Cayside Review: 2023 Q4
Our quarterly newsletter including fourth quarter review, global market update and outlook, key numbers, and firm announcements .
Q4 2023 Review & Outlook
US Equity Markets advanced strongly in the fourth quarter with a +12.1% return (S&P 500) and +14.3% (Dow Jones Industrial Average). For the 2023 calendar year, the S&P 500 gained +24%, the technology dominated Nasdaq gained +51% for the year, and the Dow Jones Industrial was up +13%.
We are now through the first four years of the current decade, recently dubbed the roaring 2020’s, which has been anything but smooth sailing. In just four short years, we have experienced a global pandemic and economic shutdown followed by unprecedented monetary creation, paralyzing partisanship in Congress, Russia invading Ukraine, regional bank failures, the Israel Gaza War, soaring global inflation, trade wars, and the most widely anticipated recession that never happened??
The S&P 500 fell over -19% in 2022 and then recovered +24.2% in 2023. However, if you extract out the mega-cap Tech companies, nicknamed the “Magnificent 7” or “Mega Cap-8”, which we wrote about in our 3rd Quarter letter, the index would still be negative since the 2022 bear market. This narrow market breadth until the start of the fourth quarter had signaled a potentially unhealthy rally concentrated amongst only a handful of mega-cap technology companies.
However, the fourth quarter reversed this trend, and we witnessed one of the most broad-based equity rallies in quite a while, hinting at a chance for normalization and an opportunity amongst other high-quality companies that have been underowned. The equal-weighted S&P 500 index, which more accurately measures the broader-based return of every company in the index, outperformed the market-weighted S&P 500 index in the fourth quarter. The equal-weighted S&P 500 index was up over +14% in just the fourth quarter exemplifying more healthy market breadth.
So, does this signal healthier equity market conditions indicating we are in the clear of an earnings recession? Is this a closing of the gap in relative valuations? Can we celebrate a soft landing? Or was this just a Santa Claus rally fueled by more dovish rhetoric from the Federal Reserve heading into an election year?
We are not market timers. We are long-term investors that own high quality businesses with compounding earnings and defensible pricing power. We like income-producing assets that are attractively priced with strong balance sheets and access to capital. We like things we can understand, and there are times when it is worth paying for talented managers and active management and there are times and situations when low-cost beta and broad market indexes make sense. Importantly, one thing we know for certain is that when sentiment becomes overly excited, and it seems fear has left the building – that is when we become defensive. Often we see periods like these followed by a correction or a powerful buying opportunity for long-term investors.
During the past four wildly eventful years, the S&P 500 has still advanced 47.6% since the start of the decade. A monumental feat during a global pandemic, global wars, inflation and Fed tightening. Last quarter, the Fed Funds Interest Rate was at 5.25-5.50%. The last time the Fed tightened to that high of a rate was 2006 to cool the economy. In 2007, the Fed decided to cut rates to 4.75% and shortly after had to call several emergency meetings as the overleveraged financial system was near collapse. While we are not predicting the next Great Financial Crisis, we are only pointing out that just because Central Bankers begin to cut rates does not mean we can celebrate a soft landing.
We are cautiously optimistic and as prudent and patient investors our number one goal is to avoid permanent loss of capital for our clients. More importantly, we think there are opportunities to be found scattered amongst neglected areas of the market.
Key Data
Our Investment Themes and Opportunities For 2024
While there are some warning signs, there are also opportunities and dislocations. We expect to remain vigilant in avoiding sub-par credit and lower quality capital risk while focusing on identifying transformational technologies and companies that exhibit margins of safety in their discounted valuations relative to other areas of the market.
We see the following themes as drivers of both opportunity and risk:
Rate-sensitive Businesses: Utilities and REITs were oversold in 2023 and a reassessment of assumptions could present opportunity in these businesses with real assets and often defensible cash flow.
Small/Micro-Cap Equities: Many large allocators, such as Pensions & Endowments, have over-allocated to Private Equity and Venture Capital over the past several years. Underowned small and micro-cap equities could be the recipient of future allocations.
Focus on Value: Overallocation to ESG initiatives left many critically important companies underowned and undervalued relative to other areas of the market.
Artificial Intelligence (AI) creates a long-term growth engine in both Private and Public sectors: The advancement and adoption of this technology will continue to boost productivity and improve operating margins in a host of important industries such as healthcare, logistics and utilities, among others.
Reconfiguration of Global Trade Agreements and Supply Chains: A chasm has been forming between the West (“The 5 Eyes”) and The East (“BRICS+”). We expect increased geopolitical volatility, supply chain stress and an increasing prospect of global war; this presents both risk and opportunity for improvement in commodity production, manufacturing and supply chain technologies.
The post-COVID consumer: Consumers are now facing decreased savings and a higher debt burden in the face of rising inflation in the “things we need” such as food, energy, housing, healthcare and insurance. This will likely increase risk in low quality fixed income and credit (auto and credit loans, etc.) and put further strain on discretionary purchases.
Persistent Inflation and Devaluation of Currency/Debt: We are focusing on real assets such as real estate, precious metals and commodities while also maintaining liquidity in the face of volatility.
The Great Migration: People are migrating to new geographies in an unprecedented way. (1) The matriculation from high income tax states to lower income tax states like Texas and Florida is creating tax states and worrisome deficits for the vacating states like California, New Jersey, New York, etc. (2) Foreign Immigrants are crossing into Western countries in overwhelming numbers with little oversight; this can create public service shortfalls, cultural volatility and imbalances in labor and supply of necessities like housing, food and healthcare.
Credit and Loan Maturity Wall: Leveraged loans and lower quality borrowers face a refinancing burden that could increase delinquency, default and systematic risk as borrowers face the reality of no longer living in an “easy money” environment (see below).
Our friends at a structured credit firm recently shared the following chart with us.
Source: Pitchbook / LCD; data through Nov. 22, 2023
Given the lack of appetite for lower quality loans in the market, refinancing the $25 billion due in 2024 and roughly $50 billion due in 2025 will require ample liquidity and friendly credit markets which may not be the case. Collateralized Loan Obligations (CLOs), which represent roughly 70% of the syndicated loan market, are ill-equipped to refinance this large contingent of debt in the face of potential rating downgrades this year.
Source: S&P Global, Preqin. Data as of Sept 30, 2023
4th Quarter Investment Activity
During the quarter, we took advantage of market sentiment around interest rate sensitivities and other factors which should create a more favorable environment for certain sectors that have underperformed. For example, we have been spending a considerable amount of time researching strategies to own smaller companies. We implemented this strategy with a small-cap growth manager that we believe will outperform in more volatile markets where active management can outperform indexed strategies in smaller market capitalizations. We also increased positions in our managed equity portfolios to Utility companies and REIT companies that were oversold during the quarter. As soon as rising rate fears abated, we saw quick support and the initial stages of price recovery for these high-quality businesses.
We are performing more due diligence on certain hedge fund strategies including private and distressed credit, equity strategies and other opportunistic pricing dislocations.
In Fixed Income, we remain overweight on liquidity and minimizing exposure to credit and duration risk with a preference for short-duration U.S. Treasury Bills and municipal bonds in certain geographies with yield and credit improvements.
Real Estate, Private Equity and Venture Capital
We utilize our network of investment professionals and clients to source and research interesting opportunities in the private market. We closed on a property in Sebastian, FL that will be developed into a boat and RV storage facility. We see this as an opportunity to provide our clients with a great development operator, yield potential and ownership of land in a growing area of Florida. We are actively scouring future real estate properties to add to the portfolio of investments in this space.
Wealth Planning: Other Key Numbers To Consider
A higher inflation environment has led to several estate planning changes and opportunities for 2024.
The lifetime gift and estate tax exclusion amounts have increased from $12,920,000 to $13,610,000.
The gift tax annual exclusion amount has been increased from $17,000 to $18,000.
The 37% top marginal tax rate will apply to individual income above $609,350 and married couples’ income above $731,200.
The Tax Cuts and Jobs Act exemption amounts are scheduled to be reduced on January 1, 2026, unless revised by Congress. The increase in lifetime gift tax limits and other estate planning strategies can allow families to shift more assets to their next generations with greater tax advantages.
Business Updates and Personnel News
NEW HIRE: DIRECTOR OF CLIENT SERVICES | Samantha Albert has joined the firm. Prior to Cayside Partners, Samantha worked at Raymond James Financial headquarters in St. Petersburg, Florida. She collaborated with internal corporate clients to promote their services to external institutional clients. Her time at Raymond James equipped her with a dynamic blend of experiences in client service, strategy and brand development. Samantha holds a master's in business administration (MBA) from Florida State University. Growing up in Jupiter, Florida, Samantha is excited to be back “home,” and we are beyond grateful and excited to add another talented member to the team. We are excited for you to meet her if you have not already.
OUR GROWING FAMILIES | Todger Strunk and his wife, Christie, have added another young analyst to their household. Welcome Andrew Charles Strunk. Congratulations, Tod & Christie!
A NOTE FROM THE WHOLE TEAM | We continue to grow our business and are continuously improving our offering of services to our clients. We have added some great clients and investment relationships during the quarter, which has grown our assets under management to a very good and scalable size. We look forward to continuing our relationship with our internal and external partners as we expand our network of clients, staff and service providers. We appreciate your support and confidence in us!
Contact Us
Please do not hesitate to reach out to us with questions or comments. You can reach us directly here.
Disclosures:
Cayside Partners, LLC ("Cayside") makes no warranty as to the accuracy or completeness of any data herein. Information presented in this report is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any securities. Investments involve risk and are not guaranteed. Past performance is not indicative of future results. This report is intended for the recipient(s) only and not for further distribution without written consent.