Market commentary equities: Breaking down the boom – Analysing 2023’s stock market success

In contrast to the pessimistic market forecasts, 2023 proved to be an exceptionally positive year for the stock market. In this article, we break down the performance of different sectors, regions, sizes, and styles to understand the driving forces behind the market boom. Additionally, we look ahead to the next year with a view on current valuations and earnings forecasts.

Mark Frielinghaus, CFA
Portfolio Manager Equities

Looking back – equity markets 2023

In retrospect, most stock market forecasts for 2023 were too pessimistic. Characterised by stubborn inflation and global recession, only slight price gains were expected. However, 2023 proved to be an extraordinarily positive year for the stock market, although interest rate and recession fears caused high volatility in the meantime. The year was once again dominated by a few large technology stocks, particularly in the USA. A diversified portfolio was unable to create much added value, regardless of the investment style. The continued escalating relative performance of the megacaps has led to historically high concentration risks on the equity markets.

Sectors: Semiconductors dominated 2023

The semiconductor sector benefited the most from the artificial intelligence hype and saw its share price rise by more than 80 % overall. However, software and online retail companies as well as car manufacturers also recorded share price gains of over 40 %. In regional terms, the spread was greatest in the USA compared to the rest of the world. The difference between individual technology sectors and defensive sectors such as food producers reached almost 100 %.

A similar picture emerged in Europe. Although the major technology stocks were absent here, semiconductor producers such as ASML and technology companies such as SAP in particular made significant gains. Overall, technology but also financial stocks and industrial and automotive stocks were the strongest performers.

There was a clear contrast in emerging markets. Although semiconductors were the biggest winners, other growth-related sectors like online retailers were down sharply. There was therefore no uniform pattern among growth stocks. Real estate stocks in China were under considerable pressure due to the ongoing property crisis. The energy sector remained the clear outperformer in emerging markets, while oil stocks in developed markets posted below-average returns.

Regions: US markets were the clear winner

Figure 1: Performance of regional indices

Source: Bloomberg, L.P. 

Regionally, European markets outperformed the leading US equity markets in the first half of the year. However, this was reversed in the second half of the year, with the result that US equity markets were once again the clear winners at the end of the year, even though the broad market as a whole contributed relatively little to this gain.

This can be seen by looking at the S&P 500 Index and the MSCI Europe, first weighted by market capitalisation for the year and then on an equal weighting basis. With the exception of a few basis points, the European markets posted an almost identical performance of 15 %, while the 13.8 % rise in the equally weighted US S&P index is only half that of the standard index.

Figure 2: Equal weighted indices lagged in 2023

Source: Bloomberg, L.P.

The renewed dominance of large technology companies is also evident when the total return of the MSCI World Index of 1500 stocks is broken down into individual performance contributions. This shows that the “Magnificent 7” (Apple, Amazon, Microsoft, Meta, Alphabet, Nvidia, Tesla) accounted for around 11 % of the 24 % increase in share prices. Their average performance in 2023 was 75 %!

Combined with a cumulative weighting of almost 20 % in the benchmark, this shows the market’s enormous dependence on a small number of stocks and explains the high contribution to the overall result.

Overall, the S&P 500 closed the year up 26.3 % in USD terms. European markets gained 15.8 % (in EUR). Emerging markets, on the other hand, lagged significantly. Ongoing economic problems in index heavyweight China resulted in a gain of just 6.1 % (in EUR) for the year.

Size: No way around large caps

Regional differences also persisted in the comparison by company size.

  • In the US equity market, there was no way around large caps. Both small caps (Russel 2000) and mid caps (Russel MidCap) lost around 10 % relative to the S&P index.
  • By contrast, the performance of European equities was surprisingly homogeneous, with large, mid and small caps all moving within a narrow range of between 13% and 16 % over the year.
  • Once again, the contrast was stark in emerging market equities. Here the 2nd and 3rd largest companies were the best performers. At 20 % (in EUR), small caps outperformed the market as a whole by only 6 %. Mid caps were in between with a 14 % gain.
  • Price performance was robust in almost all emerging markets outside China, driven by the broad equity market, while Chinese index heavyweights also posted negative returns in absolute terms.

Investment styles: Differentiated development across regions

In the global factor indices, the dispersion of the different styles was much higher than in Europe or emerging markets. The high dispersion of the US equity market therefore also had an impact here.

Figure 3: Style returns of different regions  

Source: MSCI, Inc

Styles in global indices

  • The growth index was by far the strongest performer. Growth stocks outperformed the MSCI World Index by 12 %, with technology stocks even more heavily weighted than in the standard indices.
  • Quality was also positive, often with a high correlation between quality in terms of profitability and growth factors.
  • All other investment styles underperformed the market. In particular, defensive stocks, as measured by the MSCI Minimum Volatility Index, were unable to keep pace with the price rally and underperformed the standard index by 12 %. Momentum and value factors also lagged significantly behind the index.
  • The gap between growth and all other styles also contributed to the weaker performance of the MSCI Multi-Factor Index.
  • Looking at the performance of individual factors in a long-short system, the spread between styles is confirmed.

Styles by region

Relative to the US equity market, style returns ranged from -22 % for low volatility stocks to +18 % for growth stocks. Buybacks and dividend yields, which are part of the value category, were also in positive territory. However, quality and momentum continued to be negative.

In Europe, most styles also underperformed. However, at around 9 %, the difference between the best and worst performing styles was only half that of the US market and global indices. Growth stocks barely benefited in Europe, as there are fewer technology stocks than in the US, and the largest weightings in the growth index are in luxury goods and pharmaceuticals.

As in the US indices, European defensive, momentum and value stocks underperformed. However, in contrast to global equities, the mix of factors proved successful. The multi-factor index, a combination of inexpensive stocks with high quality and positive momentum, gained around 4 % relative to the overall market. In a long-short system, value factors, particularly dividend yields and share buybacks, also delivered positive returns. Quality and momentum remain weak in the long-short view.

In emerging markets, most investment factors generated positive returns relative to the market as a whole. Although growth and momentum stocks underperformed the MSCI Emerging Market Index, quality, value and small caps in particular outperformed. The mix of investment styles also outperformed the broad market, similar to European equities. These results are also confirmed in the long-short analysis. Multi-factor, dividend yield and value in particular generated strong overall returns.

Summary: 2023 astonishingly strong

All in all, 2023 was the second best year for global equity markets over the past 10 years, after 2019. This was made possible by the robust US economy and central banks’ relentless fight against inflation. This led to a sharp fall in inflation rates to multi-year lows. On the other hand, there was a strong focus on the field of artificial intelligence. The technology heavyweights on the US stock market benefited in particular from this and continued to drive the overall market with their high price gains. The feared recession in the US and the associated dilemma of the Federal Reserve having to cut interest rates again too soon did not materialise.

Outlook: Huge gap in valuations levels between large and small caps

Looking ahead to 2024, it remains to be seen to what extent analysts’ sometimes optimistic earnings forecasts can be maintained and whether profitability can be further increased from current levels, particularly in the US. Current valuations and earnings forecasts for different regions and markets are of interest.

Figure 4: Valuation levels of regional equity markets

Source: Bloomberg, IBES

In terms of valuations, US large caps in particular have reached very ambitious levels. The premium is evident not only in regional comparisons with Europe, Japan and emerging markets, but also in comparisons with small caps. Historically, small caps have often been more expensive than blue chips due to their higher growth. This relationship has now reversed. US companies are now also trading at a valuation discount to US small caps. US small caps are 35 % cheaper than large caps, not only on historical earnings but also on earnings expectations for the next three years. This is also the case in Europe, at least in terms of estimated earnings. There is no valuation premium over large caps.

On the other hand, the picture has not changed if we look at average analyst earnings expectations. Analysts’ consensus estimates are still higher for small caps than for blue chips. This is confirmed by historical earnings over the past 10 years in both the US and Europe. Expected earnings for the next three years are between 6 % and 8 % higher on an annualised basis for US and European small caps respectively. The outlook for small and mid-caps therefore remains positive, but valuations do not currently reflect this. In view of the significantly more favourable valuation in a global context, there is a strong case for greater consideration of medium-sized and smaller companies in 2024.

Figure 5: Earnings performance and forecasts for regional equity markets

Source: Bloomberg, IBES

The concentration of the market cap indices, in particular in the US market has been skyrocketing since 2015. Looking at historical patterns, we have hardly seen similar periods in terms of duration and magnitude. So is this time really different?

A correction in the market dominance of a very small number of technology companies seems inevitable. Regardless of market direction, these stocks can either enter a correction or get left behind by the broader market. Earnings growth rates have been accelerating in the past, even more so since the pandemic, and the growing base from which future earnings growth starts is becoming more and more ambitious.

In addition, market participants have aggressively factored in Federal Reserve rate cuts following a decline in inflation rates. The Fed can hardly surpass expectations in 2024, but has plenty of room for disappointment if the economy and price developments do not follow the Goldilocks scenario. These circumstances, combined with an election year in the US, a war in Eastern Europe and geopolitical tensions in the Middle East provide some room for volatility. In addition, last year investors were more cautious and less optimistic before the rally in equity markets. This year, the bears seem to be subdued by consensus of positive equity market forecasts.

Diversification is key to mitigating risk in a volatile market environment. This not only applies to asset classes, regions and sectors but investors should also hold a balanced number and weighting of stocks within in global portfolio. 2024 looks very favourable for a portfolio of high-quality and attractively valued stocks that is well diversified, even beyond the “Magnificent 7” stocks.