Where We Were
Following 2022’s broad declines in equity and fixed income markets, 2023 turned out to be an extraordinary surprise. Equities rallied for the first half, then took a breather from July through October. From late October through year end, global equities surged, with the US large cap index knocking at the door of all-time record highs. Fixed income markets struggled for most of the year, a result of uncertain expectations for lingering inflation and possible central bank responses. Primary equity benchmarks rose between 9% and 27% for the year, with outperformance in the United States (again). The S&P 500 index returned 26%. Developed Foreign equities gained 18%, Emerging markets 9%. The tide for fixed income changed markedly during the last week of October and early November, when economic data confirmed deceleration inflation trends, and the Fed became much more consistent and forthright about its outlook for policy rates in 2024. The promise of at least three Fed Funds cuts helped push fixed income indexes higher – such that by year end, the bellwether US Aggregate Bond index had returned just under 6%, which was in line with longer-term aggregate bond expectations and a marked departure from the -15% decline experienced during 2022. All of the primary bond indexes produced positive total returns in 2023, ranging from 3% for long-duration Treasuries, up to 12% for high-yield corporates.
Where We Are
2024 ended up much better than expected at the start of the year. Yet another reminder that trying to time markets based on views of the past rarely, if ever, work out. Also, the prognosticators who lobbied hard for Foreign vs. US equity performance were again disappointed. The S&P 500 Index rose 24.7%, with the S&P 500 Value up 11.9% and the S&P 500 Growth rising by 35.5%. Foreign Developed Equities posted a modest gain of 3.5%, while Foreign Emerging Equities performed better, rising by 6.4%. The Russell 1000 Index increased by 24.1% with the Russell 1000 Value up 14.1% and the Russell 1000 Growth up 32.8. The Mid Cap Index rose 13.5%, while Small Caps gained 11.3%. The Nasdaq 100 gained 25.4%. Gold rose 26.4%.
Sector performance was led by the usual growth suspects. Communication Services rose 34.4%, Financials 30.3%, Consumer Discretionary 26.3%, Technology 21.5%. Other strong showings included Utilities, rising 23.1%, Industrials 17.2% and Consumer Staples 12.1%. Energy, Real Estate and Materials were the weakest for the year, up just 5.5%, 5.0% and 0.1% respectively.
In the bond market, the Aggregate Bond Index rose by 1.3. Intermediate Treasuries and Corporate Bonds increased by 2.9% and 0.9%, respectively. Agency Bonds rose 1.3%. Short Treasuries (2-year) gained 3.9%, and long Treasuries (20+ years) dropped -8.0%. Muni Bonds climbed by 1.3%. High Yield bonds gained 7.9%, Intermediate and short TIPS gained 1.6% and 4.7%, respectively.
Bonds fared much better for the year all the way through Q3, when the US Aggregate was up over 5% for the year mid month. The tone of inflation, as well as the Fed’s response, starting in October was enough to cut the annual performance for investment-grade intermediate back to just over zero, with longer maturities taking most of the damage.
New all-time highs in December. 6090 was the top tick for the year on December 6, and after a consolidation to 5867 the SPX rebounded to end the year at 5950. Support to retest is that same 5867, and at present the index is below its 50-day MA.
Q4 Results Pending. YoY EPS growth in Q4 is expected to be 14%. Earnings season starts to ramp in two weeks, with major banks starting on 1/15.
S&P 500 earnings expectations. For 2024, the current EPS estimate is $238/share, compared to $217 in 2023 (+10%). The 2025 estimate is $273
(+15%). The 2026 estimate is $309 (+13%). P/E ratios for those estimates are 25x, 22x, and 19x. The P/E-to-Growth (PEG) ratios are 2.5, 1.5, and 1.5.
Where We’re Headed
2025 should be an interesting, and perhaps quite volatile, year. You already know from reading our stuff that the annual expected increases in S&P 500 earnings for 2024-2026 is at a level not seen for more than 20 years (+10%, +15%, +13%). This positive, forward-looking consensus expectation has in part led to the price of equities rising significantly over the past two years – and at much higher annual total returns that all of us would have expected when we tried to look forward in 2023. Much of that was due to better overall consumer and economic conditions, which drove the 2024 real GDP estimate from just 0.7% in January to 2.7% at present.
That is an unprecedented improvement given how negative the market zeitgeist was when we started the year.
None of us knows where the value of companies, as reflected in their stock prices, will end up in 2025. What we do know, after many long years practicing in this industry, is that calling a market return based on last year’s performance is foolhardy. In addition, expecting stocks to rise further or sell off in consolidation, simply based on hitting a certain P/E multiple, has never worked. While we may wish otherwise, it just doesn’t work that way.
Why it doesn’t work that way is because actual results deviate from estimates, and expectations are always changing. In addition to the GDP example above, remember the similar “the market is overvalued” talk of 2020-21, when the SPX was trading at a trailing multiple of 22x, and a forward multiple of 31x (!) following more than a 1000 point rally in the index from the COVID low? So what happed to stocks following this “overvalued” condition? Over the next 18 months the S&P 500 rallied by more than 50%, while its trailing P/E dropped from 22x to 15x, and its forward P/E from 31x to 18x. The reason? Actual (trailing) earnings rose from $120/share to $210, while forward 12-month EPS estimates rose from $140 to $235. No one expected increases of those magnitudes while we were knee-deep in global COVID and supply-chain aftershocks. [This valuation data is included in our monthly Econ/Market slide deck, page 22]
So while we wait to see how this all shakes out, it is reasonable to expect month-to-month price variations to continue their volatile ways in this new year. There remains much for investor psyche to absorb, especially the new administration and pending policy changes regarding taxes, immigration, regulation and tariffs. In light of the heightened sense of collective uncertainty, we encourage you to review client objectives and asset allocation mixes, and make desired adjustments between more defensive equities (dividend) and offensive (growth), US vs. foreign, short duration fixed income vs. intermediate or long. For our part, our off-the-shelf strategic, risk-based fund models retain their US vs. Foreign equity overweight, and our investment-grade bond focus around the 5-year duration window with an average yield of 4.2%. The obvious caveat in fixed income is that if interest rate trajectory is to remain higher for longer, laddering/rolling T-bills may continue to be attractive for some portion of clients and portfolios. At present, 90-day T-Bills have the same yield as the 5-year T-Note (yield curve below and on pages 3 & 4 of the slide deck).
So with that said, whither investment policy for portfolios? The following charts are always in our monthly slide deck for your use, but we thought it would be helpful to review a handful of the factors we believe are of greater import:
One of the primary takeaways from the real GDP estimates is that there is no recession expected through at least the end of 2026 – a full two years from now. In nominal terms US economic growth is expected to remain in the 5%-6% range through 2026, depending on where inflation and consumer spending land vs. consensus.
Unemployment rate expectations have come down since the election, mostly due we believe to a robust uptick in small business confidence numbers. That is also the case for 2026. Overall if the US unemployment rate remains in the 4% range it is considered full employment and should be conducive for consumer confidence, personal income and spending, and unfortunately a buoyancy factor for inflation. But as we’ve written many times before, we would rather see stronger economic growth with rates that stay higher than a weak economy with aggressive cuts to Fed Funds.
The US consumer has fared better than, and spent more, than expected all through 2024. As you can see above and a correllary to overall economic growth, household consumption growth was only expected to rise 1.1% for the year, according to the January 2024 consensus. At year end, that estimate is for annual growth of 2.7%.
Inflation has indeed come down off of untenable highs, but remain higher than desired and have actually ticked up over the last several months – though just slightly. Remember that CPI calculations reflect year-over-year changes, so price levels are not going to revert backward in a lower inflation environment. We’re regularly surprised by the lack of understanding in this regard in the general populace. Somehow there is a want of knowledge that low inflation only means prices are rising slower, rather than falling.
Stocks and bonds alike have reacted sharply to changing inflation and Fed Funds expectations. The chart above tells the story of the bond market last year in particular, especially the negative sentiment change in Q4 after inflation went sideways in the low 3s instead of continuing its journey south toward 2s. Also you will notice the November uptick in Fed Funds expectations for 2025, 2026 and 2027, though minor, portending a terminal Fed Funds rate of over 3% for this cycle, at least through 2027, and in 2025 the prospect of perhaps two cuts and a year-end rate of around 3.75%.
This is the chart above all charts when it comes to equity market activity over the long haul. It is the Peter Lynch-esque portender that never goes out of style. As a reminder, it charts the price of the S&P 500 index (green) since 2000, as well as the next twelve month (NTM) EPS earnings for the index constituents (blue) over the same time frame. The NTM estimate is a rolling number, that in each period reflects the sentiment of analysts and their assessment of what the future might bring. It is easy to see the correlation between the two lines, and as our discussion about earnings and valuation levels above indicated, the change in forward earnings expectations is perhaps the most important data point to consider when trying to gauge the prospects for equity trends.
Pro tip: if one were to draw vertical lines through the blue and green when price trend changes were the greatest, one would observe that analyst estimates always seem to lag prices, by an average of 3-6 months. Somehow markets are extremely good discounters of coming fundamental activity. HOWEVER, this relationship is much more meaningful and reliable when looking at long-term time frames, especially with monthly data points. It is nigh on impossible to infer short-term opportunities or risks based on day-to-day, or even week-to-week sentiment changes.
Note that at present, the NTM estimate continues its path up and to the right, as also reflected in annual estimates previously mentioned.
Much has been said by capital market assumption purveyors over the past few years about the “relative value” of foreign companies vs. those domiciled here in the United States, and possible outperformance. In 2024, as in recent years past, the total returns at year end did not seem to concur with those sentiments.
Keen observers of foreign economic and market information will have seen the challenges to a change in regional market leadership. Whether it is China’s lagging growth, changing “lowest cost” manufacturing regions, western Europe’s hamstringing of energy from Russia through Ukraine, or other, the US – for all its faults – remains the most stable, transparent and liquid major market in the world. When troubles and worries rise, the United States is a port in the storm.
Also remember that over 40% of the revenue of S&P 500 companies is derived from foreign markets. The companies we all know and like in our portfolios are expanding into foreign markets, both developed and emerging, as fast as possible, providing incremental diversification for us. What that means from a portfolio standpoint is that country and regional concentration risks are somewhat mitigated behind the curtain, even if the Morningstar style box says otherwise.
We included this new chart in our monthly side deck (page 23), and it is a good one to refer to when considering and discussing regional portfolio weights. What you can see above is the difference between actual and expected annual EPS growth of companies within respective regional benchmarks. You will immediately notice that although the P/E of EAFE companies may be lower at 15x (not shown above), the expected earnings growth is only 7% this year, compared to 15% for the S&P 500 and 16% for the Russell 3000, the difference being slightly higher growth expected for SMID.
Expected earnings growth is much better for Emerging Market companies vs. EAFE (developed market index). This is typical and despite the higher volatility, another reason in our risk-based fund models we overweight EM vs. DM compared to the ACWI index. This double-threat of overweighting the US as well as overweighting DM in our foreign allocations (at least for now) is a primary reason for the exceptional model outperformance vs. benchmarks over the past five years. At present, we do not see a compelling fundamental reason to change this course.
We hope you will have another successful year in 2025. Thank you for your continued patronage and support.
Mark
Sources: Morningstar, Factset. Performance data represents past performance and is no guarantee of future results. This material has been compiled from sources deemed reliable; it is not guaranteed as to its accuracy and does not purport to be complete. All information contained herein is subject to change without notice. The information is not intended to be used as the basis of investment decisions. Intended for adviser use only.