Wesley Chapel, FL
“In a nation that was proud of hard work, strong families, close-knit communities, and our faith in God, too many of us now tend to worship self-indulgence and consumption. Human identity is no longer defined by what one does, but by what one owns. But we’ve discovered that owning things and consuming things does not satisfy our longing for meaning. We’ve learned that piling up material goods cannot fill the emptiness of lives which have no confidence or purpose.”
Jimmy Carter passed away recently at the age of 100. The stock market will be closed on Thursday, January 9th, in observance of a National Day of Mourning and President Carter’s funeral.
I am not sure how great a president he was, but I am confident that he was a genuine follower and disciple of Jesus Christ. I believe he is now with Jesus, and so he will be for eternity. This is what I most want people to say about me when my time here is up. It is the highest compliment I could imagine.
I pray that each of you and all those whom you love (if you/they haven’t already) will accept that same gift of eternal life and truly surrender your earthly lives to Jesus before it is too late. Most of us will not get 100 years to make that decision.
You can find a video and transcript of Jimmy Carter’s famous “Malaise” speech here. It’s a good one. Some parts of it, like the above quote, are eerily similar, if not even more accurate today, while other parts have totally flipped. Some remember and refer to the speech as the “Crisis of Confidence” speech… but what we have today, in my opinion, is a crisis of overconfidence. Or, as Alan Greenspan called it in 1996, irrational exuberance.
Keep in mind, though, that 1996 was a good four years ahead of the peak of the dot-com bubble. Markets can stay irrationally exuberant or overconfident for longer than anyone expects. For example, since last month, Fartcoin has added another 23% and is now worth $1.23 billion!
The S&P 500 Index, which is increasingly driven by just a few stocks finished the year up 23.3%. The ten largest stocks (Top 10) in the index were up 61.1% and the so-called Magnificent Seven (Mag 7) were up 63.2%. Meanwhile, the more diversified equal-weight version of the index was up only 10.9% - a slightly above-average year.
Bonds were actually down for the year, as measured by the Aggregate Bond Index ETF (AGG) price. However, on a total return basis (which includes interest), the index was up 1.9%. We’ll update our charts going forward to reflect the total return version.
Passive investors following modern portfolio theory style allocations experienced approximately the following returns (before management fees):
Very Aggressive (95% stocks): 14.7%
Aggressive (80% stocks): 12.1%
Balanced (50% stocks): 9.0%
Conservative (25% stocks): 6.0%
Another interesting aspect of 2024 returns is that gold (which I pointed out in my June commentary) actually outperformed the major indexes for the full year.
The market finished the year with some of the worst “breadth” on record. According to Porter & Co. Research:
“The S&P 500 Index is within 1% of its all-time highs, while less than 40% of the stocks in the index are trading above their 50-day moving average: That’s today’s lopsided, top-heavy market. The last time it happened? In early August 1972. (Other similarities – massive deficit spending, a ballooning federal debt, and rising inflation.)
What happened next back then? The market fell by nearly 50% over the next year. Don’t say we didn’t warn you… (hat tip: Jason Goepfert)”
According to Bloomberg, December 30th was the worst day of the year for market breadth, with fewer than 10 stocks in the S&P 500 showing gains.
Last month, I reviewed the astronomical valuations of the markets using several measures. I encourage you to read it if you haven’t already. In it, I said that buying stocks at current prices and valuations is likely to lead to poor returns. Here is what that looks like visually.
Note the yellow circle with a red outline in the chart on the left and how many of the observations one year after paying 21.5 times earnings (where we are today) were down more than 20%! Sure, several observations were up one year later, too. This is what leads me to the answer of “I don’t know,” when asked what I think the market will do this year.
I really don’t know. Nor does anyone else. That is the truth. What the market does over one year is anyone’s guess. And a guess is all it is. On average, though, the subsequent one-year return isn’t very high.
The subsequent five-year return (chart on the right in the image above) is less variable. After paying 21.5 times earnings for stocks, the expected return five years later is well below average, with a much higher level of confidence.
Momentum could certainly propel markets to new highs in 2025, but I don’t think anyone should be surprised if returns are well below average or even negative.
Looking at a basic technical analysis of the S&P 500 Index, we see (in the chart below) that a series of lower highs has developed and that the previous trend support (purple dashed line) has broken. I will not be surprised to see the S&P 500 drop toward its 200-day moving average (light blue) in the short run. That’s only about 4% lower from here and would only be about an 8% drop from the recent high – so not even a technical correction (-10%). If that happens and the 200-day moving average fails to hold, that is when things could accelerate to the downside.
And make no mistake, there is a long way to fall if momentum fades and fundamental valuations become relevant again.
It seems like a never-ending chorus of talking heads and financial media telling us that we are in a new era of valuation and that because of “fill-in-the-blank,” fair valuations have moved permanently higher. When you hear these things, like new paradigms and such, remember, we’ve been here before – repeatedly.
For example:
“The ‘new era’ commencing in 1927 involved at bottom the abandonment of the analytical approach; and while emphasis was still seemingly placed on facts and figures, these were manipulated by a sort of pseudo-analysis to support the delusions of the period. The ‘new-era’ doctrine – that ‘good’ stocks (or ‘blue chips’) were sound investments regardless of how high the price paid for them – was at bottom only a means for rationalizing under the title of ‘investment’ the well-nigh universal capitulation to the gambling fever.”
-Security Analysis, 1934, Benjamin Graham & David L. Dodd
And:
“This is the longest period of practically uninterrupted rise in security prices in our history… The psychological illusion upon which it is based, though not essentially new, has been stronger and more widespread than has ever been the case in this country in the past. This illusion is summed up in the phrase ‘the new era.’ The phrase itself is not new. Every period of speculation rediscovers it… During every preceding period of stock speculation and subsequent collapse business conditions have been discussed in the same unrealistic fashion as in recent years. There has been the same widespread idea that in some miraculous way, endlessly elaborated but never actually defined, the fundamental conditions and requirements of progress and prosperity have changed, that old economic principles have been abrogated… that business profits are destined to grow faster and without limit, and that the expansion of credit can have no end.”
-The Business Week, November 2, 1929
Thanks to John Hussman’s recent market comment for those insights.
Eventually, valuations will matter again. Whenever that comes to pass, we’ll be ready.
Let’s take a quick tour of some macro economic indicators that I follow to see what they have to say.
First, the US Dollar.
The US Dollar Index was rangebound for pretty much all of 2023 and 2024, but since the election of Donald Trump as our 47th president, it has broken out of that range. A strong dollar is great for inflation. All else being equal, the more valuable the dollar is, the fewer dollars it costs (lower prices) to purchase a product or service.
On the other hand, a strong dollar is bad for stock prices and bad for the earnings of companies that sell products and services outside of the United States as those products and services become more expensive to foreign buyers.
The most important “price” in the global stock market is probably the interest rate or yield on the 10-year US Treasury. The higher the interest rate the more it costs to borrow money to finance growth. Higher borrowing costs lead to less growth and higher prices as companies pass on those higher borrowing costs to customers.
As you can see in the chart above, the trend (light blue dotted line) of the 10-year yield has been higher for the past few years, and it recently broke out higher and looks to be headed back toward 5%. Something to pay attention to as this rate goes higher is the amount of unrealized losses that US Banks are carrying on their balance sheets. Without getting into too much detail, these unrealized losses are precisely what led to the failure of several banks in the spring of 2023. Bank of America is the bank most exposed to this risk – so if you bank with them, you might want to understand this risk a little more clearly. Perhaps this is one reason that Warren Buffett has been aggressively selling down his stake in the bank.
A higher 10-year yield also probably indicates that the market is expecting higher inflation. I am certainly expecting higher inflation, and I am not alone. As I mentioned in my November commentary, legendary investor Paul Tudor Jones was on record saying that “All roads lead to inflation.”
The December inflation numbers will be reported on January 15th, so I don’t have an update there. However, headline inflation (CPI) had accelerated for the past couple of months as of the November report. Personal consumption expenditures (PCE) was also seen to be ticking higher as of the November report, seemingly settling in at a higher rate than pre-pandemic levels.
Higher inflation will lead to higher prices and the need for even higher interest rates to reign it in, much to Mr. Trump’s chagrin.
Another chart I will be keeping an eye on this year is how the current inflation rate evolves compared to how it evolved back in the 1966-1984 period. It is too early to tell, but for the time being, it looks like inflation could be just beginning another massive move higher. This happened in the 1970s when the Fed declared inflation whipped and backed off from hiking rates too early, only to see inflation subsequently reach new highs, putting a massive strain on the economy, particularly those who are least able to afford it.
Unemployment rates are still quite low relative to history. Without getting into an analysis of how that rate is calculated compared to history, the unemployment rate has averaged 6.2% over the past 50 years.
As you can see in the chart above, the unemployment rate is historically low but rising.
The Fed’s balance sheet is another item of interest. Despite reducing their policy rate by 1% since September, the Fed is still allowing bonds it owns to mature without replacing them, thus reducing the overall size of its balance sheet. This is known as Quantitative Tightening or QT. It has the exact opposite effect of lowering interest rates and the exact opposite effect compared to when they were buying assets and increasing the balance sheet.
So far, the market has taken the reduction from $9 trillion to just under $7 trillion in stride, but that might be about to change as the level of reserves in the banking system is now at three-year lows and below the level they were at when the Fed originally initiated this round of QT. This has the overall impact of reducing liquidity in the banking system and the economy. Without excess liquidity to fuel growth at any price, current valuations could experience a quick and meaningful haircut.
On the other hand, the Fed is back to injecting even more money into the circulating supply as measured by M2, after the steepest and longest decline on record.
Maybe if they inject enough into circulation, it will offset the balance sheet reduction. Without the offsetting QT, and all else equal, more money in circulation would lead to higher inflation, but also higher stock prices.
Coming back around to my opening comment about a crisis of overconfidence, look no further than the Conference Board’s measure of expectations for stock prices to increase, which recently broke out to an all-time high.
As a contrarian investor at heart, this catches my attention. You don’t always want to invest contrary to the herd. Most of the time the herd is right. But the herd is always wrong at extremes. Of course, it could always get even more extreme, but all-time is a long time. And this level of confidence is getting pretty extreme any way you look at it.
Finally, to wrap things up for this month, one more comment on market breadth that comes from our friends at Porter & Co. Research:
“When a small number of stocks accounts for almost all of the market’s gains… Most of the time, the performance of a stock index roughly reflects the average performance of the stocks in the index. Over the long term, around half of the stocks in the S&P 500 Index have outperformed the index on an annual basis (and half have… wait for it… underperformed). But in 2024, just 32% of the constituent stocks of the S&P 500 have outperformed the index… meaning that 68% have done worse than the 29% year-to-date return of the S&P 500. That kind of lopsided performance has happened only a few times in the past: in 2023… and in 1998 and 1999, just before the dot-com bust. Market breadth is a signal of a healthy rally, which is the opposite of what we have today. Don’t say we didn’t warn you…”
On that note, Happy New Year! Make it count!
Until next time, I thank God for each of you, and I thank each of you for reading this commentary.
Clients, I encourage you to click here to access your personalized performance portal to see how your portfolio performed vs. the markets last month.
Shane Fleury, CFA
Chief Investment Officer
Elevate Capital Advisors
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