Year-End 2024 Investment Commentary

January 16, 2025

Market Recap

The U.S. economy and the stock market proved much stronger than many had anticipated in 2024, despite a range of concerns including geopolitical tensions, elevated valuations, stubborn inflation, interest-rate uncertainty, slowing growth in major foreign economies, and of course, the uncertainty brought on by the pending U.S. presidential election.

For the year, domestic stocks delivered strong returns with meaningful disparity across the market. Large-cap stocks (S&P 500 Index, which is weighted by company size) posted a gain of 25%, widely outperforming small-cap stocks (Russell 2000 Index), which rose 11.5%. Within larger cap, growth-oriented stocks (Russell 1000 Growth Index) led by technology names, particularly NVIDIA, were the biggest winners, posting a 33.4% gain. Value-oriented stocks (Russell 1000 Value Index) were up 14.4% in comparison. The equal-weighted S&P 500 Index, where each of the 500 companies accounts for the same percentage of the total index, returned 13%. The equal-weighted index failed to capture the outsized gains made by largest and fastest-growing firms in the index.

2024 Equity Returns

Source: Morningstar Direct. Data as of 12/31/2024.

Overseas, returns were not nearly as strong. Developed international stocks (MSCI EAFE) posted a modest 3.8% gain (in U.S. dollars). 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. Early in the fourth quarter, Chinese stocks were up over 60% off their January lows but ultimately, high debt levels, underwhelming fiscal support, ongoing property market troubles, weak consumption, and international trade pressures weighed on the market.

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 of 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.

Macroeconomic and Investment Outlook

As we head into 2025, undoubtedly investors will have plenty to watch — front and center being the Trump administration’s proposed policies, which could have ripple effects both here in the U.S. and abroad. Our base-case economic scenario assumes that the U.S economy will continue to grow, albeit slower, with a low probability of 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 the market will broaden out beyond large-cap growth stocks to include small and mid-caps and non-tech sectors of the market. At the same time, we anticipate bouts of volatility caused by central bank policies, slowing global growth, geopolitical tensions, and elevated stock market valuations.

As of year-end, we target a full strategic weighting to equity investments in alignment with our allocation framework, while remaining diversified across geographies. Within our global equity allocation, we also remain neutral relative to growth and value tilts. In fixed-income we continue to be significantly underweight within our allocation framework to core bond investments and interest rate risk relative to a traditional bond benchmark, while emphasizing exposure to flexible, shorter-duration and credit-oriented fixed-income investment allocations, which we think will generate better yields over time. Importantly, we are not “stretching” for yield, i.e., taking on excess risk to achieve attractive returns. Many of our exposures are investment-grade or are conservatively positioned within the high-yield space. As always, we are weighing a range of shorter-term risk scenarios against each asset’s medium- and longer-term return potential and portfolio diversification benefits assuming different macro environments (inflation/disinflation, growth/stagnation).

U.S. Stocks

The S&P 500 marched higher throughout 2024 ending the year up 25%. Despite periods of volatility along the way, the index 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 1990’s, and for only the fifth time on record.

Once again, the performance of large-cap growth/technology stocks led the way. The often-quoted Magnificent 7 stocks (“Mag 7”), generated returns of nearly 70%, while the remaining 493 stocks clocked in with a 16% return (a respectable figure to be sure, but well behind the Mag-7). Standout performers included semiconductor companies such as NVIDIA (+170%) and Broadcom (+113%).

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, left). 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, the failure of a few companies to meet extremely optimistic expectations could drag down market cap weighted indexes (like the S&P 500).

Looking ahead to 2025, we think the economic backdrop is still favorable for U.S. 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 is back to normal-ish 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.

While our economic outlook is generally positive, there are plenty of risks to consider. For starters, equity valuations are historically expensive and reflect a significant amount of investor optimism. Current valuation levels — particularly for larger-cap growth stocks — suggest that there is less room for upside, and there is more downside risk if expectations are not met. As mentioned previously, the high level of concentration in the S&P 500’s 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.

Given these risks and opportunities, we are actively considering potential changes to our U.S. equity exposure.

One consideration is to underweight larger-cap stocks in favor of mid-cap stocks. Historically, we have divided equities into two buckets: larger-cap and smaller-cap stocks. But today we think mid-cap stocks could offer a compelling investment case. Mid-caps are currently trading at fair value relative to their historical valuations, and are trading at a steep discount relative to elevated valuations for larger-cap stocks. In theory, mid-caps’ relatively attractive valuation could lead to less downside risk in a market decline. Relative to smaller-caps, mid-caps have less exposure to floating-rate financing. If interest rates and therefore borrowing costs remain elevated, small-caps will come under more pressure. This is especially true when you consider that 42% of companies in the Russell 2000 Index, a popular small-cap index, are currently unprofitable.

If the economy continues to grow, we think a broadening out of the market beyond the largest-cap stocks could benefit mid-caps. The composition of the mid-cap index has higher exposure to domestically focused sectors than the S&P 500, such as industrials, financials, and consumer discretionary. By comparison, information technology stocks, which derive a larger percentage of their revenues globally, make up nearly 30% of the S&P 500. Being more domestically oriented, mid-caps are less exposed to geopolitical risks and currency fluctuations that can affect large multinational corporations. This could make mid-caps relatively attractive in periods of heightened global uncertainty.

Mid-caps strike a balance between growth potential and stability, offering the potential for fast growth while also having the operational flexibility that can come with a mature business in the event of an economic slowdown.

We will continue our evaluation and explore opportunities for our clients’ portfolios. Looking ahead, we think investors should be prepared to weather occasional storms in 2025.

Foreign Equities

While the U.S. economy has remained strong, economic growth elsewhere in the world has been relatively weak. The European economy, for example, 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 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 structurally higher economic and earnings growth. This has not gone unnoticed by investors as the market is now paying upwards of 22x for U.S. earnings compared just over 13x for European earnings. This P/E multiple discount is at a historically wide differential.

In fairness, European equities have performed decently since the bull market that started in October 2022. The main reason for the underperformance relative to U.S. stocks is the lack of mega-cap technology companies. Analysis from Ned Davis Research shows that since mid-October 2022, the S&P 500 is up 22.6% annualized, easily outpacing MSCI Europe’s return of 16.1%. However, when removing the large eight tech leaders from the S&P 500 (Alphabet, Amazon, Apple, Broadcom, Meta, Microsoft, NVIDIA, and Tesla), the index has returned 13.8% annualized. While one cannot simply remove the best performers from an index, it does highlight the significant impact these technology giants have had in recent years.

Throughout 2024, emerging market economies faced uncertainties around the weakness in China and potential tariffs from a second Trump administration. Both factors helped push the dollar higher and weighed on emerging-markets equities. Our growing concern in late-2023 and into early 2024 led us to eliminate the tactical overweight to emerging-market stocks and fall back to our neutral positioning.

Much like developed international stocks, emerging markets trade at a historically wide discount to their U.S. counterparts. However, on a stand-alone basis, they trade at a slight premium to their own historical average. Given elevated geopolitical uncertainties, we will not consider an overweight in emerging markets until valuations are discounted in absolute terms, and we in a world that’s less favorable to the U.S. dollar.

The Federal Reserve and the Fixed Income Market

Throughout 2024 the bond market has been hyper-focused on every economic data release, ranging from inflation and employment reports to GDP growth and consumer strength. Each data point has been heavily scrutinized for its potential impact on central bank policy, driving heightened volatility as investors attempt to project the likelihood of interest-rate changes and the implications on returns. Investor guesswork has led to a very volatile year for the 10-year U.S. Treasury bond, reflecting the market’s sensitivity to economic conditions in an uncertain environment.

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 point reduction, compared to the typical 25 basis point cut. This was followed by a 25 basis point reduction in November, and another widely expected 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 increased. In fact, since the Fed started cutting rates in mid-September, 10-year Treasury yields rates have increased by roughly 100 basis points, and the yield curve has finally uninverted[1] after slightly more than two years.

Notably, the range of estimates among Fed members for 2025 core PCE increased from 2.1%-2.5% to 2.1% to 3.2%. This shift comes on the heels of September when the Fed stated that inflation was largely under control and their focus shifted to supporting the labor market. Our guess is that the Fed’s revived concern about inflation is due to a number of Fed members starting to factor in assumptions for the incoming administration’s new economic policies.

The Fed also introduced new language around the “extent and timing” of future rate cuts. Indeed, the number of expected rate cuts for 2025 were dialed back from September’s four 25 basis point rate cuts to only two rate cuts, implying a year-end 2025 level of 3.9%, up from 3.4%. Similarly, the Fed funds projection for 2026 increased from 3.0% to 3.4%. This recent shift suggests that the Fed’s current policy is not as restrictive as previously anticipated

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, the U.S. bond market is stuck between the Fed’s plans to cut interest rates (to some degree) and the risk of higher inflation and increasing federal deficits. As has been the case in 2024, we think 2025 will be another bumpy ride for fixed-income. Our approach has been and continues to be focused on shorter-term, high-yielding bonds over those with more interest-rate risk. But that could start to change, especially if volatility creates opportunities. Regardless, today’s starting higher yields will result in better bond returns over the long run.

As mentioned above, there can be a wide range of economic forecasts even within the Fed, despite its extensive resources, highly skilled staff, and a wealth of theoretical and empirical models at its disposal. Therefore, it should come as no surprise that we do not hang our hat on the Fed, and we view them as any other forecaster: imperfect.

Our investment approach attempts to navigate uncertainty rather than trying to predict precise outcomes. Instead of relying on pinpoint forecasts, we focus on understanding a range of possible scenarios and analyzing their potential implications for our portfolios. By evaluating risks and opportunities across different economic and market conditions, our goal is to stack the odds in our favor, even in complex and volatile environments.

For example, in our third-quarter commentary we discussed our view on intermediate- to long-term duration such as core bonds and 10-year Treasury notes. Our thinking was not about predicting exactly where rates were headed and by when, but rather evaluating potential returns under a variety of scenarios.

Our conclusion was that given the level of longer-term yields (10-year Treasury yields were sub-4%), we believed that over time, we could generate better returns with less volatility by owning shorter-term, higher-yielding investments. Our view was that the market was baking in too pessimistic a scenario, and that over time, rates would be range-bound or move higher. From those yield levels, even if the market moved against us, i.e., rates moved modestly lower, we would still earn returns that were in line with the benchmark over the next 12-18 months but with less volatility. And in the single scenario where rates moved meaningfully lower, we would generate returns in the 7.5% range, compared to 10.5% for core bonds. Ultimately, we were willing to give up slightly more upside in a single scenario in exchange for a tie or a win in all other scenarios with less volatility.

Earlier in the fourth quarter, we implemented this allocation into short-term bonds and that move has worked extremely well in a very short period, as long-term yields have moved up sharply (10-year Treasury yields are now at 4.6%), and our portfolios’ fixed-income exposure has been largely insulated from the negative impact of higher long-term rates. With the change in yields, we now find ourselves re-evaluating this fixed-income positioning. If rates continue moving higher, it’s likely that we will unwind some of the short-term exposure in favor of long-term bonds at attractive yields.

Marketable Alternatives

We continue to use marketable alternatives as a diversifier to traditional stocks and bonds. For example, trend-following managed futures strategies delivered a 2.7% return in 2024. Owning managed futures in a diversified portfolio offers a number of potential benefits, particularly enhancing risk-adjusted returns and potentially reducing market volatility. Managed futures strategies typically involve trading in futures contracts across various asset classes, such as commodities, equities, interest rates, and currencies. These strategies are often non-correlated with traditional asset classes like stocks and bonds, meaning they can perform well during periods of stock or bond market stress or downturns. As a result, they can act as a hedge, reducing overall portfolio risk. Additionally, managed futures strategies can capture trends in the market, potentially benefiting from both rising and falling prices, which adds another layer of diversification. Overall, we believe including managed futures in a portfolio can improve its resilience and stability, helping to smooth returns across different market environments.

In Closing

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, in and of itself, 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 leaves valuations elevated. Our focus will continue to be on identifying opportunities to improve long-term returns while being vigilant of the risks we are taking. By staying disciplined and opportunistic, we aim to navigate the complexities of the markets and position our investment portfolios for long-term success.

As always, we appreciate your trust and wish you and yours a wonderful new year.

 

Important Disclosure
This investment commentary is provided by Litman Gregory Wealth Management, LLC (“LGWM”) for informational purposes only and may contain information that is not suitable for all investors. No portion of this investment commentary is to be construed as a solicitation or recommendation to buy or sell a security, or the provision of personalized investment, tax, or legal advice. Past performance is not indicative of future results and may have been impacted by market events and economic conditions that will not prevail in the future. There can be no assurance that any particular investment or strategy will prove profitable, and the views, opinions, and projections expressed herein may not come to pass. A complete list of portfolio holdings and specific securities transactions for the preceding 12 months is available upon request to compliance@lgam.com.
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Index Disclosure
Any reference to a market index is included for illustrative purposes only, as it is not possible to directly invest in an index. Indices are unmanaged, hypothetical vehicles that serve as market indicators and do not account for the deduction of management fees or transaction costs generally associated with investable products, which otherwise have the effect of reducing the performance of an actual investment portfolio.
The Standard & Poor’s (S&P) 500 Composite Stock Price Index is a capitalization-weighted index of 500 stocks intended to be a representative sample of leading companies in leading industries within the U.S. economy. Stocks in the Index are chosen for market size, liquidity, and industry group representation.
Bloomberg U.S. Aggregate Bond Index is a broad-based, market capitalization-weighted index that measures the performance of the investment-grade, U.S. dollar-denominated, fixed-rate taxable bond market. It includes Treasury securities, government-related bonds, corporate bonds, mortgage-backed securities (MBS), asset-backed securities (ABS), and commercial mortgage-backed securities (CMBS).
Bloomberg Short-Term Treasury Index tracks the performance of U.S. Treasury securities with maturities between 1 and 3 years. It serves as a benchmark for short-duration U.S. government bond investments and reflects changes in interest rates within this maturity range.
ICE BofA Merrill Lynch High Yield Index measures the performance of U.S. dollar-denominated, below-investment-grade corporate debt publicly issued in the U.S. domestic market. The index includes bonds with a credit rating lower than BBB by Standard & Poor’s or lower than Baa3 by Moody’s.
Russell 2000 Index measures the performance of the 2,000 smaller companies included in the Russell 3000 Index.
Russell 1000 Growth Index measures the performance of the of the large- cap growth segment of the Russell 3000 Index. Russell 1000 Value Index measures the performance of the of the large- cap value segment of the Russell 3000 Index.
The MSCI EAFE Index is an equity index which captures large and mid-cap representation across 21 Developed Markets countries* around the world, excluding the US and Canada. With 799 constituents, the index covers approximately 85% of the free float- adjusted market capitalization in each country.
MSCI China Index is a free float-adjusted market capitalization index that measures equity market performance in China. The index captures large- and mid-cap representation across Chinese companies listed on various stock exchanges. It includes companies from sectors such as technology, financials, and consumer discretionary.
The MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets. The MSCI Emerging Markets Index consists of the following 23 emerging market country indexes: Brazil, Chile, China, Colombia,
Czech Republic, Egypt, Greece, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Peru, Philippines, Poland, Qatar, Russia, South Africa, Taiwan, Thailand, Turkey and the United Arab Emirates.
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Forward-Looking Statements:
Forward-looking statements are based on current expectations and assumptions about future events and economic conditions, which are inherently uncertain and subject to change. Actual results may differ materially from those anticipated, and there is no guarantee that strategies discussed will achieve their intended objectives.
Asset Allocation and Strategy Risks:
Asset allocation and diversification strategies do not ensure a profit or guarantee against loss. Portfolio positioning reflects views at a specific point in time and may not represent future outcomes. Shifts in market conditions or investment strategies may materially impact portfolio performance.
Fixed-Income Investment Risks:
Investments in credit-sensitive fixed-income securities involve risks, including credit/default risk and interest rate risk. High-yield (“junk”) bonds carry a higher risk of default and greater price volatility. Changes in interest rates may impact the value of fixed-income investments.
Use of Hypotheticals:
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[1] The term uninverted refers to a yield curve that has returned to its normal, upward-sloping shape after previously being inverted.