Nervous Start to 2025 for Markets

Happy New Year everyone and welcome to the first Q-Commentary of 2025.

Market update

2024 was another strong year for stocks with the U.S. market (represented by the S&P 500) gaining 25% including dividends. Growth and momentum stocks which include technology significantly outperformed value-oriented parts of the market like financials, energy and real estate. U.S. exceptionalism and excitement around Artificial Intelligence (AI) were the dominant themes.  

In fact, the steady rise in the stock market over the last two years with no declines over 10% have made investing seem easy and left many investors forgetful of the markets’ potential for volatility. While the rest of the stock market outside of the US Large Cap space had trouble keeping up with the S&P 500, there were still returns to be had.  

Small cap finished a second straight year of double digit returns up 11.5% following on 16.9% in 2023. On the international front, Emerging Markets were up another 8.1% in 2024 after 2023’s 10.3% rise. Foreign stocks represented by the MSCI EAFE were unable to replicate 2023’s 18.9% gain but still advanced 4.3%.  Investors were able to squeeze an additional +10% out of the EAFE by hedging against the strengthening dollar with the currency-hedged EAFE gaining 14.1% last year.  

The yield on the 10-year U.S. Treasury Bond rose from 3.88% to 4.58% over the past year.  Despite the rise in rates, the broader bond market (represented by the Bloomberg Aggregate Bond Index or Agg) gained 1% in 2024 with higher yields able to offset modest price declines. Starting 2025 with long term treasury rates over 4.5% may position bonds for success this year.  

Against such a benign backdrop, any decline can seem unpleasant. However history shows that stock market declines are common. Since 1950 the average max drawdown for the S&P 500 index in any given year was – 16%. Despite this, stock investors still earned a positive average return of 9% during the same period (excluding dividends).

At some point, volatility will return to the market and we will be reminded of the prudence and importance of diversification and risk management. When that happens, bear in mind that it often pays to stay invested. In fact, volatility may present opportunities to review and rebalance portfolios according to long-term financial goals.

AI arms race and The Magnificent 7 (or 8 ...)?

We would be remiss if we did not discuss the dominant story of 2024: Artificial Intelligence (AI). AI drove the outperformance of growth companies that spent huge sums on datacenters and other AI-related capabilities. This theme has sustained positive market momentum since ChatGPT was released in late 2022.

The stocks of the seven largest tech companies – NVIDIA, Apple, Microsoft, Alphabet (Google), Meta (Facebook), Tesla, and Amazon – drove U.S. stock returns, gaining 250% since early 2023 and nearly 500% since 2020. If we include Broadcom, these eight stocks make up more than one third of the S&P 500 and accounted for 60% of the index’s 2024 gains.

While these returns have been great, the dominance of the "Magnificent 7" raises portfolio concentration risks. Investors may now find themselves owning more of these companies than they intended.

At some point, companies will likely face pressure to show tangible results (i.e. better earnings) from large AI-related capital expenditures. When this happens, these high-growth tech stocks are at risk of being reassessed by markets, especially given how much their prices have appreciated relative to fundamentals. The market will continue to look for vulnerabilities in these tech giants, as we are seeing play out with the recent news around Chinese AI company DeepSeek.

Last year, whichever tech firm spent the most on AI semiconductors (thereby pouring money into NVIDIA who produces the most widely used AI datacenter chips) appeared to be "winning" the AI race, and markets rewarded them. This year's volatile moves may indicate that a winning AI strategy must be more than piling up warehouses of chips.

Stocks aren't cheap

The large run-up over the past two years has lead the S&P 500's price-to-earnings ratio, a measure of fundamental value, to 21.5, approaching historic highs and near the dot-com bubble peak of 24.5.  According to data from Robert Shiller, US stock valuations are in the top 10% of their historic range.

Many studies suggest high valuations are associated with lower future stock returns. However, high valuations alone are not necessarily a reason to shun equities as there is little evidence that market timing based on valuation is successful. Despite high stock prices, underlying company fundamentals remain largely healthy, with many stocks (including the Magnificent 7) posting strong earnings. One of the questions that remains is whether or not the US economy can support future growth.  

Prudent investing calls for diversification, or spreading investments across different categories, to decrease the impact of any one negative event. The chart below shows that while US Large Cap stocks have high valuations, other investment categories are priced more modestly including developed international stocks and U.S. Small Caps.

The economy remains strong

The US economy grew at a 3% annualized rate in the second and third quarters of 2024, most recent data show. The December jobs report was stronger than expected, with 250,000 news jobs and unemployment hovering near 4%. Inflation has increased slightly since bottoming at 2.4% in September 2024. December's inflation reading came in at 2.9%, still above the Federal Reserve’s 2% target.  

Collectively, these factors suggest less need for aggressive Fed rate cuts in 2025. Indeed, unusual market behavior occurred after the first Fed rate cut in September, with long-term rates rising 100+ basis points (over 1 percent), putting pressure on bonds.

What we're watching

2025 presents a mixed picture. We remain optimistic about technological innovation and growth in the US, and mindful of expensive valuations and the likelihood of volatility in the year ahead.

Another risk for markets involves government debt and deficits, something we will likely hear more about in the coming months.

U.S. market concentration in the Magnificent 7 and lofty stock prices are key risks coming into this year.  We will continue to look for opportunities to rebalance, diversify into less expensive areas of the markets, and expand our investment frontier.  

Our normal human tendencies lead us to cling dearly to the high performers that have driven recent gains.  Of course, it is unlikely that the coming years will be exactly like the past. Today’s different interest rate environment, market valuations, business cycle dynamics, and shifting political landscape are likely to create different investment outcomes.

The underlying advantage we have as financial planning-centric investors is an understanding of our own financial and life goals. This allows us to be patient and maintain a long-term mindset to take advantage of whatever 2025 and beyond have in store for us.  

We look forward to the journey together this year.  May you have a fantastic 2025.