9 minute read
It was a banner year for U.S. Stocks and the economy in 2024. With economic growth rising at a stronger-than-expected rate, U.S. stocks notched 57 all-time highs in 2024 – the sixth most since 1928. The S&P 500 also recorded consecutive annual gains of over 20% for the first time since the late 1990s, and for only the fifth time on record. There were many reasons to worry in 2024 – some of the largest concerns included geopolitical tensions, elevated valuations, stubborn inflation, interest rate uncertainty, slowing growth in foreign economies, and of the U.S. presidential election. Despite those worries, the economy remained resilient thanks to strong consumer spending, lower inflation, and healthy corporate earnings, and the stock market reacted favorably hitting new highs.
For the year, domestic stocks delivered strong returns with meaningful disparity across the market. Large-cap stocks (S&P 500 Index) posted a gain of 25%, widely outperforming small-cap stocks (Russell 2000 Index), which rose 11.5%. Growth oriented stocks (Russell 1000 Growth Index) led by technology names, were the biggest winners, posting a 33.4% gain. Value-oriented stocks (Russell 1000 Value Index) were up 14.4% in comparison. The equally-weighted S&P 500 Index, where each of the 500 companies accounts for the same percentage of the total index, returned 13%. The equally-weighted Index failed to capture the outsized gains made by the largest and fastest growing firms in the index.
Overseas, returns were not nearly as strong. Developed international stocks (MSCI EAFE) posted a modest 3.8% gain. Calendar-year returns for most foreign markets were dragged down by fourth quarter losses following the Trump presidential victory, which sparked fears of a widespread economic slowdown due to tariff risks and a stronger U.S. dollar. Emerging markets stocks (MSCI EM Index) had a volatile year, finishing the year up 7.5%. Much of that volatility can be attributed to China. The Chinese stock market (MSCI China Index) had a strong year up 19.4%, but it was tumultuous, marked by significant swings in investor sentiment. Early-year optimism over government stimulus efforts and reopening momentum faded as economic growth fell short of expectations. Then, later in the year, the Chinese government jolted the stock market sharply higher with a stimulus package aimed at supporting real estate prices and weakening consumer confidence.
Within the bond markets, calendar-year returns were mixed across fixed-income segments. The benchmark 10-year Treasury yield experienced significant volatility throughout the year amid concerns around inflation, interest rates, the budget deficit, and the impact of potential tariffs under Trump. After starting the year with a yield of 3.88%, the 10-year Treasury finished the year higher at 4.58%. Against this backdrop, the interest-rate-sensitive Bloomberg U.S. Aggregate Bond Index was slightly positive at 1.3%. Conversely, short-term and credit-sensitive sectors on the bond market – both areas we emphasized in portfolios – performed well during the year. The Bloomberg Short-Term Treasury rose 5.3%, and high yield bonds (ICE BofA Merrill Lynch High Yield Index) were up 8.2% in the year.
Overall, domestic economic and corporate fundamentals remained healthy in the quarter, although stretched valuations remain a risk. Looking ahead, the expectation is that the Fed will continue to cut rates this year next in an effort to guide the economy to a soft landing and avoid a recession.
Investment Outlook and Positioning
Looking ahead to 2025, our base case is that the U.S. economy will continue to grow, albeit slower, with a low probability of a recession. This should be a supportive backdrop for both bonds and stocks, although we expect the pace of gains to slow. We continue to think it’s likely that market will broaden out beyond large-cap growth stocks to include small- and mid-caps and not tech sectors of the market. At the same time, we anticipate volatility caused by central bank policies, slowing global growth, geopolitical tensions, and elevated stock market valuations.
As of year-end, our portfolios have a slight overweight to U.S. stocks and we remain diversified across geographies, including the U.S., developed international, and an underweight to emerging markets. Within our global equity allocation, we remain overweight to U.S. large cap equities. In fixed income, we continue to increase duration in core bonds, while emphasizing exposure to short term floating rate credit-oriented instruments which generate very attractive yields. We are not “stretching” for yield – taking on excessive risk to achieve attractive returns. Many of our exposures are investment-grade or are conservatively positioned within the high-yield space.
U.S. Stocks
The S&P 500 marched higher throughout 2024 ending the year up 25%. Once again, the performance of large-cap growth/technology stocks led the way. The Magnificent 7 stocks, generated returns of nearly 70%, while the remaining 493 stocks clocked in with a 16% return, well behind the Magnificent 7.
The strong performance of large-cap growth stocks in recent years has resulted in one of the most concentrated stock markets on record. There are now eight companies in the S&P 500 valued at greater than a trillion dollars, and the weight of the top-10 stocks in the S&P 500 index has reached an all time high of 39% (see chart). While this narrow market leadership could persist for some time, the generals cannot lead the market higher into perpetuity. The infantry must join the battle for a healthy bull market to continue. Otherwise, failure of a few companies to meet optimistic expectations will drag down the S&P 500.
Looking ahead to 2025, we think the economic backdrop is still favorable for stocks and we believe the market rally can broaden outside of large-cap tech. The U.S. economy continues to grow, albeit more slowly, inflation, back to normal levels, profit growth is expected to broaden, there are growth-oriented themes (AI) that could continue to drive investment and productivity, while Trump’s business-friendly policies could further support growth.
If the economy continues to grow, we think a broadening out of the market beyond the largest-cap stocks could benefit mid- and small-caps. The composition of the mid- and small-cap indexes has higher exposure to domestically focused sectors than the S&P 500. Being more domestically oriented, mid- and small-caps are less exposed to geopolitical risks and currency fluctuations that can affect large multinational corporations. This could make mid- and small-cap stocks relatively attractive in periods of heightened global uncertainty during a Trump administration that is more focused on the domestic economy.
While our economic outlook is generally positive, there are plenty of risks. For starters, equity valuations are historically expensive and reflect a significant amount of investor optimism. Current valuations levels – particularly for larger-cap growth stocks – suggest that there is less room of upside and there is more downside risk if expectations are not met. The high level of concentration in the S&P 500 top weighted stocks could magnify volatility if any of these companies disappoint. In addition, there is the list of usual risks to the equity market including macroeconomic developments, inflation, central bank policies, and the risk that some of the anticipated Trump policy tailwinds don’t pan out and turn to headwinds.
Foreign Equities
While the U.S. Economy has remained strong, economic growth elsewhere in the world has been relatively weak. The European economy was much more impacted by the recent rate hikes than in the U.S. – likely due to massive U.S. Fiscal programs and the boom in domestic AI-related investments. A stronger U.S. dollar was another headwind for foreign equity returns, which moved even higher after the U.S. election. Better prospects in the U.S. resulted in another year of significant outperformance. Developed international stocks (MSCI EAFE) returned 3.8% in dollar terms, and 11.3% in local currency terms. U.S. outperformance continued last year due in large part to higher earnings growth relative to European companies. This has been the case for the past 15 years – the U.S. has enjoyed higher economic and earnings growth. This has not gone unnoticed by investors as the market is now paying 22X for U.S. earnings growth compared to just over 13X for European earnings. The P/E multiple discount is at a historically wide differential.
In fairness, European equities have performed decently since the bull market started in October 2022. The main reason for the underperformance relative to U.S. stocks is the lack of mega-cap technology companies. Analysis shows that since mid-October 2022, the S&P 500 is up 22.6% annualized, easily outpacing the MSCI Europe’s return of 16.1%. However, when removing the large eight tech leaders from the S&P 500, the index has returned 13.8% annualized. This does highlight the significant impact these technology stocks have had in recent years. We are neutrally positioned on developed international markets and underweight on emerging markets.
The Federal Reserve and Fixed Income Market
With economic growth rising at a stronger-than-expected rate for this point in the cycle and inflation holding above the 2% target, the Fed appears more cautious about the need for future rate cuts. As a result, this has led to a very volatile year for the 10-year U.S. Treasury bond.
In the first three months of the year, inflation pressures proved persistent, prompting the Fed to keep interest rates elevated. This led to higher interest rates (lower prices) across bond maturities. But as the year progressed, inflation began to trend lower, and the Fed delivered its first rate cut in September. The September cut was significant for two reasons: it was the first cut in over four years, and it was a more aggressive 50 basis points reduction compared to the typical 25 basis point cut. This was followed by a 25 basis point reduction in November, and 25 basis point cut in mid-December, the final Fed meeting of the year.
Although the December cut was expected, the Fed added a bit of a twist, and the market did not like the news. Specifically, the Fed showed a renewed concern over slowing disinflation momentum. The Fed’s median inflation estimates, as measured by core Personal Consumption Expenditures (PCE), for 2025 and 2026 increased from 2.2% to 2.5% and 2.0% to 2.2%, respectively. The following day, stocks fell sharply, and long-term bond yields increase. In fact, since the Fed started cutting rates in mid-September 10-year treasury yield rates have increased by roughly 100 basis points, and the yield curve has finally uninverted after slightly more than two years.
Going forward, the Fed says it remains strongly committed to its dual mandate of supporting maximum employment and returning inflation to its 2% objective. Powell says that in assessing the appropriate stance of monetary policy, the Fed will continue to monitor incoming information and the implications on the economic outlook. The Fed is prepared to adjust its monetary policy if risks emerge that could prevent them from meeting their goals.
Looking ahead to 2025, while spreads are tight, the absolute yield on both investment grade and high yield bonds are attractive when compared to a few years ago. Investment grade bonds are currently yielding over 5% and high yield bonds are yielding close to 7%. We favor core bonds, high quality credit issues, floating rate bonds and long-term municipal bonds.
Alternative Strategies
Alternatives can provide powerful long-term portfolio benefits and non-correlated returns to traditional stock and bond holdings and improve risk-adjusted returns of balanced portfolios. Given the current rise in public equity markets, we think they offer very attractive risk/reward characteristics when compared to public equities.
We favor private real estate investment allocations to multi-family, industrial, and self storage and selected grocery-anchored centers. We expect equity-like long term returns from these investments that can offer built in inflation protection and tax efficient income generation. We also favor private equity and credit opportunities. We will continue to add alternatives to our diversified balanced portfolios.
Closing Thoughts
We remain cautiously optimistic as we enter 2025. While there are promising signs of growth and resilience in the economy, we are also acutely aware of the potential risks that could negatively impact market stability. For example, the U.S. economy will likely downshift into a slower gear. We do not believe this slower growth will cause a recession, but it does leave the economy more vulnerable to shocks, including significant policy changes from the new administration. Furthermore, the past two years of strong returns leave valuations elevated. Our focus will continue to be on identifying opportunities to improve long-term returns while being vigilant of the risks. By staying disciplined and opportunistic, we aim to navigate the complexities of the market and position our investment for long term success.
We sincerely thank you for your confidence and trust in us. Please do not hesitate to reach out to us if you have any questions or wish to discuss how all this relates to your specific financial situation in more depth.
