Client Investment Letter January 2024


“It was never my thinking that made the big money for me. It was my sitting. Got that? My sitting tight.” – Reminiscences of a Stock Operator by Edwin Lefèvre


As we close out 2023, the tumult of a brutal 2022 when stocks and bonds both went down substantially seems far away. Once again “sitting tight” with a collection of high-quality companies plus ample cash alternatives has paid off handsomely, providing less downside in 2022 when things went down and getting your portfolios back to all-time highs sooner than the broad markets. If one owns exceptional companies at reasonable valuations, the best thing an investor can do is tune out the day-to-day noise and patiently wait for those companies to do what good companies do, consistently earn handsome profits.


To be sure, the mood on Wall Street to end the year was nothing short of ebullient. The “Magnificent Seven” of Apple, Alphabet (aka Google), Amazon, Meta (aka Facebook), Microsoft, Tesla, and Nvidia, super-charged by enthusiasm for AI, pushed the broader indices back near their highs while leaving many more traditional old-world businesses in the dust. Indeed, the Magnificent Seven drove 62.2% of the performance of the S&P 500 this year. Said differently, the S&P 500 (or 493, if you will) total return excluding these 7 tech behemoths would have been up just 9.94% for the year.


The prevailing perception is that the Fed has finished raising interest rates for this cycle and will soon be easing monetary policy again. The Fed’s own “dot plots” show a projection for three 0.25% rate cuts in 2024 for the first time since this hiking cycle began. Of course, Wall Street, ever eager to get carried away, is currently pricing in six such 0.25% rate cuts in the futures market. The challenge with this setup is that typically the only thing that could reasonably induce that much accommodation is a recession, and Wall Street has convinced itself we won’t be having one. So, either Wall Street is likely to get disappointed on rate cuts or disappointed on the path of the real economy. We would rather the market be wrong about the rate cuts, but only time will tell. As we have commented before, “soft landings” are exceedingly rare.


There is certainly plenty of strength showing in the economy. Employment remains a highlight with the unemployment rate near generational lows of 3.7%. Jobless claims remain low at around 200,000 weekly. The most recent estimate for Q3 GDP growth sits at an annualized rate of 4.9%. Inflation has come down dramatically, to 3.1% from 7.1% this time last year. While moving in the right direction, this remains well above the Fed’s stated goal of 2.0% and it therefore seems hard to believe the Fed would declare victory in its fight against inflation. So far, it seems like the Fed is succeeding in slowing the economy without stalling it.


However, there are pockets of weakness out there, too. The Conference Board’s index of leading economic indicators has continued to fall throughout 2023 since peaking in March 2022. Credit card delinquencies have almost doubled since the beginning of the year to 3.0% from 1.6%. Commercial real estate markets have begun to weaken substantially with growing vacancies and pressure on property values particularly in the office market. And foreign economies are still sluggish, especially parts of Europe and China.


All in, it looks like the Fed’s rate-hike cycle may lead to a good old fashioned credit cycle, where lenders get fearful about the ability of borrowers to repay and consequently interest rates go up due to widening spreads as opposed to changes in the risk-free rate. Banks’ balance sheets suffered when government debt went down due to rising rates; it remains to be seen how they will handle a weaker consumer and commercial real estate market. Out of the over 4,500 banks in the U.S., it is hard to believe that a few won’t be caught out in a changing of the credit-cycle tide after so many years of benign credit risk.


So, while we remain hopeful that macroeconomic conditions will remain supportive, we definitely aren’t counting on it, and we have a cash cushion on hand to utilize if things get a little messy. Additionally, there are lots of non-economic concerns to keep an eye on in the coming year. Things in Washington are never pretty, but this year brings a presidential race no one seems to be looking forward to. The wars in Ukraine and now Israel and Gaza continue without a clear line of sight to resolution. Taiwan has an election in January that could upset the careful balance there with China. Shipping channels have come under assault by Iranian proxies in the Middle East. There is no shortage of geopolitical events that could temporarily upset the harmonious market conditions we have been enjoying.


However, as our long-time clients have seen many times, when volatility and fear return – as they inevitably do – we stand prepared to add to existing positions and opportunistically make new investments. Because many companies were left behind in the Magnificent Seven rally of 2023, we are still finding lots of interesting potential opportunities. And time and time again our quality companies, while they often temporarily fall in price during periods of market consternation like 2022, have come back stronger than ever just like they finished 2023.


We didn’t add any completely new positions during the torrid fourth quarter rally, but we did selectively add to some existing holdings for underinvested accounts, in addition to making a handful of trades to minimize tax liability where we could. However, we did make a very important new addition to the Penn Davis McFarland operations team in the fourth quarter.  We welcomed Arlina Lara to help service the growing number of accounts we are handling.  Please be sure to allow us to introduce you to her on your next visit to our offices. We are so glad to have her on our team and know you’ll enjoy working with her.


As we close out 2023, we certainly appreciate the trust you’ve shown by “sitting tight” with us as we navigate these rapidly changing markets. Wishing you and your family a happy and healthy 2024!


Penn Davis McFarland, Inc.
January 2024