2023 is in the books. After a dreadful 2022, the stock market rebounded. The S&P 500 finished 2023 near its record high set about two years ago.

The inflation rate slowed from 2022’s multi-decade high, and recession didn’t materialize during the year—though it’s still possible for 2024. Importantly, the Fed seems to signal that it’s done with rate hikes and expect to reduce its benchmark short-term rate this year.

Lower interest rates not only make stocks more attractive compared to alternatives like fixed income, but the looser credit also increase economic activity and, all things equal, improve business conditions, which also increase the perceived value of the shares in these companies (i.e., stocks).

A Top-Heavy Rally

As good as the market’s 2023 return was, however, it’s important to keep in mind that a handful of stocks, referred to as the Magnificent 7, accounted for the majority of the S&P 500’s gain during the year, particularly helped by excitement over the ongoing advances in artificial intelligence (AI). Thus, the 2023 rally wasn’t exactly broad based. Ideally, we’d like to see strong gains distributed across the board rather than concentrated in a small number of stocks. The first scenario is a far surer indication of a healthy market.

Of course, this doesn’t automatically mean that the market is heading for a fall, but it does mean that the underlying economy isn’t as robust as the stock market rally might suggest, and investors need to be selective about what they invest in.

The 7 stocks are: Apple (NSDQ: AAPL), Microsoft (NSDQ: MSFT), Alphabet (NSDQ: GOOG and GOOGL), Amazon (NSDQ: AMZN), NVIDIA (NSDQ: NVDA), Tesla (NSDQ: TSLA), and Meta Platforms (NSDQ: META).

The common thread that they share is that they are all innovative tech companies. They are also the largest seven components of the S&P. They are reminiscent of the FAANG stocks that led the market’s rally several years ago. In fact, with the exception of Netflix (NSDQ: NFLX), the former FAANG stocks are all represented in the Magnificent 7. (The former Google and Facebook have been rebranded and are now knowns as Alphabet and Meta Platforms, respectively.)

With the Fed expected to lower rates in 2024, the outlook for the stock market is positive. However, that depends on keeping inflation in check. The Street currently expects inflation to slow further this year, but 2022 proved how quickly things can go wrong. Since the economy is expected to only grow at a sub-1% pace this year, if inflation accelerates again and forces the Fed to consider raising rates again, the market would likely suffer a correction.

Rotating Leaders and Laggards

Don’t forget the 2023 laggards. While investors caught fervor in tech stocks, particularly in those of companies believed to have strong positioning in AI, value stocks and small-cap stocks, two groups of stocks that historically outperform over the long term, were laggards last year, but once investor appetite in the highfliers begin to moderate and they seek other opportunities, the undervalued groups have a good chance to catch up.

Remember, the market is dynamic. The market leaders and market laggards are always changing as investors continually seek the stocks that they think will provide the best return.

Despite week-to-week, month-to-month, and year-to-year fluctuations, however, over time, quality usually wins out. The companies that have the most sustainable business model and the best management that’s able to constantly adapt and innovate will tend to rise to the top over time.

This is why it makes sense to separate one’s investment portfolio into two parts. One part will be invested in long-term core holdings, blue-chip companies that are likely to keep growing over time. The other part can be invested in more aggressive bets that have better chances of delivering large returns over a shorter period of time.

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