Dear Friend and Clients, 

 

The market's main focus in the second half of last year was the presidential election and Fed interest rate cuts. The rate cut in early September was Q3's most impactful data point.  After that, much of the market's movements were a ping pong on headlines awaiting the outcome of November 5th, as evidenced by the volatility. 

 

 

The bear case is that the market is expensive and top heavy, in addition to the worry tree of inflation, tariffs, deficit, and immigration.  Last year as people contemplated recession fears, many were loving the 5% CDs/money markets as the most common question we fielded was “why buy stocks when I can get 5% “risk-free”?”  The SPX went on to 25% returns back-to-back, so 50% upside appreciation over two years vs a 10% gain if you would have been holding CDs/money markets.  

 

Regardless of market expectations, we continue to go back to the basics and trust our systematic process; that being said we wouldn't be surprised if the market had a better year than some of the naysayers predict.  

 

 

Video call link: https://meet.google.com/tbh-axxo-kyf

Or dial: ‪(US) +1 405-458-8578‬ PIN: ‪313 922 510‬#

 

Best regards,

 

Brad Banken, Investment Advisor Representative

 

Allison Banken, COO

 

We are unable to mention specific companies and or tradable investment products in order to follow compliance guidelines as the content cannot be construed as our individual view or recommendation on any investment product.  Please reach out if you have any questions or would like more specific information on anything below.

All performance metrics are as of date of publication.

 

 

To try to sum up the second half of last year, you can't just look at the monthly returns as they don't reflect the volatility we experienced.  April saw an (8.5%) pullback vs closing (4.2%) and December (4%) pullback vs closing (2.1%).  Don't forget August with an (8.5%) sell off and ending up +2.3%.  Yes, the largest pullback in 1.5 yrs is a blip, is not even a blip, on the monthly or quarterly returns.  

 

July 11th saw the beginning of the ‘rotational’ trade in historic proportions:  The Russell 2000 outperformed the Nasdaq over the next five days, rallying 11% vs the Nasdaq losing (5%).  Yes a 16% divergence in 5 days!  That is the largest 5-day divergence in the history of both indices. 

 

We continue to beat the drum to our clients that drawdowns and volatility are normal and should be expected.  The market likes to use stairs on the way up, but elevators on the way down! 

 

OCT: most indices were flattish.  We saw two hurricanes, China stimulus, a port strike, a strike at Boeing, and political headlines into November 5th. 

 

NOV:  SPX 3.89%, Russell Growth 10.5%. The first week was (1.4%), then the second saw the election on Nov 5th and the Fed cut 25bps on Nov 6th.  That second week the market was up 4.5% with Small Caps up 9%.  The second half of the month saw solid earnings, especially out of the retail sector (remember 70% of GDP is consumer spending).  Trump tariffs rhetoric starts to heat up.

 

DEC: SPX (2%), was down over (4%) at one point after the Fed had a hawkish pivot on 2025 guidance after cutting 25bps on 12/18.  The Fed adjusted their 2025 inflation expectations higher +2.5% vs prior +2.1 and lowered expected cuts from 1% of to 50bps.  December saw headlines on global uncertainty with some political unrest in Korea, Germany, France, Brazil and Canada, on top of Trump's cabinet nominations and budget stop gap process.  Also adding to the volatility in December was Powell's quote, "Most forecasters have been calling for a slowdown in growth for a very long time, and it keeps not happening. The economy won’t slow down, and the last mile of the inflation battle is proving difficult.” 

"Any mention of specific securities is for illustrative and educational purposes only to provide perspective on the market at large. This communication does not constitute investment advice, a recommendation or an offer or solicitation to purchase or sell any securities."

Let's revisit last year's setup to appreciate where we are now.  In January of last year, the market was pricing in 1.7% of Fed cuts for FY2024.   A potential recession was at the forefront of every conversation (when not if).  Bad news was also digested as good news as it meant the Fed would start the easing cycle.  There was a 100% chance of a 25bps cut in March priced in, which got pushed out to Sept and 50bps! 

 

A strong economy and resilient consumer started to lower the odds of a recession; that is defined by two consecutive quarters of negative GDP. The goal post of GDP set by the government is ~2% growth.  Not only did we not go into a recession, but the economy also grew significantly above the 2% “goal."  The market hit 57 new highs during the year which is the fifth most in history.

 

Below are some charts about divergence, volatility, and market dynamics that were notable in the last half of the year.  

Remember US Equities were up around 25%, bonds were in the red, and money markets returned roughly 5%.  If people knew how the year would end up, they would have allocated more into equities

The Russell 2000 had been underperforming the S&P 500 and NASDAQ pretty significantly over the past two years.  Pay attention to the July volatility.

In July there were a few specific data points that created the historical volatility.  

It has been since 2009 since the equal weight has underperformed the market cap weight to this extent

The VIX is the market indicator for volatility.  Early last year we warned of the election volatility that is typical, that didn't stop the market from making new highs.  Remember August sold off 8% to close up 2%! 

Volatility is normal and to be expected; this chart illustrates an average pullback of around 10% every year since 1985.  August had the largest pullback of the year at around (8%).

"Any mention of specific securities is for illustrative and educational purposes only to provide perspective on the market at large. This communication does not constitute investment advice, a recommendation or an offer or solicitation to purchase or sell any securities."

 

Given the strength of the market, it is important to look at the underlying trends - which was another year of the Mega Cap/Tech/Mag7 dominating relative to Small/Mid/Equal weight which created many historic deviations.  Roughly 27% of the SP500 companies outperformed the index…that makes TWO YEARS IN A ROW!  This dynamic has created a very tough market for professionals as the concentration within tech and the top five and ten stocks went well above what standard risk management, portfolio management, and diversification principles would advise against.

 

Only 29% of active large cap funds outperformed the SP500 index.   The average weighting of the top 3 holdings for actively managed US stock funds was 14.2% whereas SPX was 21% and the Top 5 were 20.8% vs SPX 27%. 

Below illustrates the 2024 year-end price targets of the S&P500 by the top analysts on Wall Street; all of the experts significantly missed the mark by an average of ~25%, that's what we'd call a big whiff.

Below illustrates the top heavy concentration that we are seeing

The market cap of the Mag 7 has gotten so large that it is bigger than Europe.  It is also larger than Japan, India, the UK, China, Switzerland, Canada, and France combined.

 

Another way to look at the unprecedented strength of the Mag 7, is that they accounted for 57% of the S&P 500 market cap gains in 2024… that's on top of accounting for 65% in 2023.  That said, the Mag 7 accounted for 60% of the 1H24 but only 23% of 2H24.  Market breadth started to improve in the second half of last year and we think it will continue.  

Many mutual fund managers couldn't keep up with the concentration performance last year; the average large cap mutual fund underperformed by 7pct vs the S&P500.

As you can see it's very hard to beat benchmarks.   The professional money managers are underperform across various benchmarks and time horizons.  

 

Some big banks and analysts have been projecting very low equity returns over the next decade.  Most of them hitch their wagon to rich valuations and strong recent performance; one of the most common valuation metrics is P/E (price to earnings ratio).  Outside of that there are other valuation metrics less often referenced, but it is important to note those are all expensive as well.  

 

If you were to use P/E to predict S&P500 returns, on a 1- and 5-year historical return, the valuation metric would indicate 0-3% expected returns as equity P/Es are considered high according to historical data. Based on this data, when the market traded above 22x P/E, the following 5-year returns were not positive.  Also, some bears point to reversion to the mean on average yearly performance.  As we are coming off of two straight 25%+ returns in a row, vs 7-10% which is the average of the last 150 years, could the valuations and strong performance point to a few lackluster years (and revert to the mean)?

 

As we digest all of the aforementioned data, we acknowledge that these are all statistically significant and respect these data points however we feel the situation is more nuanced and will attempt to demonstrate that valuations may not be as expensive as people may think.  

As mentioned above, when the S&P500 is trading at 22x earnings, which is a top 5 percentile rich valuation, the 5-year average return is not positive.  However, if you look at small caps, equal weight, and midcaps, the market is not as expensive.  

The top 100 market caps in the S&P 500 are trading over 45x P/E while small caps are trading around 25x. 

The ‘Buffet Indicator’ is the US stock market valuation divided by GPD.  It is one of the valuation metrics that that Buffet uses and currently is at all time highs, and over 2 standard deviations from the mean.  

 

Between the lines: US companies now get more sales from outside the US than in previous decades, those sales are not included in GDP.   The Numerator, market capitalization, reflects a larger addressable market than what the denominator GDP captures. 

Speaking of valuations, above shows the S&P 500 by sectors.  There are only two sectors MCG (mega cap growth) and tech, that are expensive relative to the S&P since 1996.

Above shows that the top eight market caps are over 35% of the total S&P 500 at historic highs.  Also notice that in the 2000's consumer staples, financials, and industrials had a large representation but are now non existent.  The tech sector deserves higher valuations, and  typically trades at a significant premium to the other sectors, because of the growth characteristics. 

This illustrates how the S&P 500 has evolved to skew towards innovation at the expense of slowing manufacturing.   Innovation typically grows a lot faster than manufacturing which justifies a higher growth multiple.   

Another way to evaluate the current valuations is to look at productivity and efficiency of the economy and market.

As you can see above, the market has continued to be more productive over time.  Is it fair to compare it to overall averages when the income margins are 2x what they were in the '90s?

Weekly profit margin is also at an all time high 

Another way to look at productivity. Revenue per worker has never been higher.  Does that deserve a higher valuation?  

We just showed four different productivity metrics that are at all-time highs demonstrating that companies are running more efficiently so valuation premiums could be warranted

 

There are many tools and metrics you can use to analyze the market, but the main driver of market performance always goes back to earnings.  Going back to Q4 of 2021, earnings have come in stronger than analyst expectations.  In terms of market performance and earnings growth, 2023 saw SPX +26% with earnings growing 1%.  2024 was +26% with earnings growing 10%.   Now 2025 earnings are expected to be up 13/15%.  We illustrate below why we think that earnings will also help small and midcaps play catchup over the next year. 

You can see earnings from the Mag 7 in 2022 and 2023 outperformed the market, however analyst expectations start to narrow that gap into 2025.

In 2023, the Mag 7 out earned the rest of the S&P 500 by 40% which in '25 should be around 7% and 3% in 2026.  We would expect as the earnings gap closes, so could the relative price performance. 

Based on expected earnings in the coming year; we would also expect the gap to close for the small and midcaps.

Above is the widely referenced small business optimism index which has had 32 consecutive months below the 50-year average of 98 until the past few months. Small businesses (250 or fewer employees) account for 55% of all new job creation since 2013; we also see this a positive sign for small and midcap sector earnings. 

Consumer spending has become more important as it has gained a larger percent of GDP since the 1950's.  It is currently 68% of GDP; a resilient consumer could continue to support earnings growth going forward.  

 

We think inflation is being overstated.  If inflation comes in lighter than Fed/market expectations, we view this as bullish for the market, especially the small/midcap names. If you adjust for the the shelter component of CPI (using current vs. lagging prices) we would already be below the 2% ‘goalpost’ set by the Fed.  We also believe that tariffs and immigration could be less inflationary than is priced into the market.  If that is the case, we could see sooner or deeper cuts than expectations.

Shelter, in light purple above, is the largest component of the CPI.  Housing is 45% of CPI; we have written about this but as a reminder the shelter category is an average of the last 12 months, so it is more backward looking.  Every month the average only changes by 1/12th; if you were to use current shelter prices it would change the CPI to be 1.8% vs. the current 2.9%.  Also, the December shelter number was the smallest 1-year gain since Jan of 2022.  The cooling of the shelter component should have downward pressure on the CPI number going forward.  

The CPI housing price metric is 4.6%; if you were to use real time data and not the lagging 12 months of prices it would really be 1.46%. The real time prices have been below the Fed's overall target of ~2% for almost a year and a half.  This is something not being written about or covered that we've seen.  

Fed 

 

In terms of the Fed, they are guiding for two cuts next year for a total of 50bps.  The market is pricing in a 14% chance there are zero cuts, 33% chance of 25bps and 31% that there are two cuts.   The risk to the market would be inflation picks up and they do not cut as much. Not many people are talking about this but have seen a small chance of a rate hike mentioned. There are certainly spots where consumers are feeling inflation; orange juice, coffee, and egg prices are very high right now.  So, if you're looking to make brunch, you are feeling inflation, but food is only 14% of the CPI.  

 

The Fed does not have a crystal ball.  Remember the Fed predicted that 2022 would have 2.6% inflation and 4% growth.  It wound up being 6% and 1.3%.  If the macro projections are off, so will the dot plot.  A few economists have studied the Feds predictive ability and the correlation is low. Consider that nugget when we sold off in Dec on their ‘2025 projections!  

Tariffs

 

From November when Trump started with the 25% Mexico 25% Canada and 60% China, the market started to price in and media outlets started to run wild.  If that were to come to fruition, we acknowledge the market would be in trouble.  However, if the past is any predictor of the future, we imagine President Trump will use tariffs as a negotiating tactic as he did with Mexico in 2019.  Either way we expect volatility from the headlines to continue.  

The above table demonstrates why tariffs would be inflationary as it is sorted by categories that we import.  As you can see, most of these are everyday items that would become more expensive for the consumer.  We acknowledge this but we just don't think the tariffs will come to fruition to the extent the media is reporting.  In addition, demonstrated below, Mexico and Canada export much more than we would import from them.

Illegal Immigration 

 

Some analysts and media outlets are citing that recent illegal immigration/deportation policies would be inflationary. The assumption is that some industries would have to raise their wages to compensate for the labor loss. Either the company becomes less profitable, or they pass along the cost differential to the consumer in higher prices. Given the strength of the consumer, and product efficiencies from innovative technology, there is an argument that the impact could be less than current expectations.  

We continue to have a favorable outlook on market performance and expect the strength in earnings and economic data to carry us forward.  It should be tough for the Mag 7/Mega caps in terms of growth and outperformance where the risk is to the upside for Small, Mid, and Equal Weights and we imagine the performance gap starts to close in 2025.

 

Globally, most central banks are cutting aggressively, which infers that fiscal policy is stimulative.  Data shows that a recession is not on the horizon.  GDP growth is ~3% vs the goalpost of 2%.  Unemployment is near 4% - historically low and technically in ‘full employment’ range.   More job openings than unemployed people.  AI and technology advances are deflatoinary(substution for labor).    Consumer Spending/Services are 70% of all the spending in the current economy, for GDP to slow, the consumer needs to take a breather - we do not see the data pointing to this.   

 

Valuation, inflation, deficit, trade wars, political uncertainty/instability, sums up the blend of the bear case.  The lack of clarity on policy prioritization, timing and magnitude of change is what makes this political transition so consequential, and in absence of a crystal-ball, we think investors should stay focused on the knowns and let the data be their guide.

 

For the aforementioned reasons, we are much more positive, and while we acknowledge potential headwinds/risks, we think the wind blows a bit calmer into these sails.  The importance of asset allocation and a diversified portfolio cannot be overstated in a year of elevated uncertainties. Having a clear strategy, sticking with a long-term approach, and building a balanced and resilient portfolio can help ride out any volatility that comes along the way.

We will continue to favor the small cap, mid caps, equal weight and dividend oriented ETFs over the mega cap and tech oriented.   We added to our Emerging Market, Indian, Building , and LatAm themes in Nov and Dec and will continue to add on weakness.    Any excess strength in mega caps and tech will likely be the first to see some trimming, making room for the themes poised for more upside.

 

Small/Mid/Equal vs Mega/Tech - Most of this rotation occurred in the first half of last year; we continue to believe this theme will work and has a decent runway.  This is a macro theme, and we express it through passive, low-cost, index ETFs.

 

International - Second half of last year saw significant international volatility.  We added to Latin America and Indian exposure.  We continue to think China is in a tough spot; our exposure continues to be limited there. 

Latin America - in addition to adding to LatAm ETFs, you might have seen specific Brazil and Argentina exposure added. 

India - we added to four different ETFs including Consumer, Tech, Small Cap and Large Cap focused ones.  Click here to read more about India from a previous note:  Unlocking Opportunity: Thematic Investing In India  

 

Construction/Building - This theme had worked well for the majority of the year and was crushed in December after the Fed signaled they would cut less in 2025 (higher rates for longer, housing market will stay tight).  We continue to like this theme with the supply/demand imbalance and look forward to putting out more content specifically on it.  

There are three ETFs that are the main exposure, which we added on to on weakness.

 

Clean Energy - We had been reducing our exposure over the past year and were in a holding pattern heading into the election.  Then lowered our exposure into weakness post-election.  We were able to utilize these losses to offset the gains/reduce exposure to the large cap tech names for tax loss selling purposes.  

- Warren Buffet

Questions? Feedback?  Drop us a line at info@oakstreaminvestments.com

The opinions and forecasts expressed are strictly those of Brad Banken's and may not actually come to pass.  

Investment advisory services offered through Investment Advisor Representatives of Cambridge Investment Research Advisors, Inc., a Registered Investment Advisor. Each company is independently responsible for the products and services they provide. Representatives of Cambridge Investment Research, Inc. do not provide tax or legal advice in their roles as registered representatives. Oak Stream Investment Advisors LLC and Cambridge are separate entities.

 

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