While robust equity market performance in 2023 was certainly in part spurred by the strength of mega-cap technology stocks, economic data and the movement of interest rates also played a critical role. To that point, a decline in Treasury yields to start last year helped fuel a low-quality rally in equity markets, though yields moderated over the next few months following the regional banking chaos that unfolded in February and March. Dynamics shifted in July, however, when yields began to surge as the U.S. Treasury announced new debt issuance to help fund a growing budget deficit. As the year progressed, the continued strength of the domestic economy, including a robust labor market and a resilient consumer, combined with hawkish Fed rhetoric caused yields to climb even further. The 10-Year Treasury yield notably rose to nearly 5% by mid-October, its highest level in over 15 years. Equity markets largely sold off in tandem with this spike in yields, with the Russell 2000 Index reaching an intra-year low on October 27, 2023. Market dynamics once again shifted in the final weeks of 2023, as cooling inflation data led to a more dovish tone from the Fed and widespread investor anticipation of near-term interest rate cuts. This changing sentiment supported a reversal in the 10-Year Treasury yield in late October. As a result of renewed optimism, equity markets exhibited a sustained rally to close the year, with the S&P 500 Index approaching all-time highs in late December. Small-cap equities, which were shunned by investors for much of 2023 amid an environment of higher rates, climbed nearly 25% from their October lows through year-end. Though this rally saw the reemergence of market breadth, as both cyclicals and growth-oriented equities notched strong returns, actively managed strategies struggled due to the outperformance of lower-quality stocks.

This “Santa Claus rally” that ended last year has ultimately tapered off, with equity markets declining to start 2024 amid slightly higher yields. While this trend could foreshadow further challenges for equities in 2024, it may also be a necessary correction. Specifically, given the sharp rise in stocks to close last year, investors may have priced in an overly optimistic probability of interest rate cuts and are just now beginning to consider the possibility that the Fed will not be as accommodative as expected in 2024. This recent correction may also provide some valuation support in the event of any missteps during this quarter’s earnings season, which is slated to kick off in the coming days. As 2024 progresses, policy decisions by the Federal Reserve and the movements in Treasury yields will likely continue to impact investor sentiment and market performance.

U.S. equities declined for the third consecutive month in October amid an environment of higher yields and underwhelming earnings reports for many key index constituents. The S&P 500 Index, while still positive on a year-to-date basis, dropped by more than 2.0% during the month and is now more than 8.0% off its July peak. The Nasdaq-100 Index, which skews more heavily to growth-oriented segments of the market like Information Technology, also saw a decline of more than 2.0% in October. Finally, the Russell 2000 Index, which tracks the U.S. small-cap market, returned roughly -6.8% during the month and is now negative on a year-to-date basis.

As stated above, elevated yields have weighed on equity indices in recent time. The yield on the 10-year Treasury, for instance, recently eclipsed 5% for the first time in over 15 years, while most short-end rates remain at levels not seen since the Tech Bubble of the early 2000s. Higher yields have the effect of applying pressure to equity price multiples and enticing investors to allocate away from stocks and toward bonds. Smaller companies are often disproportionately impacted by higher rates because of the large debt burdens typically associated with those businesses, which helps to explain the underperformance of the Russell 2000 Index relative to the broad market over the last several months. Additionally, optimism surrounding some of the mega-cap technology companies that have exhibited robust returns this year, commonly referred to as the “Magnificent Seven,” appears to be waning. For example, Alphabet (the parent company of Google), saw its shares decline by roughly 10% the day after it reported a smaller-than-expected profit in its cloud computing segment. Amazon, Meta, and Tesla have also seen their shares trade lower in recent weeks due to investor concerns about future sales and margins. While it is important to note that none of these companies reported overly problematic earnings data for the third quarter, lofty valuations and investor exuberance have left their share prices vulnerable to pullbacks when results are even slightly disappointing.

While recent performance of equity indices has surely been challenged, there are several reasons for investors to stay the course. For instance, the Federal Reserve is likely nearing the end of its hiking cycle, meaning the pressure being applied to stock prices by higher yields may soon abate. It is also important to remember that markets often exhibit mean-reverting patterns of performance, meaning strong equity returns typically follow periods of stress. Marquette will continue to monitor dynamics within stock markets and provide guidance to clients accordingly, while also emphasizing the need for prudence and a long-term approach as it relates to equity investing.