Review of 2024 – Confirmations and Surprises
Market returns for 2024 were exceptional and beyond almost every analyst’s expectation. While many on Wall Street were still calling for recession and a significant correction in the S&P 500, the market continued to advance throughout the year. Barring a few minor pullbacks (namely the one in August, which we recognized as quite silly), equity markets moved up and to the right with minimal volatility. US corporate exceptionalism shone in 2024; earnings growth continued to improve off the back of healthy capital expenditures and a robust consumer that never became tapped out on spending. This was a great year for those participating in the market, and we remain bullish heading into 2025. In this edition of our annual outlook, we will cover:
- Confirmations and Surprises from 2024
- Market Valuation – Are Stocks Expensive?
- The Federal Reserve’s Continual Market Influence
- Trump 2.0 – Equity Market Friend or Foe?
- Cryptocurrency Capitulation
- Sector Selections for 2025
Confirmations and Surprises from Our 2024 Outlook
We reviewed our 2024 Outlook to assess what we got right and where we were surprised in our forecast. 2024 unfolded mostly as expected, but there were certainly a few unexpected outcomes.
Confirmations
The Fed Cut Interest Rates by 1% – Heading into this year, we expected the Fed to conduct 4 or 5 0.25% cuts. We expected inflation to moderate sufficiently to command a respectable number of cuts and for the labor market to hold up well enough to avoid excessive cutting. These both turned out to be true and left the market in a rate-cutting sweet spot. Macroeconomic data remains “Goldilocks” (not too hot, not too cold), which bodes well for Fed action in the coming year.
The U.S. Avoided Recession – Many analysts at the beginning of the year were still calling for a recession. We viewed a strong labor market, resilient corporations, growing earnings, and sustainable megatrends like A.I. as reasons for a soft landing for the economy. Economic factors held up, and we were able to avoid recession. We still do not anticipate a recession in 2025.
Artificial Intelligence had Staying Power – As 2024 began, Wall Street debated whether A.I. was fad or fact. We believed the tech had staying power and remained invested in the picks and shovels of this megatrend. One would be hard-pressed to find an analyst who thinks the A.I. movement is simply ephemeral at this point, and we anticipate it carrying on in 2025.
Surprises
Market Returns Exceeded Our Expectations – You will never hear us complain about outsized market returns, but we were certainly impressed by the magnitude of gains in 2024. While we expected double-digit equity market returns for 2024, we would have been bold to suggest a 20%+ S&P 500 return, given the economic questions still lingering at the turn of the calendar year.
Market Breadth Remained Fairly Narrow – After 2023’s market rally was driven almost exclusively by the Magnificent 7 stocks, we expected a 2024 rally to broaden significantly into small and mid-caps (SMid caps). 2024 demonstrated slightly more diverse returns, but the largest stocks in the U.S. market still drove the bulk of market action. We believe a broadening of returns is likely in 2025, and SMid cap stocks will finally have their time in the spotlight.
Market Valuation – Are Stocks Expensive?
As the S&P soared to nearly 60 all-time highs in 2024, much discussion revolved around the major indices’ valuations. Exiting 2024 with a price-to-earnings ratio (P/E) of about 22x, the S&P 500’s valuation is above many longer-term averages, such as the 25-year average P/E of 16x and the 10-year average of about 18x.
***Listen to our Podcast on Market Valuations***
For context, we’re referring to the “forward P/E,” which is a stock or index’s ratio of price divided by its next twelve months’ expected earnings. This ratio reflects how expensive $1 of earnings is to buy. At the current ~22 P/E, an investor is paying $22 for each dollar of earnings the S&P is expected to deliver in 2025. It is important to note that there are many ways to value a company or index, and while P/E is widely used, it doesn’t contemplate many inputs that may impact a company’s valuation, such as the rate of earnings growth.
Because the S&P currently trades at a premium to historical levels, there are some concerns, but also some reasons this may be justified:
Concerns:
- High P/E’s can indicate “expensive” markets – just like any purchase, one would prefer to buy an asset when it is on sale (all else equal). If we are considering the same stocks and the same earnings, buying at a lower P/E is preferable.
- Stock Market returns are primarily a function of earnings growth (or expectations of future growth) and P/E expansion; when the P/E is elevated, it can hamper future returns due to low or negative multiple expansion.
Justifications
- Composition – Mega-cap technology companies, such as Nvidia, currently dominate the S&P 500. These fast-growing companies trade at higher P/Es and, therefore, increase the index average P/E. As an example, Nvidia exited the year at a 34 P/E, which is justified by the incredible growth rate of earnings we’ve observed over the past two years and the future expectations of growth. Looking back 25 years ago, the S&P was dominated by Financials and Utilities, which are slower growing and trade at a lower P/E.
- The S&P500, excluding the Magnificent 7, is much more in line with historical valuations.
- Earnings Growth – The future growth expectations for the S&P 500 are strong, with many projections in the low-to-mid teens.
There are many moving parts in the S&P and its valuation; however, the story gets much clearer on an individual investment level. There are many overly-expensive companies in the S&P, which is why (as we’ll talk about next) we’re excited for 2025 to be a stock-picker’s environment. While we’re not overly concerned about the market’s valuation as a whole, we remain focused on individual companies, where it is easier to assess relative value.
2025 – the year for stock picking?
As mentioned above, we’re optimistic that 2025 will be a prime year for selecting individual companies.
2023 was a famously poor environment for stock-picking, as the Magnificent 7 stocks were responsible for nearly all of the market’s return. In 2023, the Mag7 average return was 111% versus the S&P 500 return of 26%. Excluding the Magnificent 7, the S&P was up only 8%. This lack of breadth led to one of the most difficult years for active management in recent history. Bonds faced a lackluster year in 2023, only producing positive returns thanks to the final two months of the year.
2024 saw considerably more market breadth, although mega-cap stocks and AI-linked companies saw most of the gains. The Magnificent 7 once again outperformed, returning an average of 65% during the year. This constituted nearly 60% of the S&P’s gain for the year. Notably, while equities rallied, bonds still faced pressure throughout the year as yields climbed.
In 2025, we’re expecting the AI megatrend to continue, however with more market breadth than in previous years. There is more concern about the US’ ability to produce enough electricity to keep up with the demand of AI data centers, driving investment dollars into utilities, energy, and supporting industries. Outside of AI, inflation is back to typical levels, with a strong job market and healed supply chains, leading to more normal levels of consumer spending and business reinvestment. Looking to bonds: the market is currently only expecting 1-2 rate cuts for 2025, which will likely keep long rates elevated and do little to appreciate those assets.
The Federal Reserve and the Ongoing Inflation Fight
For the past few years, the markets have been broadly Fed-driven, something that is expected to change in 2025. The Fed has largely directed the market since raising rates throughout 2022 and into mid-2023. 2024 was a year spent waiting for interest rate cuts that were all but guaranteed (a “when” not “if” story). It wasn’t until September that the Fed finally cut. Now, 100bps (1%) of Fed cuts later, 2025 is projected to be a relatively ‘normal’ year, with only two 25bps cuts forecast in the Fed’s December “Summary of Economic Projections” or SEP. Given lower (but still restrictive) rates and minimal adjustments, the markets can begin to focus on company-specific data once again.
As of the November CPI report, core CPI inflation was back to 3.3%, or half of what it was at its peak in September of 2022. While 3.3% inflation is well above the Fed’s 2% target, it isn’t much above typical inflation for the US and is low enough to promote a strong economy. Jerome Powell and the Fed have signaled that inflation is close enough to target that they’re happy keeping rates fairly stable and somewhat restrictive, to help bring inflation back to target over time. The Fed is now projecting to have inflation back at 2% by 2027, one year later than previously forecast.
In 2025, there is still likely to be some market anxiety surrounding fed actions; however, short of a black-swan event triggering significant rate cuts, we expect this to be relatively sparse, given the one or two rate cuts forecast. Unlike previous years, this anxiety will be short-lived around a few FOMC meetings.
A New Administration – Tariffs, Deregulation, and DOGE
The dawn of a new political administration always brings fresh uncertainty when it comes to financial markets, and the Trump administration is no different. We have somewhat of a playbook when it comes to Trump and his administration’s impact on markets following his first term, but this round will certainly be different from the last. In particular, fiscal spending issues have come to the forefront of investors’ minds, considering the national debt has ballooned since Covid, and no recent president has made a concerted effort to balance the federal budget. After all, spending cuts don’t typically win votes, but the Trump administration promises to create significant efficiency through fat-trimming at the Federal level. There are a few significant policy areas we are tuned into as the incoming administration takes office.
Tariffs – How Big and How Broad?
Tariff implementation may be the biggest policy uncertainty financial markets will face over the next four years. For the most part, tariffs may be enacted without the involvement of Congress, so it is essentially up to the President and his advisors to decide how significant tariffs will be. Trump has floated the idea of 60% tariffs on imports from China and 10-20% tariffs on all other imports. We believe his administration will be more targeted; however, opting to limit tariffs to goods that will strategically benefit US businesses or provide negotiating leverage as trade deals are redesigned. It certainly makes more sense to place tariffs on goods we already produce, thereby promoting domestic businesses, rather than placing blanket tariffs, which will only hurt purchasing companies and consumers who have to look internationally for certain goods. We view this as the more likely scenario. Many economists have attempted to put an economic price on potential tariffs, but we won’t play these hypothetical games until there is more clarity around the admin’s tariff agenda. What we do know is which sectors are most impacted by tariffs so we can invest accordingly. Consumer discretionary companies source the most goods internationally and from China, so their margins are most likely to be impacted. Some materials and industrial companies that source products from overseas may also be impacted. On the other hand, energy, financial services, real estate, utilities, and software sectors remain relatively immune from tariffs. The tariff situation will evolve over the next few years, and we’ll be attentive to how it may impact our investments.
Deregulation and Tax Cutting
One of the greatest promises of the Trump campaign for corporate America is that of deregulation. By removing impediments to business, the administration hopes to spur economic activity. This will be particularly impactful when it comes to dealmaking. In recent years, we have seen substantial business interference by the Free Trade Commission (FTC) and Department of Justice (DOJ). Many companies have had mergers derailed by these agencies which have led to adverse situations for the companies, their workers, and the end consumer. A few of these blocked mergers include Kroger/Albertsons, Spirit Airlines/Frontier, Tapestry/Capri, and Amgen/Horizon Therapeutics. The new administration aims to remove barriers to mergers & acquisitions (M&A) and facilitate deal-making in corporate America. A less stringent FTC/DOJ and clarified bank regulations will help financial sector companies that are reliant on M&A, initial public offerings (IPOs), and lending.
In addition to the financial sector, we expect a significant easing of regulatory interference in the energy sector. Trump has expressed the desire to drill and increase American petroleum production, so we anticipate action early in the administration to remove roadblocks to drilling permits, pipeline construction, and liquid natural gas (LNG) infrastructure projects.
Tax policy is also in the spotlight for this administration. We expect the Tax Cuts and Jobs Act (TCJA) enacted under Trump’s first administration to be extended, along with a few tweaks. This legislation was originally set to expire at the end of 2025. Additional tax policy adjustments are likely to include a reduction in the corporate tax rate to 19% or less, exemption of tax on tips, exemption of tax on overtime pay, and exemption of tax on Social Security benefits.
Much of the deregulatory and tax-cutting agenda of the Trump administration will depend on legislation passed by Congress. Due to the thin majority Republicans have over Democrats in the House and Senate, it remains to be seen if bills can pass without some bipartisan support.
The Department of Government Efficiency (DOGE)
The Department of Government Efficiency (DOGE) is certainly one of the new Trump administration’s more obscure yet intriguing aspects. If the administration can cut excess spending and reduce the deficit, we are likely to see lower treasury yields and higher equity markets. Still, the question remains of how much cost-cutting is possible in the behemoth of a bureaucracy that is the federal government. We don’t believe DOGE will impact individual sectors or stocks too substantially, but it will certainly impact investor sentiment. Investors and credit agencies recognize our current spending as unsustainable, so to reaffirm the U.S. dollar as the global reserve currency, spending cuts such as those that DOGE is pursuing should be a good thing.
Crypto Capitulation
In addition to the policy agenda items outlined above, the Trump administration has cryptocurrency markets excited for an overhaul of regulation in the United States. Despite crypto’s growing popularity and market cap, there are still no clear regulatory guidelines for these digital assets, their trading, or their development in the United States. This has resulted in blockchain application development overseas, predominantly in European countries. The Trump administration desires to harness this technology within the United States and has taken a crypto-friendly approach. The result has been an explosion of cryptocurrency valuation, particularly for Bitcoin. Bitcoin price increased by 37.5%, and Ethereum has increased by 39% from election day to the new year. After the institution of spot Bitcoin and spot Ethereum ETFs, there is now a simple way for traditional public market investors to tap into this budding technology. Regulatory clarity remains to be seen for the crypto industry, but investors are already allocating to crypto ETFs in mass. Bitcoin ETFs now hold over $100 Billion, and Ethereum ETFs hold over $10 Billion. We believe holding a modest position in cryptocurrencies like Bitcoin and Ether will provide value as a diversifier and return generator as the industry matures in its domestic presence.
Sectors in 2025
We feel positive about the broad market heading into 2025, but as active allocators, we have particular sectors and industries we are even more excited about. We believe 2025 will be a great year for active stock picking, and the following are a few of the key areas we are watching for outsized returns.
Technology and Artificial Intelligence
The last two years have been positive for AI companies, but we believe there is more room to run if we look in the right places. Our strategy thus far has been fruitful, as we have allocated to the “picks and shovels” of the AI industry – computation semiconductor chips, power systems, cooling, and electricity generation. We believe these have more room to run, but we are becoming more interested in software applications that utilize AI tech. Thus far in the AI cycle, software companies have mostly been writing checks to develop the infrastructure supporting their AI applications. Now, more and more of these companies are commercializing and capitalizing on their AI software programs. We believe it is still early in the AI software cycle, as many companies are just now marketing their applications. We are beginning to allocate to AI software companies that support business analytics, autonomous driving, voice AI, and robotics. The first phase of profitability and earnings growth for the AI megatrend was relatively limited to hardware, but we believe that in the next few years, both hardware and software companies will see AI-driven earnings growth.
Financials
We believe 2025 will be very positive for financial sector companies. After a lackluster 2022 and 2023, financial companies have shown promise in 2024 off the back of market optimism for lower interest rates, deregulation, and increased dealmaking going forward. We believe these last two factors will drive companies in investment banking, private equity, and trading to higher levels over the next year. The financial sector has been significantly burdened by onerous government intervention over recent years and is desperate for some regulatory clarity. As mentioned above, a new FTC/DOJ should give companies more confidence to conduct mergers and acquisitions, and clarified banking regulations are likely to facilitate more lending on a more profitable basis.
***Listen to our Podcast Covering the Financial Sector in Depth***
Utilities and Electricity Generation
We have mentioned this before as it relates to the AI megatrend we are following, but we remain very positive on the outlook for electricity generation and electricity infrastructure over the coming years. Vertiv, one of the companies at the forefront of data center infrastructure, expects 100 gigawatts (GW) of additional power to be installed for AI over the next five years. In perspective, just 1 GW of power can power about 750,000 homes. Clearly, to install 100 additional GW of power in just 5 years, a massive effort to improve our electricity generation capabilities will be necessary. Utilities have a tall task ahead to keep up with demand, but profits will soar for companies who can satisfy this demand. We are currently allocated and will continue allocating to electricity generation and electric grid infrastructure companies building their installation base. While these companies saw strong returns in 2024, we expect this trend to continue for years.
*** Listen to Our Electricity Generation Podcast***
Other areas of interest – Energy and Healthcare
A few other areas of interest include pockets of energy and healthcare. For energy, we expect pro-drilling policy to result in a greater oil supply over the next few years. While this may have mixed results for upstream drilling companies, we expect midstream oil pipelines to see higher transmission volumes, resulting in higher profits. Additionally, we expect a resurgence in liquified natural gas (LNG) shipping activity, which will benefit LNG export companies and the shippers delivering LNG to import terminals.
Another megatrend we are following is developing in the healthcare space. The U.S. population is aging, and as baby boomers move further into their retirement years, the need for medical care continues to rise. Medical devices, managed care, hospitals, and senior living companies are some areas of the market poised to benefit from this shift. We are wary of pharmaceuticals, given potential government intervention from the next administration, but we believe there remains a large market opportunity for GLP-1 weight loss drugs.
Conclusion
2023 and 2024 witnessed excellent market returns, but heading into this new year, we don’t think the party has stopped yet. While we expect more modest returns in 2025, we believe that it will be a positive environment for equities, fixed income, and alternatives based on the details outlined above. Most importantly, we believe 2025 will be a year for individual asset selection, and we feel well-positioned to take advantage of megatrends prevalent in the market through our sector rotation and stock selection strategy. While there will undoubtedly be market hiccups and pullbacks along the way, we are excited for what should be another good year as investors. We wish you and your family the best in this new year and are excited to continue this investing journey with you!