Q4 2024 Commentary

Happy New Year!

2024 turned out to be another extraordinary year for U.S. equities – at least for some of them (see further explanation below). The S&P 500 advanced 23%, marking its second consecutive year of gains in excess of 20%. 

2023’s gains were, in many ways, a return to normalcy after a nearly 20% decline in 2022. Inflation fell significantly from its peak. The Federal Reserve slowed, and eventually stopped, rate hikes. Corporate earnings and real GDP grew, allaying fears of lasting damage from the Fed’s restrictive policies.

2024 continued many of these positive trends. Inflation moderated further. The Federal Reserve cut interest rates for the first time since 2020. Corporate earnings made new record highs, and the economy overcame recession fears. In short, just as in 2023, there were plenty of reasons for stocks to advance in 2024. 

However, while many fundamental metrics reflected a return to normalcy, some market behavior seemed to reflect a return to the abnormalcy of 2021 – a period marked by extremely high valuation multiples and rampant speculation.

The S&P 500 spent much of the fourth quarter at a price/peak earnings multiple above 29. That is a level only ever reached during the dotcom bubble (late 1998 through the 2000 market peak) and briefly in 2021. The first instance resulted in a 50% crash and, following another 50% crash, a lost decade for stocks. The more recent instance was followed by a 20% correction and two lost years for stocks (so far).

While some of the speculative excesses of 2021 have not yet returned (such as SPACs and NFTs), others have reemerged. Bitcoin’s revival has been accompanied by a surge in “memecoins” (the more generous term), and there has been a renewed rush into profitless tech companies.

Some of the renewed optimism surrounds the promises of AI in advancing productivity and scientific innovations. As with past technological breakthroughs, however, the adoption process will be competitive and capital intensive. While there will certainly be winners that capture a disproportionate share of the upside (see Nvidia), it remains difficult to justify market-wide valuations so far removed from historical norms.

There was additional market optimism following the re-election of Donald Trump, spurred by hopes of deregulation and corporate tax cuts. Following election night, there were immediate, dramatic gains among the sectors most likely to benefit from deregulation, such as financials, energy, technology and industrials.

Comparisons to Trump’s first term have naturally emerged. Prior to the Covid-19 outbreak, the Trump presidency was accompanied by double digit annual earnings growth for S&P 500 companies and commensurate equity returns, summing to nearly 45% across three years. Those returns began in 2017, which turned into one of the most remarkable years in market history as equities rose nearly 20% without a single notable pullback.

There are many reasons that we do not anticipate 2025 to resemble 2017 (or the next three years to resemble 2017-19). We believe that starting conditions matter, and conditions are markedly different today than they were eight years ago.

In the runup to the 2016 election, analysts at major financial institutions were extremely skeptical about the prospects of a Trump presidency. After the election, however, they were met with relief at almost every step of the way: from a largely mainstream cabinet, to larger-than-expected tax cuts, to trade wars that were less contentious than feared.

Markets are approaching Trump’s second term with much less skepticism, making it less likely they find perpetual relief. The wall of worry from 2016 just does not exist today.

In 2016, election jitters were quickly forgotten, and renewed optimism drove forward P/E ratios near 18 – the highest levels since 2002. This time around, at a forward P/E ratio above 23, stocks are already 25% more expensive than they were eight years ago. That sets the bar extremely high for markets. Interest rates further complicate the valuation math. The ten-year yield was below 2.5% at the start of 2017, and it is over 4.5% today.

From a macroeconomic perspective, Trump had the rare fortune of being a non-incumbent inheriting a strong economy in 2017, and is set to do so again. His inheritance is less favorable this time around, however. At the start of 2017, the unemployment rate had been on a multi-year downward trajectory. The unemployment rate remains low, but it has been trending upwards since bottoming in 2023. Core inflation was below 2% at the start of 2017 (as it had been for the previous 5 years). Today, it is stubbornly sitting closer to 3%.

The primary driver of 2017’s market performance was a dramatic decline in corporate tax rates (bringing the statutory rate down from 35% to 21%). Some additional corporate tax cuts may be in the works for domestic production (15%), but they will not match the scale of 2017s reductions.

2017’s tax cuts also significantly inflated the deficit. Given the dramatic expansion of the deficit since, there is little appetite in Congress for additional deficit growth. Further complicating plans will be a very slim majority in the House of Representatives. Republicans entered 2017 with a nearly 50 seat advantage. That margin has shrunk to the slimmest majority in nearly a century, significantly raising the risk of governance issues.

We can speculate on the outcomes of specific policy proposals, but all else equal, the administration will have a more difficult time stimulating market growth than they did eight years ago.

Although the election was the dominant headline of the quarter, most of its market effects were short-lived. The S&P 500 slid 2.5% in December, concluding the weakest quarter for stocks since Q3 2023.

By the end of the quarter, the average stock had erased its post-election gains, trading lower than they were at the end of August. This divergence was a resumption of trends that persisted most of the year, with most of the gains accruing to the largest companies. The median S&P 500 stock only advanced 10% for the full year – less than half of the move of the broader index.

The divergences were most notable among interest-rate sensitive stocks. Data throughout the fourth quarter signaled that inflation was sticky, increasing probabilities that the Fed would pause interest rate cuts. As part of this divergence, a large number of Master List stocks are now trading at a significant discount to the market and sit well below their 2024 highs.

These opportunities prompted Time Overlay strategies to end the year accumulating stocks. Though markets broadly remain expensive, we could continue to add equity exposure among high-quality names as the new year progresses.

There is certainly more downside risk to broader markets, but if this cycle plays out similarly to the last two tech bubbles, the first beneficiaries of any rotation are likely to be out-of-favor, high-quality names.  

Wishing you a happy and prosperous New Year,

Robert B. Drach

Drach Advisors LLC