Let us start with the obvious:
- The S&P has lapped other Indices and has turned in an overachieving two-year run. This Index is both historically concentrated and expensive.
- The bond market has had a very counterintuitive run. The Fed made three discount rate cuts, and most interest rates went up, not down. In January 2024, the ten-year Treasury yielded 4.0%; at year-end, it yielded over 4.6%; and as we write this in January, it is now 4.8%.
What gives? - From the beginning of November 2023, when the Fed set expectations for rate cuts, through the year-end of 2024, the S&P 500 Index gained over 39%, and the equal-weighted S&P 500 Index returned about 28% for the same period. In this period, earnings expectations remained static; that is, earnings estimates did not increase. So, effectively, this 39% gain was derived from valuation expansion, not from higher earnings.
So, what is a Rational Investor to do beyond feeling good about the increase and your constructive results?
- Expect the pace of the increase to moderate. This is not “Chicken Little,” but something between common sense and regression to the mean. Be a critical thinker and get beyond complacency.
- Stay away from premium valuations in momentum stocks.
- Concentrate your strategy on high-quality companies and reasonable valuations.
- Make growth of the business’s intrinsic value more important than the possibility of valuation expansion.
- Be a strategic business investor with an outlook spanning years and resist being a tactical trader.
- Pay attention to valuation and stay in shorter maturities.
Our take is that January 2022 represented an inflection point for the long-term secular interest rate cycle. Recent Fed cuts aside, inflationary pressures derived from financing the unprecedented scale of federal debt, wage pressures derived from lower labor participation rates, and increased costs driven by deglobalization will likely be a persistent headwind for years. For stocks, this means that valuations will face pressure. For bonds, this means that longer maturities will be stressed.
This is not bearish. The economy is stable, productivity growth is being realized, and better companies are posting better results. It is time to be selective and disciplined. Our approach is not to be complacent about the rising tide raising all boats but to be selective about which boats.
You can make progress in a headwind; however, it requires that you tack with discernment. If you plan to navigate some turbulence, you can have a successful flight. Importantly, the existence of turbulence does not cancel other opportunities.
