2023 Year In Review

2023 was a strong year for most asset classes, as shown by the following table.  An investor could hardly help but to prosper from investments in traditional assets like cash, bonds, or stocks. 

Source: Bloomberg

Note: Equity Indices - DJIA, S&P 500, NASDAQ; Fixed Income Indices - SPDR Bloomberg 1-3 Month T-Bill, BBG Municipal Bond Index, BBG US Corporate High Yield, BBG US Agg. Total Return, BBG US Gov.t 10 Year, respectively.

2023 was also practically a mirror image of 2022.  Across the two years, equity markets largely stayed in place (S&P 500 +3.4%, NASDAQ -2.3%, Dow Jones +3.7%).  On the other hand, most fixed-income investments lost money over the preceding two years, excluding cash and high-yield bonds. 

Momentum investors, who bought near the top in December 2021, and sold near the bottom in December 2022, most likely experienced significant losses. 

For investors who hail from the land of Graham-Doddsville and are looking to buy businesses for prices below the intrinsic value of a business, December 2022 presented a compelling opportunity to put capital to work.  On December 7th, 2022, we wrote to a client:

“I’m pretty excited about deploying capital tomorrow… I’m cautiously optimistic we’ll look back at these deployments fondly.”

It’s safe to say we are currently looking back at those deployment decisions fondly. 

That is not to say that it’s easy to deploy capital in the face of falling markets. On December 8th, 2022, a headline from the Washington Post read:

“Expert forecasts 2023 as a year of ‘economic pain’: No one knows where the economy is headed in the new year, so focus on stockpiling cash and investing for the long term.”

I’ve noticed across my investing career that moments of extreme pessimism tend to occur after people have watched their investments decline rapidly in value. Those moments often offer great profit opportunities to those looking to deploy capital when price seems to undercount value.  We strive to invest heavily, at those opportune times, on behalf of our clients and our own families. 

Equities

Valuation: S&P 500 Price to Forward Earnings Ratio

Source: Bloomberg, SPX Index P/E

S&P 500 Price / Forward Earnings (P/E) multiple has increased to 23x in 2023 (in comparison to 18x for 2022), which is higher than the 50-year average of 17x but below the COVID-mania peak of 30x in April 2021. Our stock screener also finds most stocks to be richer in valuation, with smaller numbers of companies screening favorably on a price vs. value basis.

We do believe that the productivity gains that AI can unlock will be a net positive for enterprises overall. On the flip side, we also believe that AI may cause businesses that do not adapt to fail in the face of better products and services delivered at lower prices from competitors. 

Public & Private Fixed Income (as of year-end 2023)

Source: Bloomberg, HY (High Yield ) Bond: LF98TRUU, IG (Investment Grade) Bond: LBUSTRUU, Municipal Bond: LMBITR, respectively. Income Tax Rate Assumptions: Federal (37%), State (10%)

US Treasuries

Expected Federal Effective Interest Rate

Source: Bloomberg, World Interest Rate Probability (WIRP)

Cash vs. 10-Year US Treasury Yields

We concluded 2023 with short-term treasury bills yielding ~5.3%. The market is pricing in six 0.25% rate cuts through the balance of the year, which, if that were to occur, would bring interest rates down by ~1.5% to roughly 3.8%.

During June 2023, at a time when cash (treasury bills) was earning a higher yield than the 10-Yr Treasury (long duration) and interest rates were expected to increase, we were strongly in favor of investing in short-term securities above most other public assets in the fixed income space.

At this point in time, the market now expects that interest rates will decline, we thusly have less strong views against longer duration assets, because long duration assets usually appreciate in price when interest rates decline.

It remains true that the 10-Year US Treasury at a 3.9% yield has lower yield and more price risk than a T-Bill at a 5.3% yield. However, it’s possible that the lower yield could be justified, given that the market believes the T-Bill rate will drop to 3.8% by year end. 

We like investing in riskier securities (like 10-year Treasuries) when there is a clear and obvious reason for doing so. While we are currently more neutral on the 10-Year Treasury vs. T-Bills, we do not think it makes sense to actively add to the 10-Year Treasury right now.  By the same token, we are no longer advising clients to reduce the duration in their fixed-income portfolios given that risks are now more balanced. 

10-Year US Treasury Yields

Source: Bloomberg, 10-Yr US Treasury Yield (USGG10YR)

High Yield Credit Spreads: Additional yield received above US Treasuries for debt of riskier companies

Source: Bloomberg, BarCap US Corp HY YTW 10-Yr Spread (CSI BARC Index)

The above chart displays a modest credit spread high-yield bonds issued by companies with riskier balance sheets. We think investing in high-yield bonds will make more sense once credit spreads breach 6% (up from ~3.8% at year-end). 

Private Credit

Private Credit has grown into $1.6T[1] industry and has become a growing part of many investment portfolios.  As banks have reduced their lending to corporations, post the 2008 financial crisis, private credit has become an alternative source of credit to un-ratable (below junk bond credit quality) companies.    

•  Since 2021, private credit funds are estimated to have raised north of $700B[2] in new capital, increasing from $500B in 2015 and projected to reach $3.5T by 2028E.

• In contrast, the more traditional high-yield bond market stands at only $1.3T[1] meaning the unrated private credit market is now bigger than the rated junk bond market.

We are not positively inclined to private credit right now.  We believe it’s unlikely that investing taxable dollars in the average private credit Fund will lead to satisfactory after-tax wealth creation for investors.  We certainly expect that there will be funds with superior underwriting, sourcing, or luck that will do well with investor money, but we don’t anticipate that the overall space is likely to produce great returns.

There are a few reasons that we do not recommend private credit to our clients at this moment:

• The size of the market is greater than the size of the High Yield market, and has grown, and is growing, rapidly.  Capital pouring into this space will have to compete with $1.6T of other capital to find good returns.

• The high-yield market, a direct competitor for companies looking for financing, is trading at relatively low spreads relative to history – meaning investors are getting less compensation than normal for their risk. We think it’s likely that this pressure will lower returns in the private credit markets as well.

• The private credit market is quite opaque and does not “mark to market.”  That is, investors who invest in this asset class usually keep their assets at “par” unless a company defaults on a payment.  While the high-yield market will change daily due to changes in credit/macro/company-specific conditions (either increasing or decreasing in price), the private credit markets will remain more “stable” – and may give the impression of less volatility. In reality, private credit is a riskier asset class than high-yield, because its borrowers are typically less credit worthy than companies that issue high-yield debt or leveraged loans. 

• Lastly, the yield from private credit is very tax inefficient, as it’s taxed at ordinary income tax rates. This means that an investor from a high-income tax state may lose >50% of their income to taxes in private credit.

[1] Source: Bloomberg

[2] Source: Axios Private Debt Fundraising 2023 Report

Investment Grade Bonds

Investment Grade Credit Spreads: AAA 10-Yr premium received above US Treasuries (in basis points; 1 basis point = 0.01%)

Source: Bloomberg, BASPCAAA Index

Investment grade bonds are debt instruments issued by companies that rating agencies deem high quality and have a low risk of defaults.  An investor is receiving very minimal additional compensation to treasuries (0.76%) for investing in this asset class. 

On an after-tax basis, we see no additional yield for investment grade bonds of similar duration, to US Treasuries, despite the fact that US investment grade bonds have a higher risk of default than US Treasuries. 

Municipal Bonds

Municipal Bond Index (YTW)

Source: Bloomberg, LMBIYW Index

Municipal bonds can be a tax-efficient way to generate yield and have recently reached levels that are more favorable. We recommend allocating exposure to the short end of the curve (maturities <1 year) as long-duration bonds still do not give adequate yield to compensate for interest rate and duration risk.

 It’s important to understand one’s marginal tax rates and jurisdiction before investing in municipal bonds as those factors determine one’s after-tax yield and the attractiveness of the asset relative to treasuries or corporate bonds.  We’ve seen some modest yield premiums lately in municipals for tax-payers in the highest tax brackets. 

Concluding Thoughts

As we enter 2024, we are not bullish on many investment categories, and thus we are being cautious and disciplined in our capital deployment strategy. 

One asset class we haven’t discussed above is Real Estate. We have found a few compelling investment opportunities in that area, and it is an area of active research and capital deployment for us.