By Eric Parnell, CFA on December 30, 2024December 30, 2024 It is a debate that has confounded investors in capital markets for the last few decades now. What is the true identity of this market? Is it really the strong and confident marketplace reflected by the S&P 500 streaking boldly to new all-time highs as 2024 draws to a close? Or has the mirage of endless stimulus obscured a vulnerable and troubled marketplace that could suddenly careen to the downside once these policy supports are finally stripped away? Investors are approaching a latest crossroads in this ongoing debate as we enter the new calendar year at the midpoint of the current decade. What should we reasonably expect going forward. “Dissatisfaction is a symptom of ambition. It’s the coal that fuels the fire.” – Trudy Campbell, Mad Men Economy. The “wall of worry”. Investors are forever confronted with the challenge of climbing it when allocating capital in the public marketplace. And boldly climb it they have over the last two years. After the Federal Reserve raised interest rates at a breakneck pace starting in 2022 to combat the worst inflation outbreak in more than four decades, it was all but a forgone conclusion that the U.S. economy was going to tumble into recession. But 2023 came and went (with a banking crisis along the way, no less), and no recession came. Then 2024 steamed past with recession worries increasingly on the fade. Thus, the economy is as strong as ever as we enter 2025, with Q4 GDP projected to come in robustly north of 3% according to Atlanta Fed GDPNow estimates. “People will show you who they are, but we ignore it because we want them to be who we want them to be” – Don Draper, Mad Men Despite this polished U.S. economic veneer that has market participants increasingly dismissing what seemingly has become the “sky is falling” worries of a recession that is always looming on the horizon but never seems to come, a variety of troubling indicators continue to hang over this economy that should not be ignored as we make our way through 2025. For example, consider the US ISM Manufacturing PMI, which historically has a high correlation not only with overall economic activity but also movements over time in the U.S. stock market. This has been consistently signaling a contraction in manufacturing activity since 2022 with a reading stubbornly below 50. Yet the headline U.S. economy that everyone sees continues to expand. Building on this point is trends in Industrial Production, which has been steadily grinding lower on a year-over-year basis for nearly two years now. While we have not definitively lurched into negative territory on this reading, past instances of decline have been accompanied by periods of economic and market difficulty. Then there is the copper-to-gold ratio, which has long been a bellwether for the health of the global economy. Whenever this ratio has steadily declined in the past, economic and market turbulence has almost always followed. In the current cycle, this reading has been persistently declining since the start of 2022, suggesting that investors are increasingly allocating away from expected economic growth and toward hedging and protection. The economy and capital markets have made an impressive practice of defying past precedence in recent years, and perhaps the U.S. economy will do so once again despite these readings among many suggesting fundamental weakness persisting underneath the surface. But what developments could converge in 2025 to push this economy over the edge? “That’s life. One minute you’re on top of the world, the next minute some secretary’s running you over with a lawn mower.” – Joan Harris, Mad Men Bonds. Investors have had good reasons to be fans of the bond market for decades. After peaking in 1981 following the brutal inflation/stagflation from the late 1960s to the early 1980s, the bond market entered into one of the greatest bull runs of all time (S&P 500, eat your heart out!). For more than four decades, the benchmark 10-Year U.S. Treasury yield steadily declined from a high of nearly 16% (!!) in 1981 to a low well below 1% during the depths of the COVID crisis. But all good things come to an end, and the bull market in U.S. bonds is no exception. For starting in 2022, the 10-Year U.S. Treasury yield broke out definitively to the upside (as bond yields rise, bond prices fall) and are showing no signs of turning back lower any time soon. We interrupt this market outlook for an important aside. If someone is a stock investor, why in the world should they care about what’s happening in the bond market? They should care bigly, in fact. Why? Because the bond market sets a variety of variables that determine stock prices and the underlying fundamental performance of the companies that underlie these stocks. For example, bond yields help determine the valuation that investors are willing to pay for stocks (if the 10-year Treasury yield is high, I may be less inclined to take on the additional risk of owning stocks, particularly if stock valuations are expensive). Bond yields also play a big role in setting the interest rate that companies have to pay to borrow money to finance capital expenditures and fixed investment to grow their business. In short, the higher bond yields go, the more tempered our expectations for the stock market should be. Back to our regularly scheduled market outlook. Recent developments in the bond market suggest potentially more difficult times ahead as we enter 2025. Not only is the long-term bond bull market over, but the downtrend in bond yields dating back to the fourth quarter in 2023 has also been broken to the upside in recent weeks in December. This move is not without fundamental justification. Not only is the Federal Reserve gradually stepping back from promises to lower interest rates much further in the coming year, but lingering concerns over a potential economic slowdown are now being overshadowed by the anticipated cumulative inflationary impact from increased fiscal spending and nationalist shifts toward tariffs and reduced immigration. In short, risks for bond have meaningfully tilted toward the upside in yields and thus the downside in prices. This has important implications for the bond market in the year ahead. Not only does this imply downside risk for U.S. Treasuries, but perhaps even greater uncertainty for the various spread product that populate the broader bond market. Consider investment grade corporate bonds, which are now trading at their tightest spreads relative to comparably dated U.S. Treasuries since before the start of the new millennium. Today, you’re only getting paid one additional percentage point for taking on the added liquidity and default risk of owning a BBB-rated bond versus a AAA-rated U.S. Treasury backed by the full faith and credit of the U.S. government, where historically you would get paid a whole lot more. Same goes for the high yield corporate bond market, which is only paying investors an additional 2.5% for taking on the risk of owning a companies that have a measurable chance of actually going bankrupt over time. Only right before the onset of the financial crisis in 2007 (dubious company to be certain) were high yield spreads tighter. Put simply, investors today are not being well compensated for taking on the added risk of owning bonds outside of U.S. Treasuries at a time when Treasury yields are starting to once again streak to the upside. This implies a potential double whammy for corporate bonds with not only yields rising but spreads relative to Treasuries widening, particularly if the economy indeed starts to slow in 2025. Looking ahead to 2025, base case expectations is for further yield curve steepening. Although the curve has already steepened meaningful on a 2/10 basis (10-Year U.S. Treasury yield minus 2-Year U.S. Treasury yield) among many others, we may have only scratched the surface so far from a historical perspective with another 250 basis points potentially to bring today’s markets back to recent peaks over the past quarter century. And if we see such steepening actually play out over the next two years, its very possible that the rise may be less focused on the short end of the curve falling in yields and more concentrated in the long end of the curve rising in yields. So what then is a bond investor to consider doing to navigate what is setting up to be a potentially challenging year in the bond market in 2025 (and perhaps into 2026)? Stay nimble with spread product, focus on the Treasury market, and shorten overall duration to protect against price risk and collect potentially higher yields at the shorter end of the curve if inflationary pressures indeed reignite. As mentioned above, this bearish outlook for bonds also has important spillover implications for stocks. “Young men love risk because they can’t imagine the consequences.” – Bert Cooper, Mad Men Stocks. A generation of investors have been conditioned to a simple premise. “Stock prices always go higher”. “Buy any and all dips”. “Lather, rinse, repeat”. And with an S&P 500 that has skyrocketed from 667 in early 2009 to over 6000 as 2024 draws to a close, it’s easy to understand why any stock investor under the age of 40 feels vindicated by this relentlessly aggressive and to date rewarding pursuit, particularly given the recent steady ascent since late 2022. But there was a time when stocks actually journeyed in a direction other than up for an extended period of time. And with the bond bull market that helped foster this environment for so many years now definitively over at a time when economic growth may be softening, investors may find themselves becoming reacquainted if not introduced for the first time to the less forgiving side of the risk sword in the coming years. In the short-term, the broader stock market outlook remains strong. Investors are hopped up on the promise of pro-growth fiscal policies and deregulation coming from the new leadership in Washington DC, and this optimism has the potential to carry investors well into the New Year. But if economic growth does start to weaken and/or bond yields start to meaningfully rise, it will almost certainly have a deteriorating impact on corporate earnings. And this would matter immensely for stock prices. Stocks are highly correlated with underlying corporate earnings. If earnings are rising, so too are stock prices more often than not. Conversely, if corporate earnings growth turns south, stock prices typically fall. And a U.S. economy descending into recession and/or higher borrowing costs are primary factors that would cause corporate earnings to shrink instead of expand. Even if corporate earnings continue to expand, stocks are still grappling with a fundamental problem that is a byproduct of their recent resounding success. The S&P 500 today is trading at 27 times operating earnings and 30 times GAAP earnings. These are historically VERY expensive multiples that have only been reached once or twice in the past if ever. This is reflected in the gap that now exists in the relationship between the S&P 500 and underlying corporate earnings in the chart above. The S&P 500 could fall by more than 1000 points, and it would be doing nothing more than coming back into line with the price implied by underlying corporate earnings. And this is without a recession or rise in bond yields. Yikes! “If you don’t like what’s being said, change the conversation.” – Don Draper, Mad Men Of course, it is always important to remember that the U.S. stock market is a market of stocks. Just because the S&P 500 may be out over its skis right now does not mean that all of the stocks that make up the S&P 500 or the other stocks in the mid-cap S&P 400, small cap S&P 600, developed international MSCI EAFE, or emerging market MSCI Emerging Market indices are in a similar state. And if it has indeed been the case that an exceptionally small number of stocks (Magnificent Seven, Fab Four, etc.) have been primarily responsible for driving the stock market higher these last couple of years, it is equally important to remember going forward that a vast majority of the 493 stocks that make up the S&P 500 along with those beyond the index may have a lot of room to catch up to the upside even if the headline index is falling to the downside. But why anything other than the mega caps heading into 2025? Why now? Because the underlying macro environment is changing. This is not to say that the very largest companies in the stock market cannot continue to perform going forward. They are the undisputed kings until they are not. But here’s the thing – they are massive, global growth stocks collectively trading at a forward P/E of more than 31 times earnings (my fingertips just blistered as I typed – these are scorching hot valuations, particularly in a market where the 10-year U.S. Treasury yield is threatening 5% – negative 2% equity risk premium anyone?). But a macro environment of higher fiscal deficits, potentially higher inflation, a steepening yield curve, a stronger dollar, increasing protectionism, and retaliatory trade policies resulting from higher tariffs are not the stuff for massive, global growth stocks trading at beyond historically high valuations, particularly those whose customers may not be coming back for even more AI spend after having already backed up the truck over the last 18 months but are not yet reaping the profits for their capital expenditures in an economy that may be on the fade. In fact, it is quite the exact opposite. Who then benefits on net in such an environment? Value over growth stocks. Domestically focused cyclical mid-caps and small caps (and many S&P 493ers) over multinationals. Energy and materials over technology (energy and technology spend extended periods trading the top and bottom spots of the sector table over time). Deeply discounted consumer staples including food and health care including pharmaceuticals. Bread and butter domestic commercial banks, particularly in an environment where regulatory pressures are likely to be meaningfully eased. In short, a good portion of the rest of the stock market outside of TMT (technology, media, and telecom) for you old school tech bubble fans out there. Many of these segments performed exceedingly well during the 2022 bear market, and this may have been a foreshadowing of what could come through the remainder of the decade in fits and starts if the macroeconomic environment continues to unfold accordingly. Let’s take this one step further down the road. If the U.S. dollar does indeed strengthen meaningfully as would be expected under such a scenario, this would create a potentially considerable tailwind for long overdue developed international and selected emerging market stocks to finally start to catch up on a deeply discounted relative valuation basis once the U.S. dollar inevitably starts to mean revert. “You’re painting a masterpiece, make sure to hide the brushstrokes.” – Betty Draper, Mad Men The bottom line. When it comes to investing in capital markets, the key to painting a masterpiece with your portfolio is proper asset allocation. No investor will ever get every call or decision right when it comes to allocating their capital, thus the beauty of a well constructed and diversified long-term portfolio strategy. For even if any seemingly strong and polished segment of the market is revealed to be actually troubled and weak, the many other uncorrelated segments of the asset allocation that are all being strategically managed along the way can provide the support and resilience to provide more consistently returns with less risk across all market environments. The most ideal asset allocation strategy is one that is prepared in advance to withstand a variety of market outcomes both good and bad over time. Maintaining this discipline over time is a key to long-term investment success. Overall, the market outlook for 2025 is one that is filled with strength and optimism but is not without vulnerabilities and risks. It will be as important as ever in the year ahead to resist complacency, for the potential exists that the opportunity set could change meaningfully from what we have come to know in recent years. Stay broadly diversified and prepared to adjust depending on how market conditions unfold. I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article. Investment advice offered through Great Valley Advisor Group (GVA), a Registered Investment Advisor. I am solely an investment advisor representative of Great Valley Advisor Group, and not affiliated with LPL Financial. Any opinions or views expressed by me are not those of LPL Financial. This is not intended to be used as tax or legal advice. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. Please consult a tax or legal professional for specific information and advice. Compliance Tracking #: 675652