Whew—what a relief! 2023 proved to be a very profitable year for most public market investors, as shown below.

One way to think about recent gains is to attempt to identify those that reflect a justifiable (i.e., durable) adjustment in price.  In other words, does this increase reflect a correction of a prior discrepancy between price and fundamental value?  Or does the increase merely reflect growing optimism for the future and/or investor willingness to pay an ever-increasing premium for a perception of comfort and safety?

Take the Magnificent Seven.  On an equally weighted basis, this group posted a stunning 107.0% return for the year, while the return was 75.7% on a capitalization-weighted basis.  Presently, we have earnings growth data from September 2022 to September 2023 totaling just under 19% overall.  Expected earnings growth for the next twelve months is approximately 25% on an equally weighted basis. Simply put, regardless of which of these figures we use, multiple expansion (i.e., optimism for the future) defined the story of last year.

Why is optimism a dangerous foundation for investment decisions?  Unfortunately, despite the positive connotation commonly attached to such an outlook, reality rarely matches hope—subsequent results are predictably disappointing as future outcomes fail to live up to lofty expectations.  The Seth Klarman quote above captures this point well, as does the chart below.

Ultimately, this is a tale of two markets. On one hand, we have the Magnificent 7 priced at nearly 40x trailing earnings—this is the ultimate “what can go wrong?” valuation.  On the other, we have scores of beaten-down stocks both inside and outside the US trading at what seem to be exceptionally low valuations¹.

On balance, we continue to believe that monetary policy is on a slow yet undoubtedly erratic path towards normalization thanks to higher structural inflation.  This introduces many less familiar but well-documented risks that investors will have to face whether they like it or not.  Given that everyone, including us, lack foresight into the future, the primary factor worth considering is the strong tendency of low valuations to create a wider array of scenarios in which equities produce acceptable returns.