US markets: After a rip-roaring 2023, the US markets are taking a breather

It was a great year for the stock market and for the vast majority of investors in workplace retirement accounts.

But let’s not get carried away.

Even after the 2023 gains, most stock investors are only barely above water since the start of 2022. It looks better when you include dividends. Then, the S&P 500 returned 3.42% over the course of the two calendar years. Even so, the paltry stock market increases haven’t kept up with inflation.

If you can stand the pain, recall the simultaneous declines in the stock and bond markets that made 2022 a terrible year for investors. It was arguably even worse than 2008, when the stock market collapsed during the great financial crisis. In 2022, bonds declined sharply in value as interest rates rose, while during the financial crisis, investment-grade bonds rallied as interest rates declined.

Lately, the markets have been much kinder to investors, with both stocks and bonds holding their own.

The good returns for 2023 are thanks in no small part to the brilliant performance of the last three months of the year — fueled by growing expectations that the U.S. economy will avoid a recession, and that the Federal Reserve will soon begin to cut short-term interest rates.

The final quarterly and annual numbers for 2023 were exceptionally good. They translate into substantial annual gains for millions of investors who hold stocks and bonds indirectly, through mutual funds, exchange-traded funds and trusts, often in workplace retirement accounts. So if you have held broadly diversified investments that track the markets, endured the bad times of 2022 and persevered through 2023, you are probably doing OK. You may even be slightly ahead of where your portfolio stood at the start of 2022.

Good Tidings
Let’s review the good times of late 2023.

The S&P 500, which tracks the most valuable stocks in the U.S. market, rose 11.2% in the last quarter — and had a total return of 11.7%, including dividends. For the year, it gained 24.2% and returned 26.3%, including dividends.

Broader U.S. stock indexes, such as the Russell 3000, the FT Wilshire 5000 and the Dow Jones U.S. Total Stock Market Index, which include smaller stocks as well as the giants in the S&P 500, also had a total return of around 26% for 2023.

Rank-and-file fund investors shared in most of those gains, the database maintained by Morningstar, the financial service company, shows. The average U.S. domestic stock mutual fund and exchange-traded fund returned 11.3% for the fourth quarter and 20.3% for the year.

Note that the average fund substantially lagged behind the broad stock market averages. Most funds are actively managed, by professionals trying to beat the market. By contrast, broad low-cost index funds, which merely seek to mirror the markets, generally did their job well.

For example, the Vanguard Total Stock Market Index Fund returned 12.3% for the quarter and 26.1% for the year, beating the average fund as well as the S&P 500. That, in a nutshell, is why I believe it’s better for most people to use low-cost index funds.

Most global markets also did well in 2023 — and, as usual, the average fund trailed the market returns. For example, an important global benchmark, the MSCI All Country World Index (often known as ACWI) returned more than 21% in 2023. The average international fund in the Morningstar database returned only 14.3%.

Of course, some individual stocks did much better than average. Nvidia, which makes advanced computer chips, rose 239% in 2023. Meta, Facebook’s parent company, gained 194%, after falling 64% the previous year on investor skepticism about the company’s focus, back then, on the so-called metaverse. In 2023, however, these big tech stocks benefited from the artificial intelligence frenzy and lifted the S&P 500. Perhaps more surprising, cruise lines surged, too: Royal Caribbean soared 162%, and Carnival rose 130%. If you had focused on any of these stocks at the start of 2023, you would have been a winner.

Then again, most stocks underperformed the averages. Dollar General, Moderna and Estée Lauder, all important S&P 500 stocks, lost more than 40% in 2023.

Stock picking and market timing are tricky and time-consuming. I avoid both practices and seek utterly average market returns, which are better than most active traders obtain.

Enduring Bond Losses

The picture for bonds improved, too, but with a major caveat. Many people who traded bonds or held bond funds since the start of 2022 haven’t yet recovered their losses.

While those who bought and held individual investment-grade bonds in 2022 have done just fine, the performance of bond funds wasn’t nearly good enough to make up for the declines of the previous year.

When interest rates rise, as they did in 2022, bond prices fall. Bond fund returns are a combination of income and price changes, and in 2022, the price declines far outweighed the income.

Fortunately for investors, that changed in 2023. The Bloomberg U.S. Aggregate Bond index, a widely followed benchmark for investment-grade bonds and core bond funds, returned 5.5% for the year, according to FactSet. But the losses in 2022 were so great that over two years, the Aggregate Bond index was still down 8.2%, and so were many bond funds.

It was even worse for longer-duration bonds. Because of the way bond math works, when interest rates rise, they lose more in price than shorter-term bonds. One proxy for longer-term bonds, the iShares 20+ Year Treasury Bond ETF, rose 2.8% for 2023, yet it was still down more than 29% for the two years combined.

The fixed-income universe is enormous. I’ll return to it in future columns. But the lesson here is that while bond funds are usually steadier and safer than stock funds, that’s not always the case. It depends on when you’re investing, and in which bonds.

So Now What?
Interest rates, inflation, and the strength of the economy are key factors for both stocks and bonds. It would be good to know in advance how all these things will play out.

But we don’t know, and nobody forecasts well enough to rely on these predictions for investing, year in and year out. Fortunately, to prosper as an investor, it’s not necessary to know what will happen in the world in the next several months or years.

From a longer perspective, I’d say that what we’ve been experiencing over the last couple of years looks a lot like mean reversion — the markets pulling themselves back into their customary long-term upward trajectory, after terrible trials. Expect more of the same: periodic bouts of market misery, interspersed with stretches of gains, giving long-term, low-cost, buy-and-hold investors handsome returns, if they have the strength to hang on during a tumultuous ride.

I base that assertion on history. Including the final tally for 2023, the average annual return for the S&P 500 since 1926 has been 10.4%. That means it has taken less than seven years, on average, for the U.S. stock market to double in value.

Getting those kinds of returns in the future isn’t a sure thing. They certainly won’t be pain-free.

Precisely because there are no guarantees, this decades-long strategy won’t work when your horizon is short, as many older readers have pointed out. In that situation, locking in returns at the relatively high interest rates that prevail at the moment makes more sense than a long-term “set it and forget it” approach.

Whatever your investing horizon, enjoy these better times in the markets, but be prudent. The losses of 2022 provided a vivid reminder of how important it is to set up your portfolio so you can tolerate market agony. Hope the current calm continues but be ready for trouble, whenever it comes.