduce short-term rates, long-term rates could experience upward pressure due to an increase in supply. This scenario is likely as the Treasury Department plans to issue long-term bonds to finance the substantial fiscal deficit.

Conclusion and Strategy: Our approach remains focused on investing prudently in a globally diversified portfolio of stocks and bonds with high-quality, less speculative assets that we believe will provide solid long-term returns with reasonable levels of risk.

We shifted half of our U.S. small company exposure in the fourth quarter from a value fund to a quality growth fund. Quality is especially important in the small-cap universe because nearly half of those companies are unprofitable, and often more susceptible to speculative booms and busts.