4Q 2024 Review and Outlook
U.S. stocks kicked off the year on a strong note, with the S&P 500 reaching an all-time high in mid-January and recording 56 more throughout the year, culminating in a 25 percent annual gain. This marked the second consecutive year with gains exceeding 20 percent—the first time such back-to-back increases have occurred since 1997-1998.
The year’s final quarter was marked by the resolution of prolonged political uncertainty and the conclusion of the U.S. presidential election cycle. Stocks experienced an initial boost as uncertainty subsided and investors embraced the potential benefits of a second Trump presidency and the growth prospects for U.S. business. Those gains were tempered, however, by lingering concerns over policy uncertainties under the incoming administration, particularly regarding potential new tariffs.
Given these developments in the U.S., both international developed and emerging market stocks were pressured by a stronger U.S. dollar and ended the quarter with high single-digit declines (yet managed to post positive returns for the full year).
Despite the Federal Reserve cutting short-term interest rates an additional 0.5 percent during the quarter (after the 0.5 percent cut in September), longer-term rates rose, leading to a 3.1 percent decline for the broader bond market but recorded positive returns for the full year. Municipal bonds also saw a similar pattern with a slight decrease in the quarter, but positive for the year.
What drove the stock market?
“What’s Changed?” is a simple explanation of what happened in S&P 500 during the most recent period but does not necessarily explain why the market moved. Let’s explore the “why” by looking at three individual components that shape market changes.
Dividend Yield: The most stable of the three factors. Dividend yields were approximately 0.3 percent this quarter.
Change in Earnings Expectations: Over the long term, earnings drive stock prices. This quarter, earnings expectations rose by 0.2 percent, continuing the trend of positive changes. Notably, expectations for 2025 project a solid 14 percent increase over 2024 earnings. While adjustments are likely along the way, we remain optimistic that double-digit earnings growth for 2025 will materialize.
Change in Valuation (Price/Earnings ratio): The Price/Earnings (P/E) ratio measures how investors value a company’s earnings. Over longer periods (spanning multiple quarters or years), a rising P/E ratio generally aligns with rising earnings. However, over shorter-term periods, such as this three-month snapshot, the two can diverge. This quarter, the P/E ratio increased by 1.9 percent, while earnings expectations edged up just 0.2 percent. This suggests slightly more optimism from investors than current fundamentals warrant. Our view is that stock market participants are focusing more on long-term prospects than usual.
What drove the bond market?
The Federal Reserve cut its benchmark interest rate twice in the quarter, lowering the Federal Funds rate to a range of 4.25 to 4.50 percent. Despite the Fed cutting short-term rates, however, the yield on the 10-Year Treasury rose from 3.8 percent to over 4.5 percent. There are several possible explanations for this upward move. To begin, inflation has remained stubbornly above the Fed’s target of 2.0 percent. Fed Chairman Jerome Powell has stated that the Committee is closely watching for signs that inflation could be re-accelerating. Higher inflation in the economy has an upward bias on interest rates and rates drifting higher could be an indication that the market is pricing in this possibility. If that is the case, the Fed would be forced to pause (or possibly reverse) their current rate-cutting cycle. Another possible explanation is the incoming administration’s focus on lowering taxes and deregulation - both potentially expansionary policies. The re-rating of growth expectations upward translates into higher long-term interest rates as bonds are sold (lower price, higher yield) in favor of higher return-potential equities. Either reason, or a combination of the two, leads to higher rates in the future.
Outlook
As we look forward to a new year, market participants weigh the potential for a third consecutive year of outsized gains. These gains, however, will be difficult to build on as continued war in Ukraine, new conflagrations in the Middle East, and a pronounced slowdown in Europe’s largest economies coupled with elevated price-to-earnings multiples in our equity market seems a tenuous foundation. A recent Goldman Sachs report posited that high price-to-earnings ratios (and a concentrated market) imply a three percent annualized returns over the coming decade, significantly below the 13 percent annualized over the past decade (Kostin, 2024).
Given these tensions, there is optimism from corporate America. Corporate tax policy is one area of focus. The Tax Cuts and Jobs Act (TCJA), passed in 2017, brought the corporate tax rate down from 35 percent to 21 percent and was designed to spur longer-term investment at America’s companies. According to the University of Chicago, firms experiencing larger tax rate cuts increased capital expenditure, in the broad range of eight to 14 percent, “reinforcing the conclusion of a positive macroeconomic investment response from the Tax Cuts and Jobs Act” (Chodorow-Reich & Zwick, 2024). If the incoming administration is looking to cut corporate taxes further in a push for more corporate investment, America’s companies should see greater productivity gains. One area that is getting heavy investment is artificial intelligence (AI). The myriad uses of AI, especially in areas of worker productivity, should manifest into future profits. Additionally, the prospect of lighter regulatory oversight when it comes to mergers and acquisitions (M&A), a market that has been nearly frozen for several years, should add to productivity gains. We believe these arguments provide a compelling case for further gains in 2025 (albeit more subdued by comparison), as earnings are the ultimate driver of the stock market over the long term. As a result, we continue to favor U.S. equities moving into the new year.
On the international front, we are turning incrementally more negative given several developments in the fourth quarter. Relative to the U.S. market, international equities look particularly cheap. This statement, however, could have been said for the majority of the last 20 years. While there may be structural reasons for the valuation disparity (e.g., European markets have more financials and industrials and fewer technology companies), there are also many headwinds facing international markets. We’ve mentioned the wars playing out around the globe but there are also lasting real estate woes in China and failed energy policies in Europe, to name a few, that are inflicting an economic toll. These problems will not last forever and there is often opportunity when these issues improve; however, we do not think this is that time. Potential new tariffs on top of already wavering economies merits further review. We will look for clarity on policies from the new administration and their potential impact on international markets before increasing allocations.
As we wrote in our last letter, either presidential candidate, once elected, would likely add to our country’s bloated debt burden and deficit. The U.S. debt is currently 123 percent of Gross Domestic Product (GDP), an all-time high. As Federal Reserve Chairman Jerome Powell said in a recent interview, “The U.S. federal budget is on an unsustainable path … and we know that we have to change that.” This seemingly leaves the U.S. with few options but two potential possibilities include 1) growing out of the debt with more revenue (e.g., higher tax income) or 2) significantly reduce spending. On a standalone basis, neither option is economically (or politically) tenable. Therefore, a likely goal from the incoming administration will be to increase revenue through growth matched with slightly less spending. The net result being higher interest rates as investors of U.S. debt require higher rates to offset the risks of elevated Federal debt levels. As this relates to your portfolio, we continue to hold fixed income securities on the shorter end of the yield curve where we believe there is greater value and plan to take advantage of opportunities to extend the duration of your portfolio as higher rates come. It often pays to be patient.
As always, please let the Oarsman Capital team know how we can be of greatest help to you and your family. We wish you a happy and healthy New Year!
Sincerely,
Your Oarsman Capital Team