December 2024
It was a particularly arduous read for me in middle school, and Great Expectations is a fitting assessment of investors’ current posture. Two years ago, investors suffered one of the worst years for balanced returns on record, with U.S. stocks down 20% and bonds lower by 13%. Many investors weighed reducing their exposure to all investments in favor of cash. In that somber year-end letter, I wrote, “For the optimists, the abundance of bearishness on stocks is itself a historically good sign for future returns. Additionally, equity markets rarely suffer consecutive years of losses following a substantial pullback like the one witnessed last year.”
Fast forward to today. Most investors happily log on to check their account balances. And what’s not to like as an investor? Barring something unexpected over the coming days, the S&P 500 will have registered back-to-back years of approximately 25% annual returns! Many investors want to put more money into stocks and pull money from bonds and cash. While there is much to be excited about as an investor in 2025, including possibilities of tax reforms, deregulation, and a supportive economic environment, equity prices have great expectations baked into them. What could go wrong?
Fear the Glee
Investor sentiment, often a contrarian indicator, has reached elevated levels. The Conference Board’s stock market sentiment survey dates back to 1987 and just hit all-time highs, as shown in Figure 1. Excess enthusiasm is often an alarm bell for investing. I’ve read a number of reports assuming a double-digit return for stocks going forward, since that is what they delivered over the past decade (obviously). I’d caution that this logic holds as much water as assuming a 0% rate of return going forward, since that’s what stocks delivered in the decade ending in 2008. I try to save my investing glee for when sentiment craters, like in 2008 and 2022.
Eggs Aren’t the Only Things That Are Inflated
In 2014, the U.S. accounted for ~35% of global market capitalization – today it is over 50%. There are several reasons for this surge, but one is certainly the lift in U.S. equity valuations. The forward price to earnings (P/E) ratio of the S&P 500 is 22.3x. There have only been two periods over the past 30 years when the S&P 500’s P/E exceeded 20x for an extended period, as shown in Figure 2. The first was between 1998-2000 in the run-up to the dot-com bubble collapse, and the second was in 2021, which preceded the carnage of 2022.
The Original May Be Better Than the Sequel
Many are quite optimistic about the market’s prospects during another Trump presidency. After all, the market prospered during President Trump’s first term prior to the Pandemic. However, when he took office eight years ago, the U.S. Debt to GDP ratio was 102% and the yield on the 5-year Treasury bond (an approximation for what we pay on the debt) was 1.5%. Today, the U.S. Debt to GDP ratio sits at 120% and the yield on the 5-year Treasury is 4.25%. This rapid accumulation of pricier debt leaves the incoming administration with little room for fiscal stimulus or error. Moreover, while some of the incoming administration’s policies are seen as pro-growth (tax cuts, deregulation), some are seen as growth detractors (tariffs, immigration reform). In aggregate, Trump 2.0 may not be as supportive for stocks as Trump 1.0.
Prudence, Balance and Discipline
What’s one to do? A quote I recall from this 400-page lunker of a novel may offer some guidance…”Take nothing on its looks, take everything on evidence.”
The looks say that your neighbor loves this market, and investing is easy. The evidence says that lofty valuations and sky-high investor sentiment aren’t the best backdrop for a strong market rally. You may have even noticed some signs of irrational speculation. If not, we’d highlight that Dogecoin is up 300% the past two months, and an “art piece” of a banana duct taped to a wall recently sold for $6.2 million at auction (and was subsequently eaten).
The looks say that large-cap U.S. technology stocks are the only place to invest. Evidence shows that diversification remains a cornerstone of risk management. Investments such as international equities, healthcare stocks, and fixed income instruments will likely be valuable components of a healthy portfolio for decades to come, even if they have been lagging exposures for the past few years.
The looks say to keep shifting more money into stocks, because they keep making money, while the evidence says that rebalancing to long-term asset allocation targets may be a wiser move. Set those feelings aside, even after great years in the market. Incidentally, we give the same advice when advocating to rebalance up your equity exposure following a sharp market sell-off.
It’s not all “Bah Humbug!” from us. On the bright side, valuations for international equities and bonds look quite compelling. Additionally, deregulation could spark a wave of mergers and acquisitions that would be supportive to stock prices. Last but not least, bull markets typically don’t die due to valuation. Major downturns in corporate earnings are what historically end bull markets, and as of now, S&P 500 earnings are expected to grow 12% next year.
It is often said that history does not repeat, but it does rhyme, and we feel like we’ve seen this story before. As such, we’ll repeat many of the same principles that we’ve conveyed so often in these newsletters – prudence, balance, discipline. Those are always wise words when it comes to investing – particularly after exceptionally good or bad years. Emotional and impulsive decisions, even those resulting from successful years, can result in harmful investment outcomes. Warren Buffett once summed it up quite nicely when he said, “The stock market is a device for transferring money from the impatient to the patient.” Like many of the lessons conveyed in Dickens’ classic novels, we expect this observation from Mr. Buffett will still be relevant and well-read for many decades to come.
All market data is sourced from Bloomberg unless otherwise noted.