Investors Expect a Repeat of the 2010s

A replay of the last decade or so is priced into the markets, and that’s an aggressive posture.

A burst of investor optimism in late 2023 pushed stock and bond prices well beyond economic fundamentals to reflect a widespread expectation that an ideal scenario will unfold over the next year.

Investors expect inflation will return to 2% or less without a recession, the Federal Reserve will bring short-term interest rates to the same level, and the 10-year treasury yield will be 3.5%. Investors expect the Fed will reduce interest rates more sharply than the Fed said it will.

For the scenario to unfold, significant obstacles must be navigated.

Valuations of stocks and bonds start at very high levels. Prices and valuations are likely to tumble if there are any surprises or deviations from the scenario that’s priced into the markets.

Inflation is down substantially from its 2022 high, but the easy work on lowering inflation is behind us. Prices on many goods are down, but inflation for services remains fairly high. Steady economic growth and imbalances in the labor market are likely to keep a floor under inflation.

Investor optimism works against the very scenario investors are betting on. The rally in financial assets stimulates the economy and supports demand for goods and services.

With no margin of safety in the prices of many investments, in 2024 we’re likely to have a repeat of the volatility and whipsaws that occurred in 2023.

There was a fair amount of pessimism at the start of 2023. Markets rallied in the spring after the banking crisis was resolved, the enthusiasm over artificial intelligence spread, and the Fed pumped additional money into the markets.

Stocks and bonds peaked during the summer. Pessimism spread rapidly as government funding needs and persistent inflation pushed long-term interest rates higher, with the 10-year treasury yield topping 5% for the first time since 2006.

In the last week of October, optimism returned, causing longer-term interest rates to plunge and stock prices to rise the rest of the year. Similar whipsaws and swings are likely in 2024.

Since about 2010, returns from large U.S. growth stocks, especially technology companies, dwarfed returns from other assets.

Historic and near-historic gaps developed in returns of growth stocks and value stocks and large company stocks and small company stocks. The return of the capitalization-weighted S&P 500 greatly exceeded the return of the equal-weighted S&P 500.

Investors’ focus on the recent past makes them expect a repeat of the 2010s in the rest of this decade, though the starting circumstances are very different.

Inflation remains above the Fed’s target, and many of the deflationary forces of the recent past are abating.

The return on safe investments is around 5%, providing competition for stocks and bonds that didn’t exist two years ago.

There now are more attractive opportunities than U.S. stocks and bonds.

Japan’s stock indexes delivered better returns in 2023 and are likely to continue that outperformance, with less risk, in 2024.

There also are good opportunities with less risk in some emerging market stocks and bonds.

The 2010s through 2023 were a good time not to be diversified and to focus on large U.S. growth stocks. Going forward, greater diversification is likely to generate higher returns while reducing risk, especially since investors expect the Fed to cut rates more aggressively than the Fed has indicated so far.