As we settle into the new year, this is a good time to reflect on where we’ve been and look to the year ahead.
At the beginning of last year, we outlined three economic themes that we thought might have an impact on the economy and markets in 2024. Inflation remained in the Messy Middle and stabilized within a manageable range. The Federal Reserve (the Fed) ultimately began to cut interest rates in September, which brought fixed income yields broadly lower from 2023. We emphasized the importance of Preparation over Prediction and ensuring portfolios are constructed to withstand uncertainty and disruption. Despite volatility from unexpected geopolitical events and a presidential election, markets have performed quite well, and the economy remains resilient. Our third theme of Concentrated Consequences carries through as we turn towards 2025. We highlighted the fragility within U.S. equities driven by the narrow leadership of the “Magnificent 7”. That narrative only intensified as the top 10 stocks of the S&P 500 made up 35% of the index (as of November 30, 2024), up from 31% at the start of 2024.
Long-time clients know that we don’t try to time the markets and, in fact, think it’s a fool’s errand. Even trying to predict short-term market or economic conditions has its own pitfalls. But it is important to periodically take a step back to understand the current state of the economy and financial markets as this context may help to provide direction to more effectively plan for the future.
As we assess the current landscape in these early days of 2025, it’s clear that markets stand, as they often do, at a crossroads. Equity markets surged in 2024, inflation eased to a level where the Fed enacted interest rate cuts for the first time since 2020, the domestic economy outperformed, and the U.S. dollar appreciated around 7%.
Markets May Be Entering a Period of Fragility
All of the above outcomes may be great for investor portfolios, but those of us who believe markets revert to their long-term averages are cautious about expectations of continued outsized returns. Two consecutive years of above average returns for the S&P 500 means valuations hover at historically high levels. One of the most common valuation metrics is called “price-to-earnings ratio” (or PE ratio) which, as the name suggests, measures a company’s current share price relative to its per share earnings and may be an indicator that a stock is cheap, fairly valued, or expensive. Just as we can apply a PE ratio to an individual company, we can also use it to value an index or the overall market. Current valuations for the domestic equity market are close to their 20-year high and well above their long-term average. When compared to other markets around the world, U.S. large-cap equities in particular appear stretched relative to their non-U.S. counterparts, adding a layer of risk for investors who are overly concentrated in this space.
Fueling these high valuations has been the continued strength of a handful of large cap growth companies concentrated at the top of the market. This narrow market leadership means that the success of a handful of companies disproportionately influences the broader market. Any misstep such as a disappointing earnings report or adverse development could lead to volatility for the overall market.
Meanwhile, in the bond market, credit spreads (a valuation measure for fixed income) have compressed near levels last seen prior to the ’07-’09 financial crisis. This suggests the bond market may provide relatively stable returns in the coming year, but some uncertainty exists in this asset class as well. Despite Fed action to cut interest rates, after months of speculation and considerable attention, interest rates actually rose in 2024 for bonds maturing in two years or longer. While this caused the price of some bonds to decline, we see this as a positive development for investors seeking income, or at least a more stable complement to their stock holdings.
We begin 2025 with the Bloomberg Aggregate Bond Index yielding nearly 5.0%, well above its five-year average of about 3.2%. If interest rates remained unchanged through 2025, bond markets would be headed towards a historically solid return. That said, it’s unlikely that rates will remain the same for the next twelve months. Further rising rates could negatively impact prices and overall returns in the short term and a slowing economy could see rates retreat from their current levels. While lower rates provide a short-term tailwind to the value of existing bonds, they also lead to lower long-term income potential. Either way, bonds are starting the year in a strong position to provide positive near-term returns.
And finally, further adding to the complexity of the current economic landscape is the threat of reinflation. While inflation has eased recently, inflationary pressures remain as a result of continued high deficits, the potential for additional Fed rate cuts, and possible policy changes surrounding issues like tariffs and immigration. As market expectations are currently driven by hopes of moderate inflation and further easing of monetary policy from the Fed, a shift in those expectations could have meaningful implications for prices and volatility.
The Importance of Diversification and Rebalancing
With markets and consumer sentiment riding near all-time highs, it’s important to remember that trees don’t grow to the sky, as the saying goes. However, we should also recognize that the economy remains strong and there is no way of knowing when the upward momentum will wane. Investing is synonymous with taking risks and there are few, if any, investments that generate meaningful returns without it. While current conditions in some markets pose additional risks, it’s not time to panic. Rather, it’s a good reminder that diversification and systematic rebalancing are as critical as ever.
We all know that the purpose of diversification is to reduce risk by avoiding concentration in a given investment or area of the market. As such, the primary goal of diversification is to reduce volatility, not necessarily to maximize returns. But who doesn’t want both? So, while the concept of diversification is easily understood, maintaining a diversified portfolio can be challenging at times when the temptation is to chase the returns of the best performing investments. While we’re steadfast proponents of diversification and believe it’s always a crucial component for long-term success, it’s worth reaffirming the importance of diversification when both markets and uncertainty are high.
It’s also important to remember that bull market returns, especially those concentrated in certain companies or sectors of the market, cause portfolios to drift away from their original target mix of investments, exposing them to risks. Without systematic rebalancing, a portfolio over time will accumulate a larger percentage of the investments that have performed the best, leaving it potentially overexposed to areas of the market that may be ripe for a correction. Concentrations amplify outcomes, and this applies to both wins and losses. While recent history demonstrates the upside of concentration, the downside risks are just as real.
For clients whose portfolios we actively manage, risk profiles are reviewed regularly to ensure the portfolio allocation target aligns with their goals and income needs. And our disciplined investment process helps to manage risk by ensuring adequate diversification through various market cycles, and ongoing rebalancing to take advantage of inevitable volatility using a “buy low, sell high” approach. For clients who manage their own portfolios, we encourage you to use this period of relative calm in the markets to ensure your portfolio aligns with your goals and risk tolerance. With markets experiencing substantial gains in recent years, this may be an opportune time to reaffirm or refine your portfolio’s objectives.
Final Thoughts
Full valuations, index concentration and the potential for a resurgence of inflation have set the stage for a potentially fragile market environment. Can prices rise further from here? Absolutely. Yet the possibility of setbacks is equally real.
Reaffirming portfolio positioning and risk exposure is a prudent exercise, while thoughtful diversification can help mitigate acute risks such as concentration and inflation.
As we look to the year ahead and beyond, our commitment to our mission remains steadfast:
Provide fee-only personal financial planning and asset management services that meet or exceed fiduciary standards of our profession and is:
- Sensitive to clients’ financial and non-financial goals
- Independent (we work for you; not a company selling products)
- Personalized (customized for each client)
- Comprehensive (consider all aspects of financial planning)
- Tax-sensitive, cost sensitive and responsive
We wish you great health and happiness in the New Year!
The views expressed represent an assessment of market conditions at a specific point in time, are opinions only and should not be relied upon as investment advice regarding investments, sectors or markets in general.
The above statistics and/or commentary have been obtained from sources we believe are reliable, but we cannot guarantee their accuracy or completeness. Past performance is no guarantee of future results.
Specific securities discussed herein are illustrations and do not represent securities purchased, sold or recommended for client accounts. Such information does not constitute, and should not be construed as, a recommendation to buy or sell specific securities.
This is not a complete analysis of every material fact regarding any company, industry, or economic condition. Due to shifting market conditions, all expressions of opinion are subject to change without notice.
The information contained in this document does not cover all tax strategies that may apply, is not a complete guide to tax planning, and does not constitute the rendering of legal, accounting, or other professional advice or opinions on specific facts or matters. Before implementing any ideas suggested here, consult with your tax advisor regarding your specific tax situation.
Talk to your financial advisor before acting on information in this document.