The stock market closed out 2023 with strong gains. Stock ETFs surged in December, adding to the solid returns in November. Investors are clearly betting that the U.S. economy will avoid a recession in 2024 and are starting to price in the possibility of interest rate cuts from the Federal Reserve as early as March.
The dramatic drop in bond yields was a big catalyst for the rally. The 10-year Treasury finished 2023 with a yield of about 3.87%, down sharply from 4.35% at the end of November and a more than 15-year high of just under 5% in late October.
"There is such a focus on the 10-year yield and the market was shell shocked when it got close to 5%," said Quincy Krosby, chief global strategist with LPL Financial. "But now rate cut hopes are rising as the Fed focuses on quelling inflation without killing the labor market."
Great Year For Most
U.S. diversified equity funds surged nearly 7% in December as bond yields sank, and closed out the year with a more than 21% gain, according to data from Refinitiv Lipper.
But investors still flocked to riskier tech and growth stocks. Cathie Wood's Ark Innovation ETF beat all other high-volume exchange-traded U.S. diversified stock funds for the month and full year. It posted a nearly 68% gain for all of 2023 according to Morningstar. ARKK soared more than 13.5% in December alone. Other momentum stock ETFs, such as the Fidelity Blue Chip Growth, Renaissance IPO and Harbor Long-Term Growers funds, also enjoyed solid gains in December and throughout the year.
Still, small cap funds outperformed larger cap stock funds in December, posting more than 10% gains in the last month of the year compared to about 5% returns for large cap funds. That's an encouraging sign since it shows the rally may be widening to include more than just the Magnificent Seven megacap stocks that dominated the market in 2023.
Soft Landing A Pipe Dream Or Reality?
Investors now are pricing in a so-called soft landing scenario, the delicate guiding of the economy by the Fed so that conditions slow a bit to remove some of the inflationary froth without leading to a full-blown downturn.
With that in mind, financial services funds really took part in the December Santa Claus rally, soaring almost 10% in the past month after lagging the broader market's gains for much of the year. The Financial Select Sector SPDR Fund gained nearly 17% in the final two months of 2023.
The market appears to be betting that rate cuts in 2024 will help boost demand for mortgages and other consumer loans. That's good for banks. Other more diversified financial firms should benefit from lower rates as well.
"We've been waiting for a broadening out of the rally," said Teddy Parrish, chief investment officer with Parrish Capital. "With the Fed finally pivoting, that bodes well for the financials." Parrish's firm owns regional lenders Bank OZK and Northwest Bancshares as well as financial giants such as AllianceBernstein, Blackstone and Charles Schwab.
Will 2024's Stock Market Be Stress Free?
Still, 2024 could be a more volatile year on Wall Street after a mostly upbeat 2023, especially for investors in the leaders of the Nasdaq.
"I expect a rough start to the year," said Brad McMillan, chief investment officer with Commonwealth. "There was a significant rally last year and valuations for Big Tech got bid up."
The good news though is that McMillan thinks there may be compelling values in stocks beyond the Magnificent Seven. "The majority of the market is not overpriced. So we may get limited growth," he said, noting that earnings should be strong enough to justify a 5% gain for the S&P 500 in 2024.
So the key to bigger stock market returns this year may lie with the other 493 companies in the blue chip index. Parrish thinks that the S&P 500's equal weight index, which doesn't give outsized importance to the likes of Apple, Alphabet, Amazon, Meta Platforms, Microsoft, Nvidia and Tesla, could outperform the cap-weighted S&P 500 in 2024 after lagging the index last year. The Invesco S&P 500 Equal Weight ETF was up "just" 11% in 2023, compared to a more than 23% gain for the overall S&P 500.
Aiming For Yield In The Stock Market
Investors shouldn't ignore higher yielding stocks or even the broader fixed income market either, even if long-term government bond yields continue to fall. Krosby said that dividend payers, which lagged the market in 2023, could make a comeback. The SPDR S&P Dividend ETF fell about 1% last year while the Utilities Select Sector SPDR Fund, which owns big dividend paying electric and water company stocks, tumbled 10%. Krosby also noted that mortgage-backed securities and preferred shares could outperform the Treasury market.
Krosby adds that investors have to be careful what they wish for when it comes to bonds, however. The drop in the 10-year yield has been one of the primary catalysts for the stock market rally at the end of 2023. However, if rates continue to fall sharply, that might be a sign of troubling times ahead for the economy ... which could hurt corporate earnings and the stock market.
"If the 10-year yield continues to head toward 3%, that's a signal that the bond market is worried about a growth scare. You want rates to come down but not collapse," she said.
Stock Market Too Hot?
But by the same token, an economy that remains too hot is also a concern. McMillan thinks investors are pricing in too many rate cuts for 2024. His big fear? Inflation could pick back up again and the Fed won't be able to ease as aggressively as Wall Street is currently expecting. Fed fund futures are pricing in the possibility of six or even seven rate cuts this year. McMillan argues that the Fed may lower rates twice in 2024 at most.
"The major outstanding risk is still inflation," McMillan said. "Everyone is pricing in a slowdown in inflation. But what if the economy starts to boom? If inflation runs hotter than the Fed wants, the Fed could have to hike again. That's what worries me."
Throw in the fact that there will be a highly contentious and polarizing 2024 presidential election and it's clear that there are more risks to the market than there were in 2023. Even if stocks still wind up having a positive year, it seems that the easy money gains of 2023 will be hard to duplicate.
