Investors may have a few reasons for optimism about the year ahead.
With inflation down dramatically over the past year, the Federal Reserve has put rate hikes on hold and signaled that cuts could be ahead this year. Investors have cheered these developments by pushing major stock indexes to within striking distance of new all-time highs.
But there’s positive news beyond the world of interest rates too. In particular, I believe that corporate earnings could be poised to accelerate in 2024—after contracting last year—thanks to a combination of rising worker productivity, improving lending conditions, and growing profit margins as input costs ease.
I analyze patterns in market history to inform my outlook on the markets, individual sectors, and investment factors. While past performance is never a guarantee of future results, history can help us understand what investments may be more or less likely to lead or lag in the current environment. Looking at historical periods when interest rates fell and earnings accelerated is leading me to favor a few asset classes for the year ahead: stocks over bonds, real estate and cyclical sectors, and small-cap stocks.
1. Why stocks could beat bonds
With interest rates high, some investors might assume that bonds are a better bet than stocks. But counterintuitively, bonds have actually trailed stocks in similar historical periods.
I analyzed historical stock and bond returns during the 12 months before and after the first rate cut of a cycle, going back to the 1950s. During the 12 months prior to the first Fed cut, which asset class outperformed depended on the economy: In a recession, bonds beat stocks, but in absence of a recession, stocks beat bonds.
But looking at periods after the first rate cut, stocks beat bonds on average across both recessionary and nonrecessionary scenarios. If earnings accelerate, as I believe they will, a recession would be highly unlikely. This would imply an advantage for stocks both before and after the Fed’s first cut.
Stocks have historically beaten bonds after the Fed starts rate cuts
|12 months before first rate cut
|Bonds outperformed by 10 percentage points on average
|Stocks outperformed by 1 percentage point
|12 months after first rate cut
|Stocks outperformed by 4.7 percentage points
|Stocks outperformed by 6.9 percentage points
Bond values could still advance in the year ahead. But I think stocks represent the greater opportunity.
2. Bullish signals for cyclical sectors—particularly real estate
2024 is also likely to bring leaders and laggards among various sectors. History suggests that cyclical sectors—and real estate in particular—could outperform.
I reviewed historical periods with falling interest rates and accelerating earnings growth relative to periods with rising interest rates and contracting earnings. The real estate sector has historically been the clear winner: Its odds of beating the market were 37% higher in falling-rate, rising-earnings scenarios than in rising-rate, falling-earnings environments.
Real estate may also have some fundamental tailwinds behind it. The sector’s fundamentals have been poor in recent years, exemplified by return on equity (ROE) near the bottom of the sector’s historical range. Although poor ROE may sound like bad news, it has actually been a contrarian bullish signal in the past: Real estate has historically outperformed the market by 4.6 percentage points over the next year, following periods since 1977 when its ROE reached the bottom quartile of its historical range. One possible explanation for this surprising pattern is that by the time ROE falls to this level, poor fundamentals tend to be priced into the stocks and the worst may be over.
Another mark in real estate’s favor is high valuation spreads—meaning the gap between the valuations of the most- and least-expensive real estate stocks is unusually high. High valuation spreads often indicate that the market has priced in a lot of bad news, leaving room for any improvements to drive prices higher. Historically, higher valuation spreads in real estate have corresponded with stronger returns for the sector over the following 12 months.
Other cyclical sectors have also benefited disproportionately in scenarios with falling rates and rising earnings—compared with their performance amid rising rates and falling earnings. After real estate, the sector that historically benefited the most from that pivot has been consumer discretionary, followed by technology, materials, financials, and industrials.
Defensive stocks, including the utilities, consumer staples, and health care sectors, have tended to trail.
One sector that I believe could have a weak setup in the year ahead is energy. Historically, energy has had low odds of outperforming when earnings growth accelerates and the Fed cuts interest rates. What’s more, the sector’s fundamentals appear to be headed in the wrong direction. Although free cash flow (meaning the cash a company generates over a certain period, after accounting for expenditures it makes to keep its business running) remains high, it has been deteriorating, which has been a negative sign for the sector in the past.
3. Small caps could have an edge
Small-cap stocks have lagged large caps by a wide margin in recent years. While the S&P 500® has been nearing new all-time highs, the Russell 2000 small-cap index was recently more than 20% below the all-time high it struck in November 2021. Those divergent trajectories have led to a big gap in valuations, such as in price-to-book value, which compares stock price to book value per share (assets minus liabilities, divided by the number of shares outstanding). As of late 2023, small caps’ price-to-book value relative to large caps’ was in the bottom 10% of its historical range since 1990.
But 2024 could bring a change in the economic environment that helps small caps finally take the lead. Small caps have historically benefited more than large caps from the first rate cut of a cycle—and their advantage has been even greater when earnings also improved. Another positive signal is that valuation spreads among small caps are wide—even wider than they are in real estate. The gap between the average price-to-book value of the Russell 2000’s most- and least-expensive quartiles was recently in the top 10% of its historical range since 1990. When valuation spreads have been this wide in the past, the Russell 2000 has historically produced average returns of 38% over the next 12 months.
Conditions in the economy and the markets seem to be setting the stage for a potentially constructive year in the stock market. While market history can’t predict the future, my analysis suggests reasons for bullishness on stocks, small caps, real estate in particular, and cyclical sectors more generally.
Investors interested in finding mutual funds or exchange-traded funds (ETFs) that provide exposure to any of the asset classes and themes mentioned above can screen for investment ideas using the Fidelity mutual fund screener and Fidelity ETF screener.
Denise Chisholm is director of quantitative market strategy in the Quantitative Research and Investments (QRI) division at Fidelity Investments. Fidelity Investments is a leading provider of investment management, retirement planning, portfolio guidance, brokerage, benefits outsourcing, and other financial products and services to institutions, financial intermediaries, and individuals.
In this role, Ms. Chisholm is focused on historical analysis, its application in diversified portfolio strategies, and ways to combine investment building blocks, such as factors, sectors, and themes. In addition to her research responsibilities, Ms. Chisholm is a popular contributor at various Fidelity client forums, is a LinkedIn 2020 Top Voice, and frequently appears in the media.
Prior to assuming her current position, Ms. Chisholm was a sector strategist focused on sector strategy research, its application in diversified portfolio strategies, and ways to combine sector-based investment vehicles. Ms. Chisholm also held multiple roles within Fidelity, including research analyst on the mega cap research team, research analyst on the international team, and sector specialist.
Previously, Ms. Chisholm performed dual roles as an equity research analyst and director of Independent Research at Ameriprise Financial. In this capacity, she focused on the integration of differentiated research platforms and methodologies. Before joining Fidelity in 1999, Ms. Chisholm served as a cost-of-living consultant for ARINC and as a Department of Defense statistical consultant at MCR Federal. She has been in the financial industry since 1999.
Ms. Chisholm earned her bachelor of arts degree in economics from Boston University.