2023 Portfolio Review: The Costs And Benefits Of Playing Defense

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Lack of mega-cap stocks caused my portfolio to underperform the S&P 500 in 2023, although I am ahead on a 2-year basis.Key lessons are to recognize and accept the impacts of deviating from the ...

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The main driver of this performance was the same as what I reported at midyear: narrow leadership with just 3 of 11 sectors far above average. These 3 are Technology (XLK) at 56.0%, Communication Services (XLC) at 52.8%, and Consumer Discretionary (XLY) at 39.6%. Seeking Alpha These 3 sectors contain the \"Magnificent 7\" mega-cap stocks which now make up 28% of the index. SPY top 10 holdings (Seeking Alpha) Despite such a strong year for the average, 4 out of the 11 sectors had a total return under 2.1%. 3 of these were even negative. The laggards this year were Utilities (XLU), Consumer Staples (XLP), Energy (XLE), and Health Care (XLV). Seeking Alpha The remaining 4 sectors had returns in the 12%-18% range, including Financials (XLF), which rebounded from a negative YTD return at midyear as fears from the March banking crisis wore off. Growth outperformed Value in 2023, with each style maintaining its ~4% gap over or under SPY that existed at midyear. The iShares S&P 500 Value Fund (IVE) returned 22.1% for the year compared to 29.8% for the Growth Fund (IVW). Seeking Alpha The big performance differentiator, market cap, remained constant through 2023. The Vanguard Mega Cap Growth ETF (MGK) returned 51.7%, compared to 16.1% for the SPDR MidCap ETF (MDY) and 16.8% for the small-cap iShares Russell 2000 ETF (IWM). Seeking Alpha Fixed income enjoyed a respectable year, with most of the returns coming in the last quarter, after the 10-year Treasury (US10Y) reached its peak yield of around 5% in October. The iShares Core U.S. Aggregate Bond ETF (AGG) returned 5.7% in 2023. The Investment Grade Corporate Bond Fund (LQD) returned 9.4%. The High Yield ETF (HYG) returned 11.5% and the Preferred ETF (PFF) returned 9.2%. Seeking Alpha The lower credit quality funds extended their performance advantage over the higher quality ones since midyear. This is not the behavior I would expect if heading into a recession. Instead, it supports the thesis of a soft landing for 2024. Average stock valuations as measured by the earnings yield (E/P, or the reciprocal of the P/E ratio) have been in line with the 10-year Treasury yield since the middle of the year. This marks the end of a long period since the bursting of the dotcom bubble when stock earnings yields had a significant premium to treasury yields (except for during the 2008-9 financial crisis). Author Spreadsheet This apparent lack of risk premium for stocks suggests they are getting expensive relative to bonds, but they have not yet reached the valuation extremes of most of the 1990s, when earnings yield was significantly under bond yields. As we saw then, these valuation extremes can persist for a long time, and there is a real opportunity cost for getting defensive too early. While it's sometimes tough for a value investor to accept, these valuations could be rational in some scenarios. These include a coming decline in interest rates, an increase in next year's earnings, or an increase in the expectation of future earnings growth. If these scenarios occur, avoiding high P/E growth stocks can hurt relative performance, as I certainly saw in 2023. Over the longer term, valuation still matters as different investing styles go in and out of favor. While it's important to understand the drivers of relative performance in a given year, it's also important to not overreact if your strategy has delivered over the long term. Portfolio Performance With that background comes the bad news. My portfolio had a total return of 12.1% in 2023, underperforming the SPY by 13.9%. That's my worst underperformance since 1998. The consolation is, it follows a strong 2022, when I had my best outperformance since 1999. On a 2-year basis, my portfolio has returned 5% total, compared to 3.2% for the SPY (nearly all due to dividends as the share price is almost unchanged). The defensiveness helped on the downside more than it hurt on the upside. My ending asset allocation was 79.7% equities, 18.7% fixed income and preferreds, and 1.7% cash. That marks a shift of 4.2% out of equities, 3.1% into fixed income, and 1.2% into cash compared to the allocation at year-end 2022. The improvement in cash and bond yields relative to stock earnings yields drove this reallocation. As for investment income, I had a yield of 2.79% in 2023 based on starting portfolio value. This is higher than the SPY yield of 1.73%. Individual bond purchases, higher cash rates, and stock dividend increases helped to drive this yield, which was achieved even after selling high-yielding AT&T (T) and (PDO) for tax optimization. My portfolio income in total dollars in my taxable account was 10.2% below 2022 levels. Overall, including my IRA from which I am not yet taking distributions, portfolio income grew by 5.4%. (See my midyear review for further details on this tax optimization.) Looking forward, my projected yield for 2024 is now about 2.6%, lower mainly because of the increase in portfolio value. Largest Holdings My top 10 common stock holdings make up 55.5% of my total portfolio. I made no trades in any of these holdings, except for reinvesting dividends. Since midyear, Toro (TTC) has fallen off the list due to a big miss in 3Q earnings, but improved results in 4Q could get it back into the top 10 soon. Target (TGT) is back in the top 10 as the worst seems to be behind it following its 3Q results which show margins starting to recover even though same-store sales are still down. Author Spreadsheet My top 5 fixed income holdings now make up 10.4% of my total portfolio. Since midyear, a 6-month T-Bill came off the list in October as it matured. Proceeds were invested in my broker's money market fund (SWVXX). Author Spreadsheet The top fixed-income holdings performed well, except for the Nuveen Quality Municipal Income Fund (NAD) due to its long duration and high leverage. These should be positives in a falling rate environment, setting up well for 2024. Top And Bottom Performers The third-best performer in 2023 was Carrier Global Corp. (CARR), with a total return of 41.4%. The company is benefitting from secular trends toward cleaner indoor air. It is also concentrating in the HVAC business by buying European company Viessmann and selling its fire, security, and refrigeration businesses. My second-best performer in 2023 was Penske Automotive Group (PAG), with a total return of 42.3%. Penske benefits from its diversification into truck sales and leasing and its global footprint. Its concentrated ownership makes it easier to take private, also helping support the share price. My top performer of 2023 was Eaton Corp. (ETN). Its 55.6% return is competitive with the mega caps despite Eaton being thought of as a cyclical industrial company. Actually, Eaton is benefitting from the secular trends toward electrification and reshoring manufacturing facilities. The fact that all three of my top performers are industrial stocks (PAG is in the Consumer Discretionary sector but has industrial exposure with the truck business) is another indicator of a soft landing rather than approaching recession. Two of the bottom three performers are a different story, achieving that distinction because of company-specific issues and not their sector. As at midyear, the third worst-performing stock in my portfolio was Toro at -14.1%. The company is well run and has done a great job growing by acquisition from its core landscaping equipment into less seasonal underground construction equipment. Demand hit a wall in 3Q, but as the channels get cleared of excess inventory, sales should come back. The second worst performer was RTX Corp. (RTX) at -14.4%. The market reacted negatively to news of problems with high-pressure turbine disks on jet engines. This will cost billions of dollars, but the company appears to have the inspection and maintenance plans in place to deal with the issue. The worst performer of 2023 has been Albemarle Corp. (ALB), down -32.8%. This is mainly due to plummeting lithium prices this year. Trading Economics The secular trend of vehicle electrification is still real, but perhaps not at the pace many anticipated in 2021 and 2022 when customers stocked up on inventories and producers added capacity. At some point, demand will catch up with supply. Albemarle can get through this period with its non-lithium businesses, and it has the resources and production capacity to ramp back up when needed. Special Situations Activision Blizzard (ATVI) was my only merger arbitrage play this year. The best case scenario that I noted at midyear - the deal with Microsoft (MSFT) gets delayed and another dividend is paid out before closing - actually happened. The deal closed at $95 in October and I am happy to report I held until the end, earning an annualized 10.58% from the cash deal, dividends, and option sales along the way. This beats Warren Buffett's (BRK.A) (BRK.B) results with this trade (or maybe it was one of Berkshire Hathaway's investment managers) who panicked during the FTC challenges and sold most of the position in 2Q, getting completely out by 3Q. I offset this nice result with a very un-Buffett like gamble on 7/21/2023 $356 QQQ Puts, as I discussed at midyear. My thesis was simply that QQQ was overvalued. Unfortunately, I was early (wrong) and ended up dumping the options one day before expiry for a 99% loss. It just so happens that QQQ hit a high on that date that it did not surpass until mid-November. If I had waited just a month to do this trade, I could have had a much better outcome. The good news is that limiting my position size held the loss to just 0.22% of my total portfolio return this year. Still, I can think of a lot more useful things I could have done with that cash. With an FTC that still seems determined to challenge all mergers and higher interest rates available on cash, there are no special situations that look attractive to me at this time. Other Trades Besides the trades discussed in the previous section, I made almost no other trades in the second half of the year. In July, a portion of my 2024 bonds from Brookfield Corp. (BN) were called early. I held the proceeds in my money market fund until November when I further extended my bond ladder to 2034 with bonds from Jefferies Financial (JEF) (Cusip: 47233JBX5). I got these investment grade BBB bonds at an attractive yield to maturity of 7.34%. See my midyear review for a recap of 1H trades. Lessons Learned The #1 lesson of 2023 is that defensiveness has its costs. Deviating from the benchmark by not holding the top 7 mega-cap stocks provided for great outperformance in 2022 but hurt in 2023. Over the 2-year period, I am still ahead with the added benefit of lower volatility and more income. Nevertheless, I actually saw value in some of the mega-cap names in late 2022, such as Alphabet (GOOGL), and failed to act. I am still looking for the opportunity to deploy some cash in this area in 2024 if the market puts on a sale. The second lesson from 2023 is that you need to be right on both timing and direction to succeed in speculating with options. The market can always get more overvalued, so if you are going to trade it, you better have a catalyst in mind for why it will go lower. The valuation itself is not a reason. Finally, the third lesson from 2023 is to ignore market forecasts. Nearly everyone expected a recession in 2023 along with limited market returns. Instead, we got strong GDP growth undeterred by high interest rates which now seem to have peaked. Going into 2024, I see many forecasters expecting the pains they thought would hit in 2023 simply delayed a year. Some others expect a big drop in interest rates even without a slowdown in the economy, leading to big market gains. I'm somewhere in the middle, expecting a decent 2024 but with performance shifting from the mega caps to the smaller and value stocks that sat out a big portion of 2023's gains. Outlook Even as I said you should ignore forecasts, I went ahead and made one anyway. As I often state, I expect the Fed to do what they say and cut the Fed Funds rate 3 times in 2024 to the 4.5%-4.75% range by the end of 2024. This is in contrast with the futures market which currently expects 6 rate cuts. Where I do not believe the Fed is in their GDP and inflation predictions, where I think institutional inertia is causing them to be too bearish. I see the great progress on inflation continuing and dropping below 2% in 2024 even as housing starts and consumer spending hold up, keeping GDP growth above 2%. In such an environment, I expect minimal change in the 10-year Treasury yield from current levels of 3.88% and therefore not much change in the fair P/E multiple for stocks. With decent earnings growth expected based on bottom-up estimates, I expect a mid to high-single-digit return from the S&P in 2024, but with performance broadening out beyond the mega-cap names that drove 2023 performance. If I'm right, my defensive posture won't cost me as much as it did in 2023 and may even be positive. Appendix A full list of my holdings as of 12/31/2023 is below:  Author Spreadsheet","kind":null,"is_publish_news":null,"is_publish_highlight":null,"is_publish_live":null,"is_publish_wemedia":null,"editions":null,"symbols":[],"gpt_button":1},"commentList":[],"isCommentEnd":true,"newsSizeData":{"likeSize":0,"commentSize":0,"repostSize":0,"favoriteSize":0,"likeStatus":false,"favoriteStatus":false},"APP":{"userAgent":"Mozilla/5.0 AppleWebKit/537.36 (KHTML, like Gecko; compatible; ClaudeBot/1.0; +claudebot@anthropic.com)","isDev":false,"isTTM":true,"deviceId":"web-server-community-laohu8-v3","version":"4.22.4","shortVersion":"4.22.4","platform":"web","vendor":"web","appName":"ttm","isIOS":false,"isAndroid":false,"isTiger":false,"isTHS":false,"isWeiXin":false,"isWeiXinMini":false,"isWeiBo":false,"isQQ":false,"isBaiduSwan":false,"isBaiduBox":false,"isDingTalk":false,"isToutiao":false,"isOnePlus":false,"isHuaWei":false,"isXiaomi":false,"isXiaomiWebView":false,"isOppo":false,"isVivo":false,"isSamsung":false,"isMobile":false},"href":"/m/news/2400071027"}