Fourth Quarter 2023 Write-Up

In calendar 2023, the Dow Jones Industrial Average gained 13.7%, the Standard and Poor’s 500 Index added 24.2% and the Nasdaq Composite surged 43.4%.  It was almost a mirror image of the carnage in the markets during 2022 when the DJIA lost 8.8%, the S&P 500 fell 19.4% and the Nasdaq plummeted 33.1%.   In 2022, the 10-year Treasury bond lost 17.8%, its largest decline since 1928, and only the second time it recorded a double-digit loss. Previous to the 2022 loss, since 1928 the 10-year has declined in value only eighteen times, usually in single-digit amounts.  The poor performance of both bonds and equities in 2022 (the first time since 1928 that both assets declined more than 10.0% in the same year) meant that the traditional 60/40 portfolio had its largest recorded annual loss (-18.0%) since 1937 (-20.7%).  In 2023, however, both equities and bonds performed well and the 60/40 portfolio returned an excellent 15.3%.  In 2022, S&P 500 operating earnings declined 5.4% and the Price-to-Earnings multiple declined 14.8%. In 2023, S&P operating earnings gained an estimated 8.6% and the P/E multiple increased 14.4% to 22.3x.  We would guess that equity performance in 2024 would be driven more by earnings than P/E expansion.  

The Federal Reserve had a very busy year, not only continuing to raise rates to stomp down the rate of inflation, but also dealing with the unforeseen consequences from the rapid escalation of interest rates.  The Federal Reserve increased the Fed Funds rate by 525 basis points in 2022 and 2023, including 100 basis points of increase in 2023.  This was the most abrupt increase in interest rates since 1980, when Paul Volcker’s Fed Funds rate stood at 18.9% (versus 5.3% today).   Something was going to break.   While most concentrated on the slow-motion explosion of commercial real estate and the rising unaffordability of residential real estate, the first thing to break was the business model of community banks.  Banks lend long and borrow short, meaning that they fund their investments in securities, loans and mortgages by paying depositors market-level interest rates.   As deposit rates skyrocketed, banks were funding their low interest-paying loans with high interest-paying deposits and losing money every day.  When depositors realized that this negative arbitrage could endanger their safe-money deposits, a bank run happened.  Silicon Valley Bank, which had $209 billion in assets, saw depositors attempt to withdraw $42 billion of deposits…on one day.  The Fed seized that bank on Friday, and by Sunday night of that weekend it had guaranteed deposits exceeding the $250,000 FDIC limit and established an open-ended fund to offer liquidity to other struggling banks.  The banking system was stabilized, but the Fed was forced to seize Silicon Valley and four other banks with total assets of almost $550 billion, far exceeding the 25 banks seized in 2008 during the Great Financial Crisis, whose assets tallied to $374 billion.

We mention this in detail because most investors seem to have forgotten the scale and scope of the incident and because the Fed’s liquidity vehicle, the Bank Term Funding Program, is scheduled to expire in March.  The Fed did a very good job of arresting a bank run that could have accelerated the commercial real estate implosion, but this was a patch and not a cure. 

The effect of much higher interest rates on the residential housing market has been anomalous, largely because we have experienced such unique circumstances prior to the tightening.   The interest rate paid on a 30-year mortgage reached its all-time low of 2.7% in January of 2021.  By the end of 2022, the interest rate had risen to almost 8.0%.  Currently, the 30-year rate stands at 6.9%, about 300 basis point above average 30-year rates before Covid-19.  Residential home sales depend on both affordability and availability. Houses are not affordable today.  According to the Atlanta Federal Reserve, the median home would require a monthly payment (including taxes, insurance, principal and interest) of 44% of median U.S. income.  That is the highest level since the housing bubble in 2006, and well above the high-20% to low-30% range common over the last fifteen years.  Only 16% of houses on the market today are affordable to a median income buyer.  Additionally, 62% of homeowners have a mortgage interest rate below 4%, and a stunning 92% have a mortgage below 6%.  This means that people who move will pay more and get less.  Unsurprisingly, people are staying put.  Existing home sales were down 19% in 2023 to 4.1 million units, the lowest since 1995 according to the National Association of Realtors.  The inventory of existing homes for sale has collapsed to a 21st century low of 1.1 million, down considerably from a more normal inventory level of 2.0 to 2.5 million homes.  The median value of an existing single-family home in December reached $387k, up from $277k in December of 2019.  Since new homebuyers tend to purchase lots of ancillary items, a frozen residential real estate market acts as a drag on the economy.  

We recently saw an article describing some polling done by Visual Capitalist, a research firm.  The firm polled 8,550 investors and 2,700 investment advisors about their long-term investment return expectations.  In the U.S., advisors expected 7.0% long-term returns while investors’ expectations were 15.6%.  As a caveat, the advisors were polled in 2022, a rough year for the markets, while investors were polled in 2023, a year of buoyant markets.  The disparity in expectations surprised us, but reminded us of an old presentation given by Warren Buffett and reported on by Fortune magazine (remember magazines?).  In 1999, at the height of the technology bubble, Buffett referred to a “Paine Webber and Gallup Organization survey released in July (1999) that shows that the least experienced investors–those who have invested for less than five years–expect annual returns over the next ten years of 22.6%. Even those who have invested for more than 20 years are expecting 12.9%.”   Buffett, who, intelligently, almost never speaks of prospective returns from the current level of the stock market, then systematically dismantled investors’ rosy expectations.  He divided the previous 34 years into two consecutive 17-year periods.  In the first, from 1964 to 1981, he showed that that over that period GDP increased 370% and the profits of the Fortune 500 gained 600%.  Nevertheless, the Dow Jones Industrial Average closed December 31st, 1964 at 874.12 and 17 years later closed December 31st 1981 at 875.00.  He contrasted that 17-year period with the one that ended in 1998 where the market went up more than eleven-fold, and compounded for 17 years at 15%.  Buffett states that the 1981-1998 period beat all other 17-year periods for returns, even the period following the Depression stock market lows of 1932.  In his post-mortem, Buffett identifies the driving forces between these two disparate periods.  In the period starting in 1964, interest rates started at 4% and ended at 15%; corporate profits as a percentage of GDP were near the top of their 4.0-6.5% range and regressed to 3.5%; and people started bullish and ended bearish. In the second period starting in 1981, people were bearish at the start and bullish at the end; interest rates declined from 15% to 4%; and corporate profits as a percentage of GDP started at 3.5% and grew to nearly 6%.  Buffett uncharacteristically posited that, in a world of 2.0% inflation and 5.0% GDP growth, the most likely aggregate return for all stock investors over the next 17 years would be about 6%.  If we use S&P 500 Index returns as a proxy for Buffett’s supposition, we see that the Index declined for the first ten-year period (the 2000-2009 and 1930-1939 decades are the only on record to decline over ten years), but by 2017 recorded a compounded annual return of 5.5%.   Warren Buffett is very rational man.  His partner, Berkshire Hathaway Vice Chairman Charlie Munger, once said, "It's stupid the way people extrapolate the past. And not slightly stupid, but massively stupid."

Charlie Munger passed away in December, just 34 days short of his 100th birthday.  Mr. Munger was an extraordinary man, brilliant, opinionated, blunt and inordinately generous.  He was committed to a life of learning and self-improvement.  He was very funny too, often telling his partner, “Think about it Warren. You’re smart and I’m right.”  We’d like to close with two of Charlie Munger’s more serious quotes and a clarifying story about how the man lived his life.

“In my whole life, I have known no wise people (over a broad subject matter area) who didn’t read all the time — none, zero. You’d be amazed at how much Warren reads — and at how much I read. My children laugh at me. They think I’m a book with a couple of legs sticking out.” 

“Another thing, of course, is life will have terrible blows, horrible blows, unfair blows. Doesn’t matter. And some people recover and others don’t. And there I think the attitude of Epictetus is the best. He thought that every mischance in life was an opportunity to behave well. Every mischance in life was an opportunity to learn something and your duty was not to be submerged in self-pity, but to utilize the terrible blow in a constructive fashion. That is a very good idea." 

When Mr. Munger was in his fifties, a failed cataract operation cost him the sight of his left eye. He did not sue the surgeon, chalking up the failed procedure to known probabilities. When doctors told him that he had developed a condition that would likely cost him his sight in his good eye, Charlie Munger started taking lessons to read in braille.  He walked the walk, and we will miss his wit and insight.

Sincerely,

Your Team at Baxter Investment Management