Your investment needs will change throughout your life.
Formidable can help.

Two major factors tilted a little more negatively, especially as the Fed’s language shifted to more hawkish and the yield on the 10-year Treasury moved higher despite Fed rate cuts. Earnings growth looks more constructive as analysts are calling for broader participation by the other 493. For details, click here.

Are investors having delusions of grandeur? We think possibly, at least based on historical valuation norms:

Much depends on the Great and Powerful Jerome Powell, and whether Fed rate cuts can bring down the 10-year yield, or if his powers are just as limited as those of Oz. Any move higher in rates has the potential to prove highly disruptive to these elevated valuations, not to mention the economy.

Similarly, this is the worst two-year run for value stocks since 1998/1999. That set up a run of seven consecutive years when value outperformed growth. It is the worst streak of underperformance for small cap stocks since 1997/1998; they went on to outperform each of the next six years.

We believe that the opportunities over the next few years are likely not on the yellow brick road of megacap stocks. Clearly some of these stocks have a place in an investor’s portfolio, though we contend that, for index investors, the 39% weight ten stocks have in the S&P 500 represents an outsized bet on the most expensive companies in the world.

Our hope is that the resilience of the U.S. economy, coupled with a presidential administration that is promising to be more business-friendly, allows for a continuation of the bull market, albeit one that is broader and led by less expensive, smaller and mid-size companies. We think there is a valuation case to be made for many of these companies, and with a less meddlesome regulatory environment, we could see a renewed wave of M&A activity provide an uplift to companies as the risk of the DoJ and FTC scuttling deals abates.

Conversely, if the risks we outlined become more pronounced, it is important to note that in a year like 2000, when the S&P 500 fell 9% as the tech bubble began to burst, the average stock was up almost 8%. Thank goodness for active management when things get tough.

1. Inflation – Negative but stable. Fed Chair Powell was a touch less confident when he spoke at his December new conference, “I think that the lower—the slower pace of cuts for next year really reflects both the higher inflation readings we’ve had this year and the expectation that inflation will be higher. You saw in the SEP that risks and, and uncertainty around inflation we see as higher.”

While goods remain in deflationary mode, it is services, where housing costs reside, that remain stubbornly high:

2. GDP Growth – Positive and stable. The Atlanta Fed’s volatile GDPNow estimate for Q4 has settled in the mid-2% range, which is clearly not recessionary, but also not scintillating, which was our exact sentiment last quarter. Job data has consistently been revised lower, which is worrying, as are some of the trends on delinquencies at the lower end of the wage spectrum.

3. Fed Policy – Negative and deteriorating. The Fed delivered a 25 basis-point cut at its December meeting, which was expected. However, as mentioned, Powell’s comments around inflation and the pace of rate cuts in 2025 were less encouraging, which is why we moved this into the deteriorating camp.

Odds are now that we get between one and two cuts in 2025 to end the year with a Fed Funds rate of around 3.9%. Three months ago, the market was pricing four to five cuts and a rate of 3% by the end of 2025.

5. Credit spreads – Negative and stable. A reminder we use this as a contrarian indicator. In other words, if we see spreads widening into the area above the green line, we may start to view risk/reward more favorably. High-yield spreads and investment grade spreads are incredibly narrow, i.e., the market is paying little premium for credit risk.

6. Stock multiples – Negative and stable. Multiples were relatively stable for the S&P 500 in Q4, but remain elevated, especially for those companies at the top. Moreover, the Index has not had such a heavy weight in the top 10 since the Nifty Fifty era.

One can make the case that these businesses should be accorded higher valuations, based on their margins and earnings growth, but whether the size of the premium is justified remains a question in our assessment. We also question whether these margins are sustainable as what were capital-light businesses become increasingly capital intensive due to the AI arms race in which many are engaged.

Meanwhile, higher quality small cap stocks remain well below their peak valuations.

7. Earnings growth – Improving and neutral. Excluding the Magnificent Seven, earnings growth has been paltry. Earnings expectations for the Magnificent Seven remain lofty (over 20%), while the other 493 are expected to turn the corner and post 13% growth for 2025, albeit back-end loaded. While this broadening is enough to tilt us into improving and neutral, the stage seems like it could be set for disappointment.