By Thomas O. Herrick
Market Strategist
Recommendations
- Equities – Prepare for a diversification cycle versus the long period of concentration markets have experienced. Our forward viewpoint on the S&P 500 is modest relative to our forward viewpoint on rotation beneficiaries. Take a more equal weight approach, have ample allocations to small caps, and maintain substantial allocations to value as well as growth.
- Bonds – Policy uncertainty calls for a much more tactical approach. Add bond exposure when the real 10-year yield (nominal yield minus inflation expectations) approaches or exceeds 2%.
- Hedging strategies – Investors looking for market participation with guardrails should continue to consider hedging strategies, many of which also deliver high current income. These strategies are helpful relative to a more traditional 60/40 stock/bond allocation, which as we saw in 2022, is correlated during periods of elevated inflation and rates. While we are sanguine on inflation, that does not mean we see rates and yields at the generational lows experienced post GFC through 2021.
First, a recap: 2024 has proven to be a strong year for equity returns. Through the first 11 months of the year the S&P 500 Index is higher by 28.07%. Looking at a slightly different period that coincides closely with our 2024 Market Outlook, over the last 12 months the Russell 1000 Index has gained 34.97%. The Russell 2000, representing small caps, is higher by 36.88%, validating our emphasis on the inclusion of small-cap allocation in the 2024 Outlook.1 The first half of 2024’s performance was dominated by large-cap technology stocks that carry a heavy weight in the S&P 500. The second half has witnessed improved breadth and rotation into other sectors and capitalizations. Short term, the biggest challenge to higher prices is overly bullish sentiment, a contrarian negative.
Source: FactSet, Goldman Sachs Research
So much for victory laps, onto 2025. Looking forward to 2025 and beyond, there are two fundamental viewpoints at play that we feel are most important. The first, which we see being impactful in 2025, is the diminishing earnings expectations differential of the well-publicized Mag 7 companies that have accounted for so much S&P performance for the last two years. These names make up about one-third of the S&P 500. Consequently, they are crucial to that average’s performance. While the expectation for earnings is that the Mag 7 will continue to exceed the remaining 493 companies, the difference will be smaller. This likely occurs from both ends, inevitably slowing earnings growth from the Mag 7 as they become larger and larger, and improved earnings growth from the remaining 493. The rock-solid economy also supports improved earnings in the larger group. The diminishing differential is at the heart of market rotation to other sectors and companies, which has been at work to some extent in the latter half of 2024. While a healthy development for the wider market, this diminishing differential does create a challenge for cap-weighted indexes, especially the S&P. Number one takeaway: the S&P has a much more difficult task in maintaining its vaunted outperformance in 2025 and beyond.
A history of concentration peaks
Source: MFS, NYSE, American Stock Exchange, and NASDAQ sourced from Kenneth French database
Our second viewpoint is closely related to the first. The stock market has become increasingly concentrated over a long period, beyond a decade and a half. As noted above, we see high odds of this concentration cycle concluding as the earnings expectations differential of mega caps diminishes versus the remainder of the market. If we continue to move beyond peak concentration, what happens next? Historically, performance favors three dynamics: equal-weight large cap strategies versus cap-weighted large caps, small caps versus large caps, and value stocks versus growth stocks.
Concentration peaks in markets don’t always align with the same point in the cycle. Some, like in 1973 and 2000, happened near market highs as investors flocked to popular stocks, while others, like in 1932 and 1957, occurred near market lows.
Three position winners after concentration peak
Source: MFS, NYSE, American Stock Exchange, and NASDAQ sourced from Kenneth French database
The above table shows average annualized and cumulative outperformance after concentration peaks for these comparisons: US equal-weighted vs. cap-weighted indexes, small-cap vs. large-cap stocks, and value vs. growth stocks.
Yields and Macro Outlook
Yields have increased over the last quarter, which has taken some of the wind out of the bond market. Despite the recent surge, bonds have produced close to a 3% positive total return for the Bloomberg US Aggregate through the first 11 months of the year. Keep in mind, the Federal Reserve is lowering Fed funds. That overnight rate is the only rate it directly controls. There are many and varied inputs to pricing on longer-term yields, such as the benchmark 10-year Treasury. Fear accumulated in the bond market from early September until late November. This was in reaction to potential public policy initiatives from the new administration, chiefly related to proposed tariffs but also increased deficit spending projections. While generally constructive on bonds, we anticipate the need to be much more tactical in our thinking as policy gets priced into markets.
The current economic dynamic is very favorable. GDP growth remains around the 3% range, propelled by consumer spending and strong productivity growth. Consumer spending is well supported by real income growth across all cohorts, an outcome of the dis-inflation the US has experienced since the middle of 2022. Despite a little recent stickiness, inflation expectations remain well-anchored, given the modest growth in money supply over the last 18 months.
The largest economic uncertainty is future trade policy. If widespread and substantial tariffs were imposed on our trading partners, there would be a one-time hit to inflation. Where we differ from the street somewhat is that we see the potential growth impact as being the larger issue. The history of tariffs is that they lead to retaliatory tariffs, changing a win-win dynamic into a lose-lose dynamic. Output in this instance would drop in the US as well as trading partner countries. That said, this is a situation loaded with the words if and what. IF tariffs are widespread and steep, IF they were imposed all at once, IF the countries involved are our main trading partners, IF there is retaliation. What are the offsets? Lower corporate taxes? Currency devaluation by trading partners? The takeaway: public trade policy is a risk but completely unpredictable at this point.
1 Bloomberg
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