The Brave Report: market Commentary for Q4 2024

Click here for .pdf version of this report: The Brave Report-2024Q4

There are two certainties in life, death, and the stock market just going up….  We continued to see the markets rally over the 4^th quarter, continuing to be led by the large tech names.  Rates spiked higher, and the markets went up.  We went through a highly polarizing election cycle and markets went higher.  Inflation data came in higher than expected and markets went higher.  Government debt continued to climb, and markets went higher.  Valuations have been called into question and markets went higher.

We are now entering 2025 on the heels of two major up years for the markets.  It is the first time since the late 1990s that we saw back-to-back years of at least 20% gains for the S&P 500. We enter the year with several unknowns.  What will the new administration prioritize and how cooperative will Congress be on this new agenda?  Will the Fed continue to cut rates in the face of stubborn inflation?  When uncertainties are present, I tend to be cautious but as we have learned over the last few years the markets haven’t seemed to care about uncertainty.

Market Overview

The markets finished 2024 with another winning quarter. Although we saw a little weakness into year-end, especially from the Dow industrials, all three major indices ended the year with a winning quarter. The Nasdaq rose 4.7%, the S&P 500 gained a little over 2% and the Dow lagged slightly but still eked out a small gain of about half a percent.  This brings the total gains for the year to 12.9% for the Dow, 23% for the S&P and just shy of 25% for the Nasdaq. This was a very similar return number for the S&P that we saw in 2023 and again we saw a select group of technology names lead the way and account for most of the market’s returns for the year. The Mag 7, which we have discussed in the past, were responsible for more than half of the return of the S&P. While these names continue to perform well, we will need to see some other names join the party if this rally continues into 2025.

The fixed income side saw quite a bit of movement over the fourth quarter.  Even in the face of the Fed cutting rates, the rate on the 10-year treasury rose by over 80 basis points.  Similarly, the rate on the 30-year treasury rose by just over 70 basis points.  Sticky inflation, fear of rising government debt and an adjustment in the outlook for Fed action in 2025 all put upward pressure on rates, especially at the long end of the curve.

The markets have been on quite a run for a little over two years. After bottoming in October 2022, we have seen the markets scream higher. While we have seen a few short-lived pullbacks over that time, all of the dips have been bought.  This run-up has been in the face of recession fears, elevated inflation, rising rates and uncertainty from the Fed.  However, even with these uncertainties hanging over the markets, stocks have just shrugged and kept moving higher.

We are now at a point when valuations are being called into question. The PE ratio on the S&P is at levels last seen coming out of covid crisis and during the financial crisis. I don’t point this out to scare people but just to put where we are in context.

As the rally has continued it has become more and more reliant on a smaller group of names. These names leading the way are high growth names which typically demand a higher PE ratio than the rest of the market. These names also happen to make up a very large percentage of the market cap of the S&P 500, currently making up around 35% of its entire market cap. With higher PE names making up such a large percentage of the overall market, they will skew the market PE ratio higher.  One could argue that this elevated PE is justified since this group grew earnings by over 20% during the 4^th quarter when compared to a year earlier. However, it is important to point out, as I have in the past, that we will need to see more broad participation if this market rally is sustainable into 2025.

Last quarter, I discussed the Fed finally cutting rates. However, the market reaction was the exact opposite of what the Fed expected as we have seen rates spike in the face of these rate cuts. Much of this can be attributed to a couple of factors.  First, strong economic data and stubborn inflation data have forced the market to adjust expectations for future rate cuts in 2025.  Just six months ago the expectation was for a series of continued rate cuts throughout 2025.  That expectation has changed dramatically, with the number of rate cuts now expected to be much smaller. Some investors are now predicting the need for rate increases to get inflation under control.

Second, there is a major concern around government spending.  The government deficit and debt servicing burden for the country has grown out of control and there are few signs of this slowing down. This has put upward pressure on rates.  We saw through the election cycle a lot of different policy agenda items being tossed around, some to cut spending but many that will add to the growing debt.  With debt servicing now making up around 14% of our federal spending, something will have to change drastically, or the bond market will continue to push rates higher to make up for the increased risk.

With Trump getting elected, he has promised tax cuts along with an overhaul in government efficiency and a reduction in regulation.  However, a lot of his other proposals will require quite a bit of spending.  It is also not as simple as just axing spending across the board.  I think we can all agree that the government needs to operate more efficiently, but that is not an overnight process. Cutting spending is not typically politically popular but the process has to start somewhere, or our country will eventually face a fiscal crisis.

In terms of the election outcome and how it will impact the markets, I am still taking a wait-and-see approach.  During the election cycle, many initiatives get tossed around in an effort to win votes.  We now need to see what initiatives are prioritized and how willing Congress is to support Trump’s agenda.  I also want to see what spending cuts are going to be made to help finance proposed tax cuts and other spending initiatives.

With all of this said, what is my outlook for the coming year? With markets sitting near all-time highs, I do think we are in need of a bit of a pause or a small pullback in the short term. I feel like I have said this same thing for quite some time now but that does not make it untrue.  We need earnings outside of the Mag 7 to catch up a bit and to see broader participation in earnings growth. I am not saying the larger tech names can’t still lead.  They should lead, based on the growth they have been able to sustain, but we need to see more companies join the party and not just in the tech space.  I do not see the markets being up another 20-plus percent this year, but we could see some smaller gains after a capitulation period.

I do think higher rates will hang around much longer than I once anticipated and we will continue to see a steepening of the yield curve but we will eventually see rates drop back down toward longer-term averages. Barring a major financial shock, I do not see the 10-year getting down where we saw it during Covid, but if we can see some progress on inflation and government spending then I think we will see it settle back in the 3-4% range over the next one to two years.

Strategy Commentary

I continued to trim some equity exposure during the fourth quarter and have been hesitant to put new money to work too aggressively.  Most of this trimming was just profit-taking in some high-flying names and sectors but with markets near all-time highs and valuations seeming a bit stretched in certain areas I am happy to be patient with new money. Any new money put to work in equities was just normal, systematic dollar cost averaging into longer-term portfolios.  I want to be clear that I am not making a bearish call on equities but I am cautious. I feel like it is prudent to be patient at the moment and look for a lower entry point for most equities.

Domestically, I continue to keep my overweight in Technology and Communication Services.  I have been overweight these two sectors for quite some time now and it has been very beneficial to portfolios.  In the last 12 months, Technology has been up over 26% and Communication Services has been up around 35%.  I have trimmed both allocations slightly over the last quarter, but that is simply some profit-taking after a great run.  Financial Services has been on my radar lately. With rates remaining elevated and the prospect of a reduced regulatory environment under the next administration, this could be a position I look to add in the near future.

I continue to be cautious on most international markets. We have seen the economies in a few developed European countries contract over the past year and geopolitical risks are still dragging on the markets outside of the US.  At some point, the dispersion between international and domestic markets will get to great to ignore and we will need to add some additional international exposure but we are not at that point yet.

On the fixed income side I have been biased to the short end of the curve for quite some time.  Last quarter I started to add some positions at the longer end of the curve.  Its seems I was a bit early on this call and quickly reduced this exposure as the reaction to the Fed’s actions actually sent rates much higher at the long end.  The sell-off in longer-dated treasuries has been pretty rapid but I think this will provide another entry opportunity in the coming month.  For the time being, I am still comfortable rolling short-dated treasuries until we see some bottoming in long-term bond prices.