Jan 22, 2025 2024 4th Quarter Investment Commentary
- A post-election rally helped the S&P 500 gain 2.4% in the quarter and over 25% on the year. US growth companies continued to lead stocks while other sectors trailed.
- The US economy remained healthy on the backs of a strong consumer and profitable corporate sector, but there were signs of a downshift to a lower growth rate.
Market and Economic Summary
Despite a 2.4% dip in December, U.S. large-cap stocks (S&P 500 TR Index) posted its fifth straight quarterly gain, which lifted the index’s year-to-date return to 25%. The S&P 500 returned back-to-back 20% gains for the fifth time since 1928 while logging 57 record highs during the year. Solid economic growth, falling inflation, Federal Reserve interest-rate cuts, and strong corporate profits all helped stock prices. The boom in artificial intelligence led to strong gains for US large-cap growth stocks. Most major asset classes posted positive returns in the year, but they all, except for gold, underperformed the S&P 500.
The fourth quarter hit non-US stocks and bonds particularly hard due to policy uncertainty around tariffs and upside risks to inflation. For the full year, only three sectors outperformed the S&P 500 (Discretionary, Communication, and Financials), and most asset classes significantly trailed US large-cap stocks for the second year in a row. As an example, the equal-weighted S&P 500 trailed the market-capitalization-weighted S&P 500 by over 10% for the second straight year (1).
The fourth quarter proved difficult for bond investors. While the Fed cut short-term rates, longer-term rates rose due to higher economic growth expectations, a Republican sweep in the elections, and higher inflation expectations. Bonds with shorter maturities and higher credit risk performed the best in the fourth quarter and for the whole year.
The economic foundation remained in good shape. Corporate profits were expected to continue rising with the help of deregulation and lower tax policies, inflation was coming down (albeit at a slow pace), and the Federal Reserve projected further interest rate cuts. In addition, technological breakthroughs in artificial intelligence could result in meaningful labor productivity.
But risks remained. The U.S. economy’s momentum appeared to be downshifting to a more normal pace. While this alone is unlikely to trigger a recession, it does leave the economy more vulnerable to shocks. Potential shocks include lingering inflation pressures, rising interest rates, and a highly uncertain policy environment that could affect trade, tariffs, and fiscal policy. Additionally, after back-to-back years of strong performance, a lot of good news was priced into the S&P 500 leaving little room for positive surprises. Below is a summary of benchmark returns. (2)
Markets
After a strong upward move post-election, the S&P 500 Total Return Index was down -2.4% in December as the US dollar rose and long-term yields moved higher. Investors digested potential policy changes under the incoming Trump administration including taxes, tariffs, immigration, and deregulation.
Despite the decline, most asset classes gained during the year. U.S. growth stocks, seen as the main beneficiaries of artificial intelligence, continued to lead stocks higher. The so-called Magnificent Seven (3), now comprising more than a third of the S&P 500 index, averaged more than a 60% gain for the year, while the average stock in the S&P 500 rose a more modest 13%. Smaller companies and value stocks performed well but continued their multi-year underperformance. Non-US stocks, negatively impacted by a strong post-election US dollar rally, finished the year in modest positive territory.
Price momentum and trend measures remained supportive of equities. In addition, earnings growth was positive, defensive sectors were not leading (a good sign), economic sentiment was improving, recession odds were low, and corporate spreads were low relative to Treasuries. All of these are good signs of continued equity strength, but a major risk was high valuations.
The S&P 500 returned more than 18% in five of the last six years, except for 2022 when it was down 18%. Over the past five years (2020-2024), we pretty much went through an entire market cycle: a recessionary bear market followed by a quick recovery, a non-recessionary bear market with the Fed hiking rates from 0% to over 5%, and another recovery to new all-time highs with the Fed lowering rates.
Over that time, the S&P 500 returned 97%. Returns over that period were primarily driven by a strong corporate sector and a strong economy. The chart separates the S&P 500’s total return into contributions from, 1) earnings growth, 2) valuation change, and 3) dividends (4). We can further separate the earnings growth component into two pieces: sales growth and margin expansion. Sales rose thanks to strong nominal GDP growth (~ 4.5 – 5%), and margins also expanded. Notably, nearly all the earnings were from the largest companies. Earnings of the Magnificent 7 companies grew by 31% in 2023 and 36% in 2024, while earnings for the rest of the S&P 500 contracted by 4% in 2023 then grew by just 3% last year.
What makes the last two years different is that valuation growth, not earnings growth, drove the bulk of the gains. This left valuations near record highs on the S&P 500. In addition, household equity allocations were high, Wall Street strategists increased their price targets dramatically from last year, and many investors were shunning diversification for concentration in recent winning stocks. History shows that a strong bullish consensus and high valuations may be a recipe for increased volatility in 2025. High valuations aren’t necessarily a harbinger of bad things to come, but they do fatten the downside tail if risks arise. At the same time, a strong equity upside case is harder to make. Though this was also largely true in 2024, and the S&P 500 gained 25%.
Meanwhile, bonds had a positive but volatile year as the Fed continued to battle sticky inflation. Following the Fed’s first rate cut in four years, long-term interest rates rose due to continued strong economic growth and fears of resurgent inflation. The orange line shows the Fed Funds rate, and the blue line shows 10-year Treasury yields. Just as the Fed started cutting, long-term yields rose, a very unusual occurrence.
Historically, when the Fed lowered interest rates, long-term interest rates also moved lower. On average, 1% of interest cuts reduced the 10-year Treasury by .5%. We saw the exact opposite over the last three months, with short-term rates falling 1% and 10-year rates rising nearly 1%. Rising yields aren’t necessarily a bad thing as they signal higher nominal economic growth expectations. The risk is that higher long-term yields can also signal higher inflation expectations. By the end of the year, markets were pricing in only two more rate cuts in 2025. The good news is that higher yields can now be earned on an inflation-adjusted basis. Real (inflation-adjusted) yields were at their highest level since 2015.
Economy
Overall, the U.S. economy remained in good shape. The US consumer was healthy, with solid income growth, low debt burdens, and strong balance sheets. Corporations were also extremely healthy. A deregulatory push from the incoming Trump administration spurred CEO confidence and small business optimism and may give the economy an additional burst. The labor market was solid, with the unemployment rate still historically low and Americans, on average, bringing home paychecks that were growing faster than inflation. In addition, leading economic indicators rose for the first time since February 2022, no longer signaling a recession (5).
A few warning signs kept us alert to the possibility of an economic slowdown. Weakening employment numbers, low industrial production growth, higher long-term yields, and an inverted yield curve were flashing cautionary signs. The decrease in housing construction in the second half of 2024 was particularly notable. None of these indicators suggested a recession ahead, but what they could add up to is a slow weakening of the U.S. expansion.
For example, the yield curve has a strong track record of predicting a recession. Since 1960, the spread between the 3-month and 10-year Treasury yield has inverted before every U.S. recession, making it one of the most reliable indicators of economic downturns (6). There has only been one instance where this spread inverted and a recession did not follow (1966). Normally, longer-term yields are higher than short-term yields, but for the past 25 months, short-term yields were higher than long-term yields, inverting the normally upward-sloping curve. In December, it un-inverted, but this isn’t an all-clear sign. The last four cycles saw the curve un-invert on average six months prior to a recession.
The year ahead also carries new uncertainties from the incoming Trump administration. The administration plans to change policies on several fronts that may impact the consumer, global trade, inflation, and economic growth. These include tariffs, immigration, the extension of the 2017 Tax Cuts and Jobs Act (TCJA), deregulation, and the budget deficit—to name a few. The potential list of reforms is large, and all the various effects are impossible to know. This creates a wider distribution of possible outcomes for the economy.
Many of the reforms outlined by the new administration have the potential to spur higher economic growth – for instance, reduced regulations and incentives for small businesses and low-wage workers. Additional tax cuts could also lift business profitability. But other proposed policies—such as reshoring initiatives, tariffs and restrictions on low-cost immigrant labor—carry risks. These policies may disrupt supply chains, elevate production costs, and embed structural inflationary pressures into the economy.
Not all portfolios are identical. We manage accounts with additional complexities not discussed in this update. Some of the statements are forward-looking but do not guarantee future performance. Please reach out to your advisor with any questions.
Footnotes:
- S&P 500 equal weight assigns each of the 500 companies in the index an equal weighting, regardless of market capitalization, meaning large companies like Apple or Microsoft have a significantly small influence the traditional S&P 500
- Morningstar Direct, as of 12/31/2024
- Alphabet (Google), Amazon, Apple, Meta (Facebook), Microsoft, Nvidia and Tesla
- Carson Investment Research as of 12/31/24. Next 12-month data used for earnings and valuations
- Conference Board of Leading Economic Indicators. As of 12/19/24
- JPMorgan, see chart. As of 12/31/24
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