2024 Q1 Market Commentary: All-Time Highs

Investment markets started the year much the same way they ended 2023. US Large-Cap Stocks led the way again with a 10.6% return in the quarter, with developed market international stocks and US Small-Cap stocks not far behind at 5.8% and 5.2%, respectively. Those three asset classes posted the strongest returns in 2023 as well. Growth stocks continued to outperform Value stocks, though the margin narrowed from last year. Volatility remained quite low in the markets, with the Volatility Index (VIX) at the lowest level since 2017. The S&P 500 made 22 all-time highs in the first quarter after not making any new all-time highs in 2023.

When markets start hitting all-time highs, many investors worry that they should get out of the market or stop putting money into stocks. While now might be a good time to rebalance your portfolio if your stock allocation has grown to a level above your target, all-time highs in the market have historically not been a time to dump stocks. In fact, JP Morgan found that investing in the market when it’s at an all-time high beats investing in the market on any other day. As you can see from the chart below, investing in the market at new all-time highs has consistently generated higher returns than investing in the market on other days! It’s a counterintuitive result but again proves that time in the market is more important than timing the market.

Of course, past performance is never a guarantee of future results, and there’s no way to know where stocks will go from here. This is why having a diversified portfolio with exposure to asset classes other than US Large-Cap stocks is important. While international stocks have done well recently, they continue to underperform US stocks, making them look much more attractive from a valuation perspective than US stocks. This chart from JP Morgan shows the price-to-earnings discount on international stocks compared to US stocks. 

There are many reasons why international stocks are cheaper than US stocks, and these lower valuations may persist into the future. However, we have seen similar underperformance in the past, and as we have written before, there are usually cycles to the outperformance in US vs International stocks.

International stocks are not the only place to add diversification to your portfolio. Bonds have struggled since the Federal Reserve began raising rates in early 2022, but they did finish 2023 with positive returns. This year started weaker in the fixed income markets, with the Barclays Bloomberg Aggregate bond index down 0.8% and international bonds down 3.9%. The fixed income markets ended last year anticipating rate cuts by the middle of 2024, but persistent inflation worries have pushed back expectations for that first rate cut. This caused interest rates to creep higher in the quarter. Higher rates also helped lead to a slight pullback in real estate as the REIT index dropped by half a percent after advancing 10.5% last year.

The moderately higher inflation reports negatively impacted bond and REIT performance, but they helped lead commodities to a strong 10.4% return in the quarter. Gold prices also hit new all-time highs with an 8.1% return in the quarter.  

While it’s important to keep an eye on market performance and to rebalance your portfolio when appropriate, we know the performance of the market is out of our control. However, there are things that you can do to improve long-term returns that are within our control, and minimizing taxes is at the top of that list. We just wrapped up another tax filing season, and we have a few observations from working through many tax returns that are relevant to everyone’s portfolio:

1. Money Market Funds – With the rise in interest rates in recent years, money market funds are paying much more interest. If you have cash in a checking or savings account that is not earning much money, you should consider a high-yield savings account or a money market fund, most of which are paying over 5% right now. If you use a money market fund, there are different options to consider, and your tax rate and state residency will come into play. There are money market funds that are federally tax-exempt (like most municipal money market funds), state tax-exempt (like most US Treasury money market funds), federal and state tax-exempt (like the TRP Maryland Tax-Free Money Fund for Maryland residents), or not tax-exempt at all. It’s important to weigh the tax benefits of each fund and compare the before and after-tax yield based on your situation.
2. State Taxes – Most states do not tax US Government Bond interest, which could make those bonds more attractive than corporate bonds with similar yields. Many bond mutual funds own US Government bonds, so they will disclose the percentage of the income that might be tax-exempt at the state level. On the flip side, municipal bond interest is not taxed at the Federal level, but if the interest is not from a bond issued by your state of residence, it is taxable in your state. Again, municipal bond funds generally disclose how much interest was earned from each state, so you know how much is exempt for you. It’s essential to understand how your bond interest is being taxed.
3. Asset Location – The rise in interest rates has made asset location more critical again. When bonds were yielding 1 or 2%, the tax impact of having them in a taxable account compared to having them in a tax-deferred account was minimal. However, as that yield rises, the tax benefit of shifting bonds to your tax-deferred account also rises. Holding more of your stock portfolio in taxable accounts where you can take advantage of the preferential tax rates on qualified dividends and long-term gains is also important. Chris was recently quoted in this Forbes article highlighting the benefits of asset location.
4. Capital Gain Distributions – Mutual funds continue to have a severe disadvantage compared to ETFs regarding taxes. Two T. Rowe Price funds provide a prime example of minimizing taxes by shifting to ETFs where you can. In 2020, T Rowe Price introduced some of its mutual fund strategies in ETF format. Last year, their Equity Income mutual fund (PRFDX) and ETF (TEQI) both had an identical return of 9.65%. The mutual fund paid $1.38 per share in capital gain distributions at the end of the year, but the ETF had no distribution. That means you were forced to pay long-term capital gains tax just for holding the mutual fund, while you could have had the same return in the ETF and deferred the tax on any gains until you sold. While many investors are stuck in mutual fund positions with significant unrealized gains, depending on the size of the gain, it might still be beneficial over the long term to take those gains and reinvest the funds into an ETF.

This is a very short list of how taxes impact your investment portfolio. While you never want to “let the tax tail wag the dog,” minimizing taxes is a fundamental way to improve your financial situation over the long term. Feel free to reach out if you’d like to discuss the tax efficiency of your portfolio.

-Chris Benson, CPA, PFS

The views expressed represent the opinions of L.K. Benson & Company and are subject to change. These views are not intended as a forecast, a guarantee of future results, investment recommendation, or an offer to buy or sell any securities. The information provided is of a general nature and should not be construed as investment advice or to provide any investment, tax, financial or legal advice or service to any person. Please see Additional Disclosures more information.