Quarterly Market Letter- Q4 2024

By Bruce Thompson on January 10, 2025

SUMMARY

On behalf of all of us at Lexington Wealth Management, we thank you for your continued trust and confidence. We continue to work tirelessly to earn it every day. We wish you a peaceful, healthy, and prosperous 2025!

We look ahead with a great deal of optimism, but also with what we regard as common sense realism for 2025, given high equity valuations, market concentration, and proposed policies that may produce long-term gain, but also short-term pain.

Reviewing portfolio positioning and risk exposure is a prudent annual exercise. However, experience dictates that reviewing your goals is most effective when done during calm market periods rather than times of significant volatility. With markets experiencing substantial gains in the last couple of years, now is an optimal time to review or refine your portfolio’s objectives.

One tenet of modern portfolio theory is to take only compensated risks. Currently, the small difference between intermediate-term forward equity return expectations relative to the yields available on lower-risk fixed-income investments, as well as opportunities to diversify beyond traditional assets, opens the door for thoughtful conversations about asset allocation with your Lexington advisor.

Before shifting investments around, it is important to remember that a portfolio’s allocation should align with your planning objectives and risk tolerances. Incremental adjustments may be appropriate, but wholesale changes should only follow a shift in those goals and take tax costs into account. 

With the Republican sweep of the White House and Congress, current income and estate tax rates are expected to be extended, meaning clients shouldn’t have to scramble to adjust plans.

Nevertheless, as time goes on, discussed rule changes may warrant fine tuning for some clients. These include indexing capital gains for inflation and increasing the cap on itemized deductions of state and local taxes (SALT), which may be paid for by lowering Alternative Minimum Tax (AMT) thresholds.

Unlocking M&A may also have benevolent ramifications for private equity and debt investments. For qualified investors, these represent additional diversification opportunities to discuss with your advisor.

As we look to the year ahead and beyond, we remain committed to make disciplined, risk appropriate decisions that will help you reach your financial goals.

(For clients who hold employee stock options, we’ve prepared a separate article explaining why this is a good time to review diversification strategies with your advisor. With recent market strength and anticipated financial market deregulation, which could unlock M&A (mergers and acquisitions) and IPO liquidity events, these proposals may provide an opportunity to start the capital gains clock while AMT thresholds are higher. To read the article, click HERE.)

Market Review
“It Was a Very Good… But now the days are short…”

In the mellifluous tenor of Frank Sinatra, 2024 was on the whole a very good year. But as the days grew short, post-election uncertainties began to weigh on markets, particularly bonds, interest-rate sensitive equities, and international stocks. As the below Benchmark Performance table reveals, there were wide variances in asset class returns, which may be helpful to understanding overall portfolio results ahead of reviews with your advisory team.

Lost in the generally positive headlines is the reality that since September interest rates on the benchmark 10-year Treasury Bond climbed almost a full percentage point to end the year at 4.6%. As a result, the Bloomberg Bond Index dropped 3% in Q4, while eking out a 1.25% return for the year, which impacted balanced portfolio returns.

For stocks, the broadly representative MSCI All Country World Index (ACWI) returned 17.5% in 2024. The increasingly less diversified S&P 500 Index (of which just 7 stocks now comprise 35% of the index), returned 25%. Both indexes dropped 2.4% in December. Without those “Mag-7” stocks, the S&P 500 would have returned just 10% in 2024. (JP Morgan, Q1 2025 Guide to the Markets).

The burgeoning game of catch up for the broader equity markets ran into a wall in December, when Value, Mid Cap, and Small cap stocks gave back about a third of their gains for the year.

Q4 saw a sharp decline in international stocks, as measured by the -7.6% drop in MSCI All World Ex-US Index. The decline was driven by rising rates and, by extension, strength in the US dollar, as well as concerns about the potential impact of tariffs on trade and growth.

New Year’s Resolution: Sobriety?
“Bull-markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria.”

As we enter a New Year, you will no doubt be barraged with market forecasts for 2025. Does the Q4 deterioration in bonds and the broader stock market signal a correction to come?

One should always be prepared for that possibility, but the reality is that no one knows the course of the market, certainly not Wall Street firms. They are often off the mark and, looking back over 2024, the performance of the bond and stock markets once again humbled prognosticators.

According to Bloomberg, at this time last year the consensus among top Wall Street analysts was for the S&P 500 Index to end the year at about 4800 for a modest gain. The most bullish forecasters expected the S&P 500 to reach 5,200 for a gain of about 9%. Instead, the S&P 500 closed just shy of 5900, with a total return of 25%.

As we observed last year, analysts expected a recession, which did not occur. In 2024, they continued to be surprised by the economy’s resilience. Afraid of being caught behind the curve, each firm incrementally boosted their S&P 500 targets. They essentially “climbed a wall of worry,” as the old saying goes.

This brings to mind a timeless observation by legendary money manager John Templeton on the relationship between investor emotions and market cycle stages, “Bull-markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria.”

The highest market returns tend to happen when pessimism is widespread and prices are low, as they were in 2022 amid inflation fears. The outlook then was more uncertain, meaning perceived risks were higher, and investors were amply compensated for taking them. In 2024, the market rally gained steam, fed by the gradual capitulation of skeptics.

Where are we today in Templeton’s cycle? Possibly in the “mature on optimism” stage, but one can never be sure, which is exactly the point. Stocks surely could go higher if speculation takes hold and investors throw caution to the wind, like they did in the late 1990s. That could be triggered by optimism around new technologies, anticipated post-election deregulation, and pro-growth fiscal plans.

But, as the actions of Wall Street analysts indicate, bearish sentiment — and caution – is waning on Wall Street, which alone is reason for sober skepticism. Stock valuations are higher – very high by historical standards – and as a result forward fundamental return expectations are lower.

This chart compiled by JP Morgan shows that, since 1999, when valuations have been near today’s levels, the average 1-year return has been just above 0%. And 5-year returns averaged about 5% annually. Not coincidentally, this is about what Fiducient, Lexington’s research consultant, is currently modeling for large-cap US equity returns.

The key takeaway, conveyed by the red line, is that future returns are likely to be lower when prices are higher (and vice versa), which may be counter to how we feel, precisely because of the connection between valuations and confidence.

A more understandable way of looking at the market price/earnings valuation is to calculate it as earnings/price, which provides a simple earnings yield that can be compared to yields available on fixed income and other investments. The current earnings yield for the S&P 500 is 4.65%, on par with the 4.6% yield offered today on lower risk 10-year US Treasury Bonds.

Of course, it is important to understand that earnings are expected to grow and compound over time, which is why stocks have proven to be one of the best hedges against inflation. That’s also why stocks are and should continue to be cornerstone holdings in retirement portfolios.

Stock prices are reflecting a high degree of optimism about the growth outlook, supported by the sheer resilience of the economy over the last few years, especially in the face of large Fed rate hikes. That the economy skirted a recession and continued to grow with plenty of jobs under those monetary conditions is largely unprecedented and, indeed, confidence inspiring.

Absent a major recession or financial crisis event, which doesn’t appear in many crystal balls at this time, the prospects for a shift to a big bear market seem low. Nevertheless, in the short run, it is important to recognize the possibility of a mid-cycle “valuation” correction. Given the modest spread between stock’s earnings and lower risk bond yields, even a modest shift in the outlook could spark an uncomfortable rotation from stocks to bonds.

We’re not telling you anything you don’t already know. The market often follows a “two steps forward and one step backward” pattern. Investing is synonymous with taking risk and there are few, if any, investments that generate sufficient returns without it.

As noted above, US equity valuations have been fueled by the performance of a handful of large-cap companies concentrated at the top of the market. On the negative side, the fortunes of a handful of companies disproportionately influence the broader market, and any adverse developments could lead to significant volatility.

On the positive side, this means that the remainder of the market may provide more reasonable risk/return opportunities. For example, “value” stocks currently have an earnings yield of 6.2%. International stocks also offer diversification value for investors.

The companies in the MSCI All Country all World Ex-US Index are currently priced to offer a 7.6% earnings yield. That’s right at their 20-year valuation averages, while the S&P 500 is trading at a 35% premium to those averages.

Charles Schwab points out that since the recent bull market started on 10/13/22, if you subtract the performance of one single stock – Nvidia — from the S&P 500 Index, the MSCI Europe (EMU) Index has outperformed the S&P!

“May You Live in Interesting Times.”

It is reasonable to anticipate new economic cross currents from policies the incoming administration is expected to pursue. From a high level, how these cross currents work out will depend on whether productivity gains from deregulation and tax policies will be enough to offset the potential inflationary impact from tariffs and immigration policies.

Initially, stocks reacted positively to the election. But the rally evaporated as the bond market fell on concerns that inflation could tip higher at a time when stock valuations are anchored on expectations for moderate inflation and continued Fed easing.

In previous letters, we posited that elections haven’t proven consequential for market returns, which have been roughly similar under either party. However, we also pointed out that returns were significantly lower than average when a single party controlled both branches of government with few checks and balances.

However, this observation is tempered by the razor thin majority Republicans will enjoy in the House, and the reality that deportations, tariffs, and potential retaliations to tariffs would have an outsized negative impact on key industries in red states, meaning support may splinter. A large percentage of employees who are likely unauthorized immigrants work in farming, meat packing, and food industries.

Other countries would no doubt retaliate with tariffs of their own, China among them, which may further restrict sales of computer components and rare earth minerals, affecting many of the influential companies that have boosted the stock market.

At a time when deficits and the interest we must pay on our debts are high, these responses may place additional upward pressure on interest rates. As we remember painfully from past experience, most recently the 2023 bank failures, when interest rates rise something in the economy is apt to break!

“May you live in interesting times,” is a saying attributed either to an old Chinese curse, or to words spoken by British Prime Minister Joseph Chamberlain:

“I think you will all agree that we are living in most interesting times. I myself never remember a time in which our history was so full, in which day by day brought us new objects of interest, and, let me say also, new objects for anxiety.”

We shall see how all this plays out soon enough. Meanwhile, this is a good time to prepare mentally and financially for a period of more volatility, and to review your financial plans and portfolio positioning with your advisor. Even if markets continue north, assessing your risk position is always a prudent exercise.

Lexington Wealth Management is a group comprised of investment professionals registered with Hightower Advisors, LLC, an SEC registered investment adviser. Some investment professionals may also be registered with Hightower Securities, LLC, member FINRA and SIPC. Advisory services are offered through Hightower Advisors, LLC. Securities are offered through Hightower Securities, LLC. This is not an offer to buy or sell securities. No investment process is free of risk, and there is no guarantee that the investment process or the investment opportunities referenced herein will be profitable. Past performance is neither indicative nor a guarantee of future results. The investment opportunities referenced herein may not be suitable for all investors. All data or other information referenced herein is from sources believed to be reliable. Any opinions, news, research, analyses, prices, or other data or information contained in this presentation is provided as general market commentary and does not constitute investment advice. Lexington Wealth Management and Hightower Advisors, LLC or any of its affiliates make no representations or warranties express or implied as to the accuracy or completeness of the information or for statements or errors or omissions, or results obtained from the use of this information. Lexington Wealth Management and Hightower Advisors, LLC assume no liability for any action made or taken in reliance on or relating in any way to this information. The information is provided as of the date referenced in the document. Such data and other information are subject to change without notice. This document was created for informational purposes only; the opinions expressed herein are solely those of the author(s) and do not represent those of Hightower Advisors, LLC, or any of its affiliates. 

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