Where do we go from here…
It would be understandable if you thought the market has already experienced a correction here in the first two months of 2025. It was just last week however that the market touched all-time highs, but over the last week the Standard & Poor’s 500 Index has traded down by about 4.2% with many popular stocks (Tesla, Palantir & Nvidia to name a few) down multiples of that amount. Concerns about a slowing US economy based on softening recent data and a torrent of policy announcements have contributed to the weight on the tape. It may turn out that this was the start of something more substantial or a healthy flush out of the excess enthusiasm ushered in after November’s election. Time will tell.
Let’s take a short walk down memory lane to frame where we stand presently. After a brutal 2022 that saw double digit declines for both stocks and bonds, keep in mind only two other times in history have we seen simultaneous negative calendar year returns for both stocks and bonds (1939 & 1961), the combination of cooling inflation and more attractive valuations for both asset classes kicked off strong rally in the 4th quarter that year. Aside from a correction that started in the summer of 2023 that wrapped up around Halloween, the market has been on a tear, with only a few pockets of volatility flaring up along the way. Market concentration has been a factor with a significant source of the overall returns coming from a handful of stocks, though it is safe to say that the rising tide lifted most ships in that time. Heading into 2025, following back-to-back 20% return years, valuations hovered at 22 times forward earnings, more than 20% above their 30-year average and nearly 38% pricier than the p/e ratio over the last 95 years. A return to earnings growth was a welcome driver of higher stock prices, though truthfully much of the increase in the 2+ years since the bear market trough has come from multiple expansion. What makes that particularly interesting is that this is in spite of higher interest rates, where there attractive sources of alternative return would typically be a net negative for equities.
Let’s be clear, higher valuations do not necessarily need to reset back to historical levels though that’s entirely possible. It is reasonable, however, to assume richer prices will impact future returns and leave little margin for disappointment when it comes to the data, whether we are speaking about the macroeconomic backdrop or idiosyncratic factors impacting individual companies. All this is meant to suggest the merits of diversification, which can and should be used as a tool to both possibly augment returns or reduce portfolio volatility. The early indications here in 2025 are illustrating those benefits. The MSCI EAFE index, the S&P equivalent for the developed markets outside the US, is up nearly 8%, perhaps finally looking to close a wide performance chasm that occurred over the last 15+ years. Similarly, bonds have offered a port in the storm, as the Bloomberg US Aggregate Bond Index is up about 2.50% year to date.
More on the topic of bonds… As we spend the early part of the year commiserating about the news of premium hikes for our health, auto or homeowners’ policies it is not uncommon for us to question the value of those policies, especially when year after year we go without filing a claim. Insurance has been resigned to being a necessary cost to avoid a financial catastrophe in the face of some adverse event, but I am not sure it is appropriate to share the same perspective about portfolio insurance. There are a variety of ways to protect one’s portfolio from raising cash, to using structured products or derivatives, but as the saying goes the only free lunch in investing is achieved through diversification. 60+ days into 2025 spreading out your bets is paying off with the vaunted Magnificent 7 down about 8% while many other areas are positive if not materially positive in that time. Sure, we have seen a number of head fakes over the last 4-5 years where the luster was seeming to wear off only to see these hyper-scalers find their footing and catch investor’s fancy, but all good things must come to an end eventually. Whether or not that’s 2025 or at some point in the future, we’ll need to wait and see, but do not expect me to keep wagering on a handful of expensive stocks alone. The capital markets are vast and deep, odds are when we reflect back in 5-10 years the top performing assets likely will surprise us. With a 5-year annualized return of -.62% for the Bloomberg US Agg, it is understandable why investors may be disinterested in this asset class. Stocks on the other hand, as measured by the S&P 500, have averaged 15.15% over the same period, that’s a nearly 80% difference and if history was to consistently repeat itself it would be fair to ask yourself what’s the point in owning bonds. However much like car insurance or homeowners’ insurance they are there to provide some real value (protection) should something calamitous happen to the stock market. What’s unique here is that typically insurance, comes at a cost, in the form of a premium, but with bonds you actually get paid (interest) while you are holding them and the real downside is opportunity cost or foregone returns, which seems a lot better than a premium payment for a claim never filed or a 20% bear market for that matter.
Back to the present, in the aftermath of the 2024 election, markets reflected an optimistic tone regarding President Trump’s return to the oval office. The thinking mainly focused on a pro-growth agenda where regulatory relief and further tax reform would support asset prices. While questions remained about the impact of tariffs and immigration policies, the administration was given the benefit of the doubt that any approach would be measured and hopefully well telegraphed. Now roughly 40 days into his second term, the President has issued innumerable executive orders, some of which will be challenged in court while the impact of others still needs to be flushed out and the rhetoric on tariffs has been far more bombastic when it comes to historic allies and perhaps less onerous on China where much of the political capital and energy was spent in 2017-2018. On balance, tariffs are a net negative as the costs are born by the importing country, possibly contributing to inflation at a time when there is little appetite for higher prices. A country that historically espoused the merits of free trade would be best served to limit tit for tat trade policy and instead source goods from nations that have been more aligned with our interests. In the end I am hopeful this ends up being about negotiating leverage rather than the start of something more painful for consumers and workers who likely would feel the second order effect of waning demand or strained budgets. While perhaps well intentioned, the fact is other countries may very well have ample capacity to ride out any policies that they find detrimental to their own economies.
DOGE and the microscope on spending. Over 60 years ago, Lyndon Johnson who campaigned on the notion of the Great Society introduced legislation that created Medicare and Medicaid, the formation of the U.S. Department of Housing and Urban Development and Head Start among others embarking on a journey that would see the government’s role in society expand exponentially. These programs added to the social safety net that was initially created in the aftermath of the Great Depression where Social Security and the Supplemental Nutrition Assistance Program (SNAP) were born. In general, these programs have grown far faster than the rate of inflation, in some instances crowding out the private sector and creating ample opportunities for mismanagement, whether intentional or otherwise. To their credit, both Ronald Reagan and Bill Clinton instituted policy priorities to right size these programs, but other administrations have been willing to grow entitlements with little consideration to demographic dynamics, incentives or the capacity to cover these costs which eat up more and more taxpayer dollars with less and less accountability. The United States with a budget of $7TT, of which $2.8TT is attributed to deficit spending, finds itself with 60%+ dedicated to mandatory spending which is comprised of interest on our debts, some veterans benefits and the aforementioned Medicare and Medicaid programs along with Social Security. Discretionary spending, which makes up the difference, is where you’ll find defense spending as well as outlays for education, transportation, science, foreign aid etc.… We can all agree that any opportunity to eliminate waste or fraud or for programs that have limited benefit to our interests abroad should be heavily scrutinized and eliminated. Assuming a more measured approach around enacting reform should be welcomed and will likely have a positive impact on the economy and the markets in the years ahead. The public seems comfortable with the idea of reviewing expenditures, but the “move fast and break things” approach has been unsettling as witnessed by recent poor readings on consumer sentiment from both the Conference Board and University of Michigan monthly read outs.
The irony of the “tough on everyone” approach, including our allies, may result in invigorating economic regions that have been prone to bouts of sclerosis. The Europeans seem particularly rallied around the idea that the United States sense of elitism is misguided which could foster some healthy competition though it could foment some ill will towards Americans and their corporations. The combination of less demanding valuations, more space for fiscal and monetary stimulus along with something resembling animal spirits would go a long way towards creating synchronized global growth which we have seen on a few occasions in the last several decades. Assuming you see something of a détente with China later this year so long as they allow for some modest currency appreciation and fiscal stimulus it could be off to the races for foreign stocks.
Lastly, on the topic of interest rates, the real cost of money after all, the next few months will be rather interesting to watch unfold. March offers the February Nonfarm Payroll Report and a Fed meeting with the updated Summary of Economic Projections (SEP) where the possibility exists that they may shift from a slightly more hawkish posture to a more balanced tone, hinting at 3 rate cuts for this year, which would be well received. We are still likely 6-7 rate cuts or 1.375% away from neutral, but far less restrictive than we were just 6 months ago. If rates do head back down in an orderly fashion, it’s hard to envision a scenario where that’s not modestly bullish for risk assets. Away from short-term rates, which are really driven by Central Banks, Treasury Secretary Scott Bessent has been talking about the efforts to bring the 10-year Treasury yield lower. The rate has dropped about .50% since the start of the year though perhaps the fact that it’s been a somewhat rapid decline has served to spook the market somewhat as after all the bond market has been considered the smart money versus the stock market but we won’t get into that today. Since the 10-year rate has more influence on long-term borrowing costs, including mortgage rates, it was welcome to hear that there is extra attention there, though government policy is only one component of the pricing behind that security. If rates remain rangebound this year somewhere between 4-4.50% it bodes well for the economy and markets, rates falling too sharply would likely be the result of a risk of trade perhaps related to an exogenous shock and rates going too high (5%+) would start to put more pressure on equities and high yield bonds.
To come full circle, there is a lot going on and perhaps a bit more uncertainty than would be the case with a newly elected administration that controls both chambers of Congress. Until there is further policy clarity and businesses are able to show their ability to grow earnings and improve margins, we would be well served to prepare for more volatility than we experienced in the last couple of years. Over the last 25 years the average intra-year decline for the stock market has been 15.4% so while we will not ask you to enjoy something like that we should be prepared for the possibility. Diversification seems like as good of a tool as any to provide you with a little insurance if there are a few more bumps along the way.
Sources: WSJ, Barron’s, AMG, FRED
