Magnificent Seven tech stocks and a recession that never showed up despite the Federal Reserve hiking interest rates to a 22-year high set a bullish storyline for investors in the best mutual funds in 2023.
The average stock mutual fund returned more than 13% in the final three months of the year (through Dec. 26), according to Morningstar Direct. But funds that owned the Magnificent Seven megacap names (Apple, Microsoft, Alphabet, Amazon, Nvidia, Facebook parent Meta and Tesla) fared far better. Those seven stocks, many of which are leaders in emerging artificial intelligence (AI) technology, accounted for more than 75% of the S&P 500's total gain this year of more than 20%, according to Morningstar.
S&P 500 index funds, which weight stocks by market value, benefited from the dominance of these megacap stocks, rising 26% this year through Dec. 26. Large-cap growth funds posted the biggest returns, surging 34.4% this year just through November, says Lipper. In contrast, small-cap growth funds gained only 6.1%. Science and technology funds were the top-performing sector funds, surging 40.1%. Lagging sector funds included health and biotechnology funds, which fell 4.7%, and consumer goods funds, which declined 3.1%.
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Picking The Best Mutual Funds Of 2024
Investors peering into their crystal balls for 2024, though, will view a different setup for markets in the new year.
Wall Street, which once feared Fed rate hikes, is now expecting rate cuts. Core inflation, which peaked at 9.1% in 2022, has run at just a 1.9% annualized rate over the past six months as of December, Commerce Department data show. That's within the Fed's 2% target. Corporate earnings, which turned negative early in 2023, are expected to grow 11.4% in 2024.
There's still a murky unknown, though, that poses risk. A recession — an enemy of the stock market — still hasn't been ruled out. So, be prepared for volatility next year as the soft landing vs. hard landing debate rolls on. And as Wall Street weighs the timing of Fed rate cuts.
Bulls and bears are split on where stocks are headed in 2024. S&P 500 year-end price targets from Wall Street strategists range from a high of 5200 (9% higher than the Dec. 26 close of 4775) to a low of 4200 (a 12% drop from current levels.)
In 2023, the Nasdaq Composite Index, powered by AI, was the big winner, rallying 44% in 2023 through Dec. 27. The S&P 500 rose 24%. The Dow Jones Industrial Average gained 13%. The small-cap Russell 2000, lifted by a late-year rally, rose 17%.
Since no one really knows for sure if stocks will soar or stumble in 2024, we asked top portfolio managers who run funds that are IBD Best Mutual Funds winners to see where they're putting their money now.
Large-Cap Stocks To Buy In 2024
Given that the "jury is still out" on whether the economy will dodge a recession, taking a balanced approach to risk and stock selection is a prudent way to invest in 2024, says Peter Bates, manager of T. Rowe Price Global Select Equity Strategy.
"I think it would be a mistake to be super bearish or super bullish," Bates told IBD. "The outlook for next year is incredibly opaque and uncertain."
One reason why the stock market may be more challenging in 2024 is that short-term bond yields are still north of 5%, which creates competition for equities. "There is an alternative to stocks," Bates said.
For 2024, Bates prefers a portfolio that plays both defense and offense with the help of stocks and bonds. With recession still a possibility, he likes stocks whose businesses aren't reliant on the economy to do well. Examples include health care insurers like UnitedHealth and reinsurers such as MunichRe and RenaissanceRe that provide coverage for primary insurance carriers.
He also likes property and casualty insurers that are benefiting from steady demand and higher premiums due to inflation. "Regardless of what happens to the economy next year, you're still going to insure your car and house," said Bates.
AI's Bright Future
Bates also expects AI to continue to drive markets in a positive way. AI's ability to boost productivity, for example, should help companies save on worker wages and help bring inflation down further. "The largest companies are still best positioned to win in AI," said Bates. "So, I definitely want some exposure to the Magnificent Seven."
He expects the Magnificent Seven to outperform the S&P 500 in 2024. His favorites in the select club include Nvidia, which is a leader in the AI chip space, as well as Amazon and Microsoft. "It's hard to see those companies not continuing to win," said Bates.
Bates also likes stocks that have underperformed this year and offer value as well as ones that are in the stages of a positive turnaround. He likes Stanley Black & Decker, which sells power tools. The company, which has been hurt by the decline in home sales, has been reducing inventory and is poised to benefit from a housing recovery and increased sales. "I think they're very close to that inflection point," Bates said.
Opportunity In Health Care
Health care stocks benefiting from popular obesity drugs also offer opportunity, says Bates. Eli Lilly is a good example. In November, the FDA approved the drugmaker's type 2 diabetes drug Mounjaro to be marketed as a weight loss drug under the name Zepbound. The obesity drug's active ingredient glucagon-like peptide-1 (GLP-1), which reduces food cravings, will be "significantly disruptive" and drive sales for Eli Lilly.
When it comes to playing offense, Bates likes cyclical plays, or stocks that will benefit from an economic resurgence. He sees opportunities in infrastructure-related companies that will benefit from the reshoring theme, or moving supply chains closer to home. He likes Steel Dynamics, a low-cost producer. Bates also is bullish on Ashtead Group, which rents construction equipment. He also likes Canadian Pacific Kansas, a railroad that will benefit from moving reshored products across the country.
"All of these stocks are cyclicals tied to housing, construction, and infrastructure," said Bates. "They are all a good way to play offense. When the economy starts to grow again, I think they can show very good earnings growth. And they're not that expensive."
Quality Stocks Still The Place To Be In 2024
The rosy market scenario for 2024 is if interest rates start coming down because inflation is moderating due to productivity growth — not because the economy is severely slowing, says Tom Hancock, manager of GMO Quality (GQLIX). "That's kind of our base case," scenario, said Hancock.
The less bullish outcome is if inflation isn't coming down fast enough and the Fed waits too long to cut rates and causes damage to the economy, says Hancock.
Following a year in which just a few stocks were responsible for a big share of the market's gains, Hancock sees opportunity in more defensive and value-type names that lagged both the market and Magnificent Seven in 2023. "We do have an inclination to rebalance back into the more defensive stocks," said Hancock. "It gives us the opportunity to take some profits on the growth side of the portfolio."
Hancock's defensive investment template includes sectors such as health care, which is benefiting from the new obesity drug use trend. He also likes consumer staples companies, including ones that sell snacks that have been hurt by fears that rising use of obesity drugs will reduce consumption of chips, cookies and ice cream.
Medical Devices Open Opportunities
Medical device makers, such as Intuitive Surgical, which specializes in robotics surgery and Abbott Laboratories, also look attractive, says Hancock. They've also been hurt by fears that obesity drugs will lower their sales and profits due to less need for health procedures. As a result, both stocks offer good value. "The whole medical device area has become more interesting," said Hancock.
On the consumer staples side, Hancock likes spirits companies and food companies that have experienced a hangover of sorts after spiking sales during Covid-19 and taking a more recent hit due to the challenges they face from obesity drugs. Hancock likes Diageo, the British company with spirits brands such as Guinness, Smirnoff vodka, and Captain Morgan rum.
Hancock also sees opportunity in clean energy stocks after the huge sell-off they have suffered in 2023 due to higher funding costs and other headwinds, including a rethink of ESG (environmental, social, and governance) investing. "Even green companies with high-quality businesses are getting killed," said Hancock.
But clean energy, Hancock says, is still a long-term trend with legs. He likes Enphase Energy, a leader in residential and commercial solar, battery energy storage and EV charging stations. He also likes SolarEdge, which makes solar panels.
Hancock is also a fan of the Magnificent Seven. Microsoft and Apple are longtime holdings. These leading tech stocks still sell at good valuations and will continue to be winners in AI, he says.
Why Small Caps Are A Compelling Long-Term Buy
Sure, small-cap stocks lagged last year vs. megacaps. But they're now trading at the largest valuation discount to large-company stocks since 1999, says Ken Farsalas, manager of Oberweis Micro-Cap (OBMCX). Small cap stocks now represent less than 4% of the entire U.S. stock market, the lowest level since the 1930s, adds Farsalas.
Small stocks have been hurt by higher rates, fears of recession, and the market's love affair with the Magnificent Seven.
"So, from a contrarian standpoint, investors should love small caps," said Farsalas. "Psychologically it's hard to do, but investors who can put their feelings aside and trust the data, I think over the next five to 10 years small caps can pay off very handsomely. I don't think you need a catalyst. I think you just need to pull the trigger."
Sticking With Profits
The best place to fish in the small-cap stock pond is the profitable ones. He likes Weatherford International, an oil and gas services company. "They've got a new management team that has led a very aggressive turnaround in the business," said Farsalas. The company also gets 75% of its business overseas in places like the Middle East and Latin America, which has helped it overcome slowing business in the U.S. energy market. "They're exposed to very strong markets outside the U.S.," said Farsalas.
He's also bullish on ADMA Biologics, a health care company that makes plasma-derived drugs that treat people with compromised immune systems who have failed to respond to other therapies. "This is a new product story," said Farsalas. The growth outlook is compelling, as the company has only penetrated 1% of the high-risk, immune system compromised population, says Farsalas. "The runway ahead is very substantial."
Another small-cap stock he likes is CECO Environmental, which makes pollution control systems used in the automotive, chemical, energy and pharmaceutical industries. "We see strong growth ahead in 2024 and valuations are very compelling," said Farsalas.
Bonds Are Back: Buy Fixed Income In 2024
The days of zero percent interest rates are long gone. We're in a new era of higher yields. And that means bonds once again provide the type of stability and total return capabilities they're known for.
In 2023, the Bloomberg U.S. Aggregate bond index, which tracks investment grade bonds, returned 5% through Dec. 26.
"The bond market today is as compelling an investment opportunity as any time in the past 20 years," said Jeff Moore and Michael Plage, fixed income portfolio managers at Fidelity Investments.
Bonds, of course, are an important part of a balanced portfolio for three primary reasons: income, diversification and capital preservation.
"All three reasons have arguably improved as the Fed raised rates in their fight against inflation," the Fidelity managers said.
