The Markets
It was a stellar year for stocks, building on 2023’s strong results. While finishing the year below recent highs, stocks flourished amidst a highly supportive backdrop of earnings growth, favorable Federal Reserve policies, a resilient economy, excitement around Artificial Intelligence (AI), and a new administration promising lower taxes and reduced regulation. Investor sentiment remains bullish, even as stock valuations appear historically expensive and the Fed has reduced its forecast for rate cuts in 2025.
For the quarter, the S&P 500 gained 2.4%, bringing the full year return to 25%. This quarter saw a return to strong leadership from a select group of mega-cap growth stocks, following signs of market broadening in the prior quarter. Conversely, value, small-cap, high-dividend yield, and non-US stocks posted flat to negative returns for the quarter and exhibited a wider range of performance for the year.
The bond market lost ground in the quarter, despite the Fed lowering the overnight interest rate two additional times. The Federal Funds rate now stands at 4.25%, down 100 basis points from its 5.25% peak. For the full year, the Bloomberg Intermediate Government/Corporate bond index gained 3%, while intermediate tax-exempt bond indices rose by 1.2% to 2.0%. Bearish commentary from the Fed in December highlighted inflation being stickier than expected. Fed Chair Powell noted that the economy’s resilience allows for a cautious approach before implementing additional rate cuts.
Investment Strategies
The fourth quarter returns from our equity strategies reflected the market’s divergence between the strength in the mega-cap growth stocks and the broader market’s malaise.
- Value Equity Strategy: The Value Equity strategy was flat in the quarter, outperforming its value benchmark. An overweight position in the Technology sector and an underweight in Health Care were key contributors throughout the year. Strong performers in the quarter included Salesforce (an AI beneficiary), Tapestry (takeover of Capri disallowed), and Wells Fargo (perceived beneficiary of less financial regulation). Pulte Group (reduced housing activity and elevated mortgage rates) and Elevance Health (regulatory pressure on managed care companies) detracted from performance.
- Growth Equity Strategy: Growth Equity posted strong gains, but lagged its growth benchmark, driven by an overweight in Health Care and less concentrated exposure to mega-cap stocks. Weakness in the broad semiconductor sector, after posting strong gains earlier in the year, also impacted performance. A notable exception was Broadcom, a chip company that we highlighted in the mid-year Investment Update. The company recently raised revenue expectations for custom chip design for AI applications, triggering a 35% gain in the quarter. Other strong performers included the cyber security firm, Fortinet, and William-Sonoma, which performed well through a slumping housing market.
- Yield-Focus Equity Strategy: Yield-Focus faced challenges from rising bond yields and a strong dollar, impacting non-U.S. investments, where attractive dividend yield opportunities are more plentiful. This strategy remains well positioned to generate well above average dividend income and as an overall portfolio diversifier. This approach should have defensive characteristics should high market valuations become vulnerable and if interest rates pull back from recent highs.
- Fixed Income Strategies: Meritage bond strategies were well positioned for the rise in interest rates over the quarter. Both our short and intermediate duration strategies handily outperformed their respective benchmarks from a combination of duration underweight and incremental income from BBB corporate credits when credit spreads tightened even further. For more detail, click here.
While a mixed bag globally, the U.S. economy has remained relatively strong. Labor markets continue to grow and wages continue to rise, albeit at a slower pace. Despite rising to 4.3%, the levels of unemployment remain historically low and job openings are relatively plentiful. Inflation has cooled to around 2.5%, close to the Fed’s target. That said, the actual prices of many goods and services remain 20-25% higher than pre-pandemic levels of 5 years ago. This is the difference between the disinflation we are seeing and a less likely prospect of deflation to actually bring prices down.
Internationally, in September alone, global central banks cut interest rates some 21 times. Further, a number of countries continue to inject liquidity or continue with Federal spending programs to support their economies and labor markets. Most notably, the recent actions taken by the PRC (People’s Republic of China) have boosted their stock market, even though previous attempts to do this very same thing have not had lasting effects. Some non-US markets who trade with China have responded favorably to this stimulus, though the full effect and degree of success will take some time to manifest.
Is Past Prologue?
Many of the favorable conditions that drove strong returns in 2023 carried through last year. Given recent economic data, the easing of Fed policy, and new pro-business policies on deck, these characteristics seem likely to persist. This two-year recovery from the 2022 bear market aligns with previous bull market cycles and two years is hardly ‘long in the tooth’.
As for market expectations, much of this positive outlook is reflected in current stocks prices, as well as other assumptions necessary to drive markets higher for a third consecutive year. Prominent among these is a reacceleration of earnings growth. Analysts are expecting earnings growth in the 12% – 15% range for 2025, an increase from last year’s growth rate under 9%.
The Technology sector, heavily influenced by AI investments, is expected to continue driving this growth, alongside rebounds in cyclical sectors like Energy and Industrials. However, market valuations remain elevated, with a current Price/Earnings (P/E) ratio of just under 22 – three points higher than last year. Sustained stock price gains will depend largely on earnings growth, as further valuation expansion may be limited.
A case for sustainably higher P/E multiples can be supported by the meaningfully higher levels of return on equity (ROE) and return of capital (ROC) that shareholders receive today compared to 10 years ago. Conversely, a potential source of pressure on valuation multiples could come from interest rates moving higher. This last happened in early 2022 when stocks tumbled, coming off three strong years of returns.
A standout feature of the current bull market is the strong outperformance of momentum factors. Strategies driven by momentum inherently bet that current trends, be it rising stock prices or earnings growth, stay in place. Momentum strategies naturally perform well in strong bull markets, but the current outperformance of momentum is among the highest in decades. These strategies have naturally embraced AI-related tech stocks, and more recently, Financials have joined momentum ranks. These trends warrant monitoring, as any earnings shortfall could lead to significant downside risks.
Outlook
The markets always present a range of compelling reasons why they could veer off track, and many have made such cases over the past two years. However, predicting market cycles remains challenging and is rarely productive.
At this stage in the cycle, we believe it is prudent to temper return expectations and anticipate more frequent market corrections. The longer a period of strong returns persists, the narrower the margin for error becomes. Historically, elevated starting valuation levels have correlated with lower prospective returns. While we believe this principle likely still holds, we also know that traditional forecasting models have proven less reliable in the post-pandemic environment.
The continued advancement of AI is expected to play a transformative role in shaping investment opportunities. We anticipate a progression of beneficiaries—from the infrastructure stage (chip designers and manufacturers), to the software stage (platforms providing specialty applications and access to advanced AI tools), and eventually to end users across nearly every business model.
Our focus remains on identifying opportunities that emphasize the generation of high-quality, free cash flow, which these emerging technologies are poised to enhance. For now, we will navigate this evolving landscape, optimistic about the long-term opportunities and realistic about the unpredictable paths markets will take to get there.
