January 2024 / VIDEO

Video: Three important insights from 2023

A focus on bond yields, the Magnificent 7, and the Fed pivot

Timothy C. Murray, Capital Markets Strategist, Multi-Asset Division

Transcript

We have learned a lot during 2023, including these three important insights that investors should keep in mind as we enter 2024.

After an extended period of extremely low yields in bonds, yields have finally rebounded. From 2013 to 2021, the average yield to worst for the Bloomberg Global High Yield Bond Index was a modest 6.04% but stood at 8.36% as of December 15. Even more striking, the average yield to worst for the Bloomberg Global Aggregate Index was 1.57% from 2013 to 2021 but was more than twice that level on December 15 at 3.60%.

Now that the Fed has signaled intentions to cut rates in 2024, we can expect to see yields drift lower. But we should not expect a return to the anemic levels of the 2010s, as long as inflation remains a threat. This means that current yield can once again be a useful feature in bond portfolios as we move into 2024.

In 2023, we witnessed one of the most top-heavy equity markets ever. The “Magnificent 7” posted massive returns—gaining over 70% through December 15 on a market cap-weighted basis. Meanwhile, the other 493 stocks in the S&P 500 returned 13.6% on a market cap-weighted basis—a lower return than that of MSCI EAFE Index, which gained 15.7%. This massive gap drove home a lesson that we believe investors need to be keenly aware of: The Magnificent 7 should be viewed as a separate asset class.

It is tempting to look at the valuations of U.S. stocks and conclude that they are too expensive and should therefore be avoided in favor of stocks in other regions of the world. But the reality is that U.S. stocks are not broadly expensive. Rather, the aggregate valuation of U.S. stocks is distorted by the high valuations of these seven “mega-cap” companies that make up nearly 30% of the index.

It is also tempting to assume that valuations of the Magnificent 7 are unreasonably high. Whether these elevated valuations are warranted is a difficult question to answer, but one simple way to provide a sanity check is to compare a P/E ratio to return on equity—a measure of how profitable and efficient a company has been over the past year. For the Magnificent 7, their high valuations were accompanied by similarly high returns on equity as of December 18.

The bottom line is that the elevated valuations of the Magnificent 7 collectively, and U.S. stocks in aggregate, are not unreasonable when taken in context. The real question is whether or not the level of profitability and efficiency that these seven companies have exhibited can be sustained moving forward.

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