The dominance of the Magnificent Seven has been well documented, although it is interesting to observe the degree to which a strong year-end advance left many areas with solid gains for the year.  Nevertheless, 2023 in many respects mirrored the trends of the last decade.

A pessimistic mindset following 2022’s losses was clearly the wrong perspective for the year ahead.  Should we be similarly suspicious of any optimism born from 2023’s gains? 

Due to the simple fact that we base investment decisions on rigor, history, and patience to produce a high probability of longer-term success, engaging in the admittedly attention-grabbing matters of near-term market-direction speculation has never been of interest.  To be blunt, we are afraid to risk making a forecast where our odds of success are at best the same as a coin toss.  

Two great quotes come to mind when thinking about future investment outcomes.

One way to think about recent gains is to attempt to identify those that reflect a justifiable (i.e., durable) adjustment in price.  In other words, does this increase reflect a correction of a prior discrepancy between price and fundamental value?  Or does the increase merely reflect growing optimism for the future and/or investor willingness to pay an ever-increasing premium for a perception of comfort and safety?

Take the Magnificent Seven.  On an equally weighted basis, this group posted a stunning 107.0% return for the year, while the return was 75.7% on a capitalization-weighted basis.  Presently, we have earnings growth data from September 2022 to September 2023 totaling just under 19% overall.  Expected earnings growth for the next twelve months is approximately 25% on an equally weighted basis. Simply put, regardless of which of these figures we use, multiple expansion (i.e., optimism for the future) defined the story of last year.

Why is optimism a dangerous foundation for investment decisions?  Unfortunately, despite the positive connotation commonly attached to such an outlook, reality rarely matches hope—subsequent results are predictably disappointing as future outcomes fail to live up to lofty expectations.  The Seth Klarman quote above captures this point well, as does the chart below.

When history and logic collide in this way, the wise take notice.  Yet, there is more to the story, as a wide array of public equities trade at what appear to be very compelling valuations—this is not merely relative to indices such as the S&P 500, but is in fact true on an absolute basis.

Considering the gap between smaller and larger companies merely on an index basis, the current discount levels are stunning.

Ultimately, this is a tale of two markets. On one hand, we have the Magnificent 7 priced at nearly 40x trailing earnings—this is the ultimate “what can go wrong?” valuation.  On the other, we have scores of beaten-down stocks both inside and outside the US trading at what seem to be exceptionally low valuations¹.

On balance, we continue to believe that monetary policy is on a slow yet undoubtedly erratic path towards normalization thanks to higher structural inflation.  This introduces many less familiar but well-documented risks that investors will have to face whether they like it or not.  Given that everyone, including us, lack foresight into the future, the primary factor worth considering is the strong tendency of low valuations to create a wider array of scenarios in which equities produce acceptable returns.