The Margin of Safety Quarterly Winter 2024
A Look Ahead:
- Investment Outlook & Portfolio Positioning
- “Magnificent Seven” At It Again
- Foreign Stocks: Why You Should Hold Them
- Retirement Planning Beyond the Numbers
- Firm News & Closing Thoughts
Quarterly Investment Commentary Fourth Quarter 2023
What a difference a year makes. In 2022, high inflation and the Fed’s commitment to tame it, led to sharply rising interest rates and negative returns for both stocks and bonds. In 2023, much to the surprise of many forecasters, global stock and bond markets ignored widespread expectations that we were headed for a recession and were able to shake off a host of uncertainties to post strong gains for the year. 
Aided by a powerful year-end rally, U.S. stocks (S&P 500 Index) jumped nearly 12% in the fourth quarter to finish up 26% for the year, and end within a whisper of its all-time high. Smaller-cap stocks (Russell 2000 Index), which lagged their larger counterparts for most of the year, also rallied sharply in the fourth quarter (+14%) to end the year with a respectable gain of 17%.
Developed International and emerging-market stocks also posted solid gains. Developed International stocks (MSCI EAFE) finished the year up 18%, while emerging-market stocks (MSCI EM Index) posted a nearly 10% return.
Bonds also rallied sharply in the fourth quarter aided by a significant drop in Treasury yields. The benchmark 10-year Treasury yield declined over 100bps in the fourth quarter resulting in a 6.8% return for the Bloomberg U.S. Aggregate Bond Index. Interestingly, despite massive intra-year volatility, the 10-year Treasury yield ended the year exactly where it started. For the year, U.S. core bonds (Bloomberg U.S. Aggregate Bond Index) finished up 5.5%. Credit was a standout performer both in the fourth quarter and for the full year. High-Yield bonds (ICE BofA High Yield Index) were up 7% in the quarter, finishing up 13.4% for the year.
Tax Corner
We are sure everyone is excited that another tax season is rapidly approaching! One of the items we are asked by probably the most people is “How do I save money on my taxes?” Here are some items to consider and potentially take advantage of:
Contribute to Savings: You can still contribute to a traditional IRA or a Health Savings Account (HSA) for 2023. Contributions will yield you savings at your marginal tax rate. It is not bad to get the government to chip in 20-30% towards your savings goals. These contributions can be made up to the April 15th due date. For those that are self-employed, there are even more options as some self-employed plans allow for even higher contribution limits and can be done up to the due date of the return plus extensions.
On this same subject, be sure that you provide the information that you made an IRA contribution to your tax preparer. Tax documents that you receive will not include this information, so it is common for people to omit it on their taxes. This results in no deduction and worse still, the money potentially being taxed twice!
Consider Charitable Giving: Now is also a perfect time of the year to think through your charitable giving plan. Are you over age 70.5? You can take Qualified Charitable Distributions (QCDs) from your IRA to give directly to charity. This can save you more than getting a deduction on the same gifts through itemization and is also available to those that can’t itemize. If you aren’t age 70.5 yet, then is there anything you can do to get a deduction for charitable giving? Yes, a Donor Advised Fund (DAF) can help with potential deductibility of charitable donations and can also allow you to give stock to multiple organizations without realizing a taxable gain.
For those of you that have made private investments with us, you should be aware that this will result in additional tax reporting to you and that this reporting can be delayed. For those investments that issue a 1099 (which is most private investments that we have implemented) 1099 documents should be issued by the end of March. These 1099s will, in some cases, come from the individual fund companies and not be reported on your Schwab 1099. For private investments that were in limited partnerships, these funds will issue K-1 documents that could be issued later in the year. This would result in the need to file an extension for your tax return. If you have questions as to which investments you may have, do not hesitate to ask us. We will be sending an email with additional details on this shortly.
Investment Outlook and Portfolio Positioning
Looking ahead to 2024, all eyes will continue to be on the Fed. When will the Fed start to cut rates, by how much, and why? Will the Fed cut rates enough to meet the markets’ lofty expectations? While these questions will be in focus, monetary policy is just one of many factors that will influence markets. Geopolitical risk, the U.S. presidential election, labor markets, and inflation will likely fill the headlines, and all could be sources of volatility.
From an economic perspective, we enter the year on solid footing and believe a recession is unlikely, at least in the first half of 2024. There are several factors supporting solid economic and corporate earnings growth, while inflation continues to decline. We think the biggest recession risk will come from weakness among consumers in the latter half of the year and we will continue to closely monitor economic data and adjust our views accordingly.
As we stated in our third-quarter commentary, we thought the Fed had the upper hand on inflation and that it would continue to trend lower. That has been playing out and we continue to believe that inflation will grind lower in the near term. Many of the metrics we observe suggest that inflation is already at or below the Fed’s target.
The chart below illustrates the year-over-year inflation rate and year-over-year inflation rate excluding shelter costs, which is a key CPI input. (It makes up about 30% of the CPI.) While year-over-year inflation recently came in at 3.1%, this number drops to 1.4% when excluding shelter. These levels are near the Fed’s goals, which suggests that the Fed’s policy has been working, and with time inflation could continue to fall, particularly if shelter continues to decline.
Since the Fed started their aggressive tightening cycle, the debate has been about the odds of a “soft landing” or “hard landing” for the economy. In other words, would the Fed be able to thread the monetary policy needle and raise interest rates enough to stamp out inflation, but not so high it slams the brakes on the economy and tips it into recession.
The National Bureau of Economic Research (NBER) is the scorekeeper when it comes to determining recessions. Their definition of a recession is a “significant decline in economic activity that is spread across the economy and that lasts more than a few months.” The business cycle since the onset of the pandemic has been anything but ordinary. Instead of a simultaneous and broad-based decline in economic activity, we’ve observed specific industries struggling with isolated declines over time, while the broad economy has managed to stay afloat.
Throughout 2020, Covid had an unprecedented impact on societies around the world. Many non-essential service-oriented businesses such as air travel and tourism experienced a depression-like scenario as demand evaporated. Conversely, goods-related businesses experienced a boom. Then through 2021 and 2022, consumer habits flipped and demand for services surged as economies around the world re-opened. As inflation took hold and interest rate increases became inevitable, rate-sensitive areas of the economy contracted. The housing market froze, and a higher cost of capital for technology firms caused funding to dry up and there were layoffs across the sector. In 2023, we have seen regional banks and commercial real estate face declines.
Indeed, the most anticipated recession ever has yet to happen. Some economists now expect it to happen in the second half of this year, we will see if these prognostications are correct or not. If there is a recession most now expect it to be a mild one and there are some that see a soft landing for the economy. That said, we recognize that soft landings are quite uncommon, occurring only four times in the last 75 years.
The “Magnificent Seven” Are At It Again
As we mentioned last quarter performance in 2023 was driven by the handful of mega-cap growth stocks, dubbed the “Magnificent 7” (Apple, Microsoft, Nvidia, Facebook, Alphabet, Netflix, Amazon). These stocks had an average return more than 100% for 2023 and now represent a combined weight of more than 28% in the S&P 500 and 47% in the Russell 1000 Growth Index – near historic highs. However, much of the return in these stocks were driven by expanding valuation multiples leaving them expensive relative to the broader market.
However, in the fourth quarter we did see a shift where equity gains broadened out beyond the “Magnificent 7.” As seen in the chart above, the remaining 493 stocks in the S&P 500 index rallied 15% to end the year. We believe the recent broadening out of equity performance has the potential to persist over the course of 2024, and we could see areas of the market that have significantly lagged perform much better. For example, small-cap stocks beat large-cap stocks and value stocks outperformed growth stocks late in the year. We anticipate rebalancing portfolios away from the big winners of 2023 and towards higher quality, more attractively valued strategies that could perform well in periods of heightened volatility or an economic slowdown.
Foreign Stocks – Why Should I Have an Allocation Outside the U.S.?
Many investors have shifted portfolios to be highly focused on U.S. stocks. We have had a view that U.S. stocks are overpriced vs. the rest of the world. Heading into 2024, the valuation discount for developed international and emerging-market stocks versus the U.S. is the widest it’s been in decades. From 2006 through 2016, the U.S. and developed markets traded within one multiple point of each other. The average forward P/E for the S&P 500 over the period was 14x compared to 13x for MSCI EAFE. Since 2016, the valuation gap has widened substantially. The S&P 500 now trades at nearly 20x forward earnings while the MSCI EAFE remains close to 13x. The story can be seen in the chart below—U.S. stocks trade toward the top end of their valuation range while other regions offer up better relative values. Most other markets are trading roughly in-line or slightly below their historic averages. All else equal, lower starting valuations imply better long-term expected returns and provide more of a valuation cushion should multiples contract in a stock market sell-off. In other words, the reasoning for why foreign stocks should outperform U.S. stocks has only gotten stronger from 2016 until today. When this trend unwinds the changes could be drastic and quick.
We remain positive on Core Investment Grade bonds (Bloomberg U.S. Aggregate Bond index). Within credit, we believe fundamentals remain relatively healthy despite higher debt costs. Interest coverage, the level of leverage, and cash levels all look better than in historical periods late into a rate cycle but acknowledge this is factored into today’s valuations. And, as we have stated for several quarters now, bond investors continue to benefit from higher starting yields. Core Investment Grade bonds are currently yielding 4.5%, which is above the current 3.1% inflation level, so bonds are providing a positive real (after-inflation) yield. Finally, we believe core bonds will provide downside mitigation in the event of a recession or decline in the stock market.
In addition to core bonds, we continue to have meaningful exposure to higher yielding, actively managed, flexible bond funds run by experienced teams with broad opportunity sets. There are several fixed-income sectors outside of the traditional parts of the bond market that provide attractive risk-return potential, and we access them through active managers. Some of these funds are currently yielding in the high single digits, while maintaining an eye on capital preservation. In fact, some of our bond holdings have incrementally become defensive through the year.
Finally, outside of public markets we continue to view private investments as being very attractive for those that can access them. Private credit funds are generating yields of between 10-13% currently and have defensive characteristics that are like public market debt. Banks have had to cut back on lending to companies and this has opened an opportunity for private credit. For private equity, there are opportunities to invest in companies before they get into the public markets. Secondary investments are particularly attractive as these can be bought at a discount to value. Finally, select private real estate and infrastructure investments provide an inflation hedge and attractive risk adjusted return. Most private real estate funds are invested in rental properties and industrial warehouses as their largest allocations. This avoids the much tougher retail and office environments.
Retirement Planning – Beyond the Numbers
A retirement planning conversation with a financial advisor used to focus only on the money factors. How much do you want to spend? How much can you save? How much will you receive in Social Security? While the numbers are necessary, financial advisors now are focusing much more on how they can help clients have a happy and healthy retirement. This has led to advisors asking questions like what makes you happy? What do you enjoy spending your time doing? What are some of your core values? These can catch clients off guard, especially if they are used to more of the old school questions that revolve around “just the facts” to quote Dragnet. However, what advisors are finding is that only finding out the facts often falls short. Retirement is as much a shift in purpose as it is a financial issue. As working individuals, many of us get a lot of our value and spend a lot of our time at work. Work can be where we have some of our closest connections outside of our family.
This means that we as advisors are uniquely positioned to help individuals think through this unique life change and how to approach it. We have seen what others have done and can report back on paths that have helped others adjust and what they found to be pitfalls in their process. After all, who sees more people retire than a financial advisor? So, if in your next meeting with us we are asking you what you like to do in your spare time or if you have thought about what will keep you cognitively engaged in retirement – this is just our way of trying to address the full picture of retirement and not just focus on the surface issues. We have seen this process create “Aha!” moments for people and realizations that are very different than they expected.
Firm News
We are happy to announce that Dana Carney has been promoted to a Wealth Manager at the firm. Dana joined RCA a little over a year and a half ago. Prior to working with River Capital, she had worked for the University of Georgia and helped families that needed financial counseling and tax assistance. She has since passed the Certified Financial Planner™ examination and has been doing a great job in assisting clients to reach their goals. In addition to the CFP® designation, she also has a Masters in Financial Planning and the Accredited Financial Counselor® designation.
In other news, we are in the process of adding an additional Client Service Specialist to assist Grace Baker with her duties as the firm has grown to the point where one Client Service Specialist is not sufficient. We are making this addition to ensure that service requests are met in the expeditious fashion that you are used to. We also believe that this will allow our Client Service team to provide even more hands-on service to you.
Unfortunately, change and growth also sometimes leads to us saying goodbye to a member of the team as they pursue new opportunities. On that note, Stephen Kyle has decided that he is going to be leaving River Capital Advisors. We wish Stephen well in his future endeavors and have found him to be a valuable member of our team for the past eight years. While many of you have enjoyed working with Stephen and will miss his counsel, rest assured that Rob, Wesley, and Dana are fully versed on each of the clients at the firm. This is why we work as a team – so that changes in the team do not result in a loss of knowledge of your goals. We are actively looking for an experienced advisor to join our team. While Stephen will be missed, we expect to have exciting news soon as we search for the ideal candidate that will meet our strict criteria for skillset and values.
River Capital has experienced meaningful growth and change since its inception in 1998 with last year being its twenty-fifth year in operation. We have consistently grown over this time and modernized our processes and capabilities. We have expended significant time and resources to offer a premier and compelling value to our clients with industry leading technology. We are excited to see what the next twenty-five years will look like for the firm. One thing that won’t change is our client first methodology that features a strong fiduciary concept and fee-only approach. This is rooted in our core values.
Closing Thoughts
New years are usually times for reflection on what has gone well in the past year, what has perhaps failed to live up to expectations, and for setting new goals for the next year. This can be a great time to set new financial goals for ourselves. To reevaluate if we are saving enough, spending too much, spending on the wrong things, or perhaps even spending too little. There are so many distractions that can take us away from thinking about the future and what we really want. The new year can provide a great time to restart our commitment to making changes towards where we want to be. We can help you think through all these matters and what you are trying to achieve in your financial life. Also, if you know of others that perhaps need some assistance on this path to their goals, we would love to meet them and assist them as well.
As we enter 2024, we wish you and your loved one’s peace, happiness, and good health in the new year.
Thank you for your continued trust and confidence.
