Key takeaways

  1. Stocks surged in the fourth quarter of 2023, erasing losses from earlier in the year
  2. Declining inflation opened the door for potential Fed rate cuts in 2024
  3. Strong corporate earnings in Q3 ended an "earnings recession" and supported further stock market growth
  4. Bond markets posted a comeback as rate cut expectations increased
  5. Chinese stocks continued to underperform
  6. The market is "overbought" but historical data shows this often coincides with further short-term gains

Stocks surged in November and December, erasing a tough October to finish the quarter sharply higher.

The Morningstar Global Markets index rose just over 11% in the fourth quarter, ending the year with a 21.5% gain.

Meanwhile, bond yields fell sharply during the quarter, which propelled a 6.6% rebound in the Morningstar Core Bond index.

That was enough to erase the YTD losses for bonds, pushing the 2023 total return to a solid 5.3%.

The potential for 2024 rate cuts from the Federal Reserve got most of the attention over the last several weeks, but several factors drove the strong results this quarter.

Here is our analysis of what happened and what it might mean looking forward.

Moderating inflation opens the door for Fed rate cuts

Inflation data looked encouraging for most of 2023, but in the 4th quarter, we saw an important milestone. Over the last six months, the Fed’s preferred inflation measure only rose by 1.9%, below their stated 2% target. That’s the first time inflation has been below 2% over a six-month period since 2020.

When the Fed suggested pausing rate hikes in September, this six-month inflation measure was still 2.7%. Now, in just three months, it has fallen another 0.8%. 

This has markets speculating about when the Fed might be willing to cut its target interest rate. The speed at which inflation has declined probably has Fed officials at least a little worried that disinflation could overshoot. The Fed wants inflation to decline to around 2%, but not much lower. If the Fed keeps interest rates this high for too long, they risk causing inflation to fall too far below their target.

As the market priced in more Fed rate cuts, stocks started to gain upward momentum. The chart below shows the number of Fed rate cuts priced into futures markets (assuming each cut is 0.25%) by December 2024 in blue and the 4Q return for the S&P 500 in orange.

The market is currently assuming six rate cuts in 2024, which would result in the Fed’s target rate falling from 5.5% to 4.0%. 

Our view is that some number of rate cuts are very likely in 2024. Exactly how many rate cuts will depend significantly on how the economy performs. For example, if job growth wanes or inflation falls materially below 2%, the Fed may cut more than six times next year. However, if inflation levels out around 2% and job growth is steady, six cuts are probably too many.

Why does the potential for Fed rate cuts matter so much for stocks?

The chart above plainly shows that the market was cheering the potential for rate cuts in 2024, but it isn’t about the number of cuts per se. Remember, what actually drives the stock market is profit growth. When thinking about how any external factor will impact stocks, including Fed rate actions, what really matters is how it ultimately impacts company profitability.

When seen through this lens, you can see that whether the Fed cuts to 4.5% or 4.0% doesn’t matter very much. What does matter is that the Fed can cut if necessary. Going into 2023, one of the biggest risks was that the economy would start to slow, but because inflation was so high, the Fed couldn’t react to the impending slowdown by cutting rates.  

Now, with inflation subsiding, the Fed can respond if the economy stalls. This is not without precedent. The Fed either cut or stopped hiking rates in 1995, 1998, 2016, and 2019 in response to threats of an economic slowdown. A recession was avoided in each case, and stock market performance was strong.

The earnings recession is over

While the Fed got most of the attention, the strong third-quarter earnings season was at least as important for stock market performance this quarter. Of companies in the S&P 500, 82% did better than analyst projections this quarter, significantly better than the 67% long-term average.

Source: Bloomberg

As we wrote in more detail in a recent article, stocks had been going through something of an “earnings recession.” This is where companies generally see their profits decline, even as the economy broadly keeps growing. That ended this quarter, as the S&P 500 broadly posted earnings growth for the first time in four quarters.

We’d consider that a sign of a healthy market: stocks rising because earnings are actually growing is probably more sustainable than when they rise on speculation of future growth. 

Another healthy sign is the fact that the sectors seeing the strongest profit growth are the same ones that are producing the best performance. In other words, the market is valuing companies based on their core fundamentals. Sectors like technology, telecom, and consumer had the best earnings season in terms of profit growth, and these same sectors have been the outperformers.

The sector weights have been something of a mixed bag for Facet’s equity performance vs. our benchmark. Within the U.S. stock ETF allocation, Facet is overweight companies with steadier revenue, lower debt burdens, and high profit margins. This has been a benefit in that we’ve been overweight sectors like internet media and semiconductors, both of which were very strong performers in 4Q. However this mix wound up underweight consumer stocks, which were also strong performers. On net our U.S. sector weightings wound up being a small detractor from relative performance.

Bonds post a comeback

The end of Fed rate hikes followed by the increasing odds of future Fed cuts resulted in a big rebound for the bond market in 4Q. When we published last quarter’s report, the Morningstar US Core Bond index was down 1.17%, which would have been a third straight year of negative returns. 

What a difference a quarter makes. The Core Bond index surged 6.6% this quarter, erasing the loss from the prior three quarters, and bringing the 2023 return to 5.3%. Notably, that’s actually higher than the average bond return from 2009 to 2019 of 3.7%.

Facet’s results were slightly better than our bond benchmark in the quarter. For tax-deferred accounts, Facet’s overweight of corporate bonds was the main driver, as this was the best performing sector in bonds. For tax-paying accounts in higher brackets performance of municipals was modestly better than taxable bonds generally.

This quarter’s results add to what has been a good year of relative performance from Facet’s bond allocation, with our tax-deferred bond ETF mix outperforming the benchmark by 0.95% in 2023.

Chinese stocks continue to struggle

Early in 2023, Facet made the decision to reduce our weight to emerging markets ETFs, effectively putting our portfolios at 5% vs. approximately 10% of the equity benchmark. As a result, this also leaves us with half the weight to China, about 1.5% for Facet vs. 3% for the benchmark.

Chinese stocks have struggled all year, and the 4th quarter was no different. While the rest of the globe rallied, Chinese stocks continued to decline.

The Chinese economy is suffering from several problems, hitting all at once. China’s real estate market is suffering through a downturn as something of a bubble in construction has burst. That is putting pressure on construction spending and lending markets, both heavily exposed to real estate. 

Meanwhile, consumers in developed countries are spending more on services and less on goods, which hurts heavy manufacturing economies like China. In addition, many developed countries are looking to move more of their supply chain to “friendly” countries. 

This trend is called “friendshoring” and has grown out of both companies and nations wanting more stable supply chains, especially in the aftermath of Russia’s invasion of Ukraine. This trend has resulted in companies reducing their use of Chinese manufacturing in recent years.

China is a big economy with plenty of long-term potential. For this reason, we do not want to have zero weight to China. We continue to think the risks outweigh the potential return in the near future. 

For China to fix its domestic economy, it must enact policies supporting domestic consumption. Doing so would help the country wean off its dependence on debt-funded construction and bring its economy into better balance. 

Unfortunately, this is a political decision, not an economic one. If Xi Jinping does not choose to pursue stronger domestic consumption for political or ideological reasons, it may take many years for China’s economy to regain its footing. We are comfortable remaining underweight until the opportunity set is more attractive.

Facet’s underweight of Emerging Markets was a significant positive for Facet’s portfolios in 4Q and was the biggest single driver of the equity mix’s outperformance in the quarter.

What does it mean for the market to be “overbought?”

The S&P 500 rose nine weeks in a row from October 27 through the end of the year. That is a rare feat: It is the longest weekly winning streak for US stocks since 2013. Because of the persistence of up days, you may have heard commentators describe the market as “overbought” and, therefore, “due” for a pullback.

It is worth noting that the term “overbought” has a specific definition, which means we can test historically whether an overbought market typically suffers a near-term pullback or not. As it turns out, it doesn’t.

Over the last 20 years, the S&P 500 has hit an overbought condition 112 times. We tested what happened in the 25 trading days after it first hit the overbought threshold. This is approximately one calendar month. What happened? The S&P was up 9.3% annualized over these instances, producing positive results in 69% of periods.

Note that’s almost exactly the same as the S&P’s overall 20-year return of 9.8%. In other words, nothing is special about the market being overbought.

Most recently, the S&P was first technically overbought on November 20. From that point until year-end, the S&P rose 5.1%.

It is undoubtedly true that the market won’t keep going up forever. The point is that waiting around for a pullback is usually a losing trade. Yes, eventually, there is a pullback, but the market often rises more before pulling back. If that happens, you might not get a cheaper entry. 

All too often, investors get tied up in thinking about the timing of any buying decision. In reality, stocks go up much more often than they go down, even over short periods. In other words, if you buy, the dice are loaded in your favor. If you wait to add to your portfolio, history says you will likely regret that decision.

What might be coming next?

Our process is to build portfolios that can perform reasonably well across a variety of potential scenarios, not to make specific predictions about the economy or markets. We think getting macro forecasts consistently right is extremely challenging. We believe taking a balanced approach and focusing on risk and reward is more likely to lead to success.

We think there is one scenario we can cross off the list for 2024. There is little reason to expect inflation to rebound materially. It is possible that progress on inflation stalls, and this prevents the Fed from cutting rates as many times as is currently expected. 

But the conditions for inflation to rebound to 4% or higher just aren’t present. That makes it extremely likely that the Fed will not be hiking rates again and very likely it will cut rates to some degree. However, this does not automatically mean longer-term bond yields will decline. 

The 10-year Treasury ended 2023 at 3.88%. As we said above, futures markets have priced in that the Fed will cut rates by 1.5% in 2024. If those rate cuts don’t come to fruition, bond yields could rise, especially on the longer end. 

We believe there is probably a near-term ceiling to how high yields might go. As long as the market anticipates the Fed’s next move is any kind of cut, it is very likely that long-term bond yields will be lower than the Fed’s current target.

Right now, that target is 5.5%. So if the Fed cut by only 0.5% instead of the currently assumed 1.5%, the 10-year Treasury would probably rise, but likely to something like 4.5% or 4.75%. Rates rising by that degree would probably still allow for a positive return for a diversified bond portfolio. In other words, while bonds are by no means a guarantee to make money, the scope for a 2022-style disaster year in bonds is very unlikely at this point.

For stocks, we think Fed activity will be much less important for returns than in 2023. As we said above, if the economy keeps growing at a decent clip, the Fed may not cut as many times as the market currently assumes. But for stocks, the more robust economy probably propels better earnings growth. We would expect stock returns to be quite good in such a scenario.

On the other hand, if the Fed winds up cutting more than 1.5% in 2024, that implies the economy was weaker than is currently expected. That could mean company earnings come in below expectations, which is probably a scenario where stocks struggle. 

The last two years have felt like the Fed’s decisions dominated all market conversations. While the Fed is going to remain influential, we think the performance of stocks will hinge on the strength of company profits.

Given that, we think being a bit overweight companies with more resiliency is the proper stance. Note that we’re using the term “resilient” over “defensive” intentionally. We came into 2023 overweight companies with low debt burdens, more consistent revenue streams, and high-profit margins. Our view was that these companies had more financial flexibility than others, and thus, if the economy were to slow, they would be better equipped to weather the downturn.

This is different from buying “defensive” companies. Generally, these kinds of companies have little exposure to the economic cycle but lack considerable profit growth prospects. Historically, these kinds of companies usually have only outperformed in down markets. In other words, overweighting defense is an explicit bet on the market’s direction, and that is never our approach.

Returns for 2023 illustrate this point well. We used the iShares Quality Factor ETF as part of our effort to get more resiliency into the portfolio. We can compare the return of this ETF to MSCI’s Defensive Sector index to get a sense of what would have happened if you made an explicit bet on defense in a year when stocks soared.

MSCI, iShares

This is an excellent example of what we mean when discussing risk-reward balance. Making a one-way bet on defense in 2023 would have been a disaster. Leaning a bit toward resilience probably would have helped our relative returns had the economy weakened in 2023. As it happened, the economy stayed strong, but Facet portfolios were hardly worse for the wear.

It isn’t always easy to find these kinds of risk-reward opportunities, but this is what we spend our time doing. We are hunting for ways to add a bit of extra value where the risk-reward is leaning in our favor.

Short-Term Strategy

Facet’s Short-Term Strategy (STS) is designed to produce stable returns commensurate with the yields available in shorter-term bonds. 

STS was solidly ahead of its benchmark in 4Q. In short periods, such as a month or quarter, STS will generally outperform the T-Bill benchmark if interest rates are steady or falling and underperform if rates rise. This is because about ⅓ of the strategy is in Treasury bonds with maturities between one and three years. These bonds will have mild price increases or decreases as rates move around. 

This held true this quarter. The 2-year Treasury fell from 5.05% to 4.25% during the quarter, and this boosted STS’ return for the period by about 0.3% in addition to its normal income generation.

Over longer periods, we expect price return to have a very mild impact on results either way. Income generation will be the dominant factor in STS returns.

See our recent article for more details on your different short-term investing options.


Facet’s ESG equity strategy was ahead of the Morningstar Global index for the quarter. The strategy utilizes a set of ETFs that screen out stocks based on certain ESG criteria. These screens remove a large chunk of energy-related exposure to the strategy. 

During the fourth quarter, oil prices fell sharply, dropping from over $90 per barrel at the start of the quarter to as low as $69 before rebounding slightly to $72. This put pressure on the whole energy sector. It was the only sector within the S&P 500 to post a negative return in 4Q, falling 7.0%. 

The ESG bond portfolio also outperformed this quarter. This was primarily due to strong performance from corporate bonds, the best-performing sector in the bond market during the quarter.

Retirement Strategy

Facet’s Retirement Strategy is meant for members who are either already in retirement or close to it. The strategy utilizes ETFs that we expect will have somewhat less volatility than our traditional growth model. 

Lower volatility becomes more important when you are actively drawing from your portfolio, but it remains essential to have enough growth to ensure your portfolio lasts your lifetime. This strategy aims to strike a balance between lower volatility and solid growth prospects.

Given the strategy’s focus on lower volatility, we expect it to underperform modestly during a strong up quarter. That held true in 4Q, with the strategy producing a solidly positive return but somewhat below the benchmark.