NEWS

2025 Outlook and Commentary

on January 11, 2025

Equity markets delivered a strong year of returns for the second year in a row. The S&P 500 delivered back-to-back returns of over 20%. This occurrence is rare and has only happened four other times in history (1927/28, 1935/36, 1954/55 and 1995/96). Also, like in the prior year of 2023, most of gains in 2024 were concentrated in the largest stocks. Removing the top ten stocks from the index would have dropped the overall return of the S&P 500 down to slightly less than 10% for the year. International stocks were left in the dust in 2024 returning under 4%, while the U.S. bond market delivered less than 2% for the year. T-bills did well, returning over 5%, a 25 year high.

This extreme outperformance in the largest U.S. stocks has been the trend for the last few years. Since the end of 2021, the price return of the average stock in the S&P 500 is surprisingly only 5%. Small cap stocks, international stocks, and bond markets are even worse delivering negative price returns over that period. This contrasts with the mega-cap tech sector (top ten stocks) being up more than 30% over the same period!

This relative outperformance is well deserved. And we’ve been fans of these companies through the years. The outperformance does make sense, since the bulk of earnings growth has been concentrated in these top companies. However, there are some statistics today that do have us very concerned. For one, the top ten stocks in the S&P 500 account for almost 40% of the index. To put this into context, the last time the stock concentration was at a peak was in 1999. The top ten stocks at that time represented only 25% of the index. You must go back a hundred years to see such a high index stock concentration as there is today.

So today, are you really buying a diversified stock index when you buy the S&P 500? The math says a resounding no! Can it continue? The price to earnings ratio (P/E) for the top seven companies in the S&P 500 is currently at 30 (meaning you pay 30 years in price for the current year in earnings), while the average historic P/E for the top seven companies is around 20. There should be a premium for buying the highest quality companies, but we are clearly at extreme levels today.

Why does this even matter? It matters because this makes passive indexing very dangerous today, given the reliance and faith in the top companies to continue to deliver stellar earnings. Up until now this has been the winning strategy, but it is a double-edged sword. Any disappointment from these top companies will have a significant impact on the entire index. The positive takeaway is that stock picking and diversification will be much more impactful in generating returns and managing risk. The bottom (and neglected) 490 companies of the S&P 500 may not have as big an impact on the index but could in an individual portfolio.

What we do know from prior peaks is that the companies that lead the charge in one era aren’t necessarily the same ones in the next era. Although the belief is that it is (recency bias). Case in point, the top ten companies in 2000 were Microsoft, GE, Cisco, Intel, Exxon, Walmart, Oracle, IBM, Citigroup, and Nokia. Only Microsoft is still in the top 10 today. And even Microsoft underperformed for over a decade after the 2000 peak.

It is not all doom and gloom. The AI revolution has certainly been hyped (just like the internet and broadband before) and there has been an explosion of excitement and early adoption. What tends to occur is throughout history, when there is a new technological breakthrough, there is initially an overexuberance and imaginations running wild. Unfortunately, this is usually followed by an early bust (think railroads, autos, airlines, internet, etc.) But then the infrastructure built that remains is inherited to the next wave of innovators. And boy do they innovate (E.G. iPhone, Netflix, Google, Tesla). Top put into context, here is a list of “stuff” that did not exist in 2000: iPhone, Tesla, YouTube, Google maps, Twitter, SpaceX, Instagram, Bitcoin, Facebook, Skype, Amazon Prime, Netflix streaming, Android, WhatsApp, TikTok, Xbox, Fitbit, Uber, Airbnb, Spotify, Zoom, Reddit, to name a few. We are very excited and optimistic about what the AI revolution will bring over the next decade. And we will be in the hunt for the next Apples, Nvidias, Googles, etc.

Another theme for 2025 and beyond is that we want to continue our almost absolute focus on U.S. company-based stock exposure. This has been our view for over a decade and will continue to be in the foreseeable future. There might be pockets of “value” overseas (and we may dabble), but our view is that U.S. is still best positioned. This is more evident given an anti-globalist wave sweeping the world.

What does 2025 have in store? For one, there is continued momentum in AI spending. Microsoft recently announced that they are investing $80 billion in data center spending in 2025. Also, crypto is attempting to enter the mainstream with the adoption of Bitcoin and Ethereum in the traditional ETF world. The new administration also seems to be more Crypto “friendly.” There is also great investor and Wall Street optimism surrounding a continued growth trajectory, one fueled by a stock market friendly new administration, along with the anticipation of persistent economic resiliency. Retail investor and professional allocations to stocks are at multi-year highs. Additionally, retail investors have flocked to leveraged ETFs and options to enhance returns. There are few, if any Wall Street analysts with pessimistic projections heading into 2025, as there have been in the last couple of years. This extreme optimism can be viewed as a contrarian indicator (I.E. when everyone expects the same outcome something else happens).

Our view is that expectations today are too high. The backdrop of elevated stock valuations along with the assumption of swift and effective implementation of new administration policies and agenda make the margin for error very slim. Also being overlooked is that the economy is not as strong as it appears. The job market has been subtly slowing, and various manufacturing and consumer surveys are still in contraction. Anecdotally, credit cards and auto delinquencies are at their highest levels in 15 years. And this is all supported by backdrop where the market valuations are in the top 95 percentile of history.

The equity markets have had a great run which is why our primary goal today is to preserve the gains we’ve accumulated over the years. Investor assets and overall wealth have grown significantly over the past decade. But there is a reason why Warren Buffet is sitting on record cash levels today. There is a saying among seasoned investors, that markets go up like an escalator, but go down like an elevator. We also know that picking a top or bottom is next to impossible. This is why we still want to take advantage of the possibility of the momentum continuing and benefit from additional gains in the markets. Markets are historically overvalued but can stay overvalued for longer than we think (for example 1928 and 1999).

We are open to the possibility of another strong year in the markets. We are in a transitionary year and want to identify trends and shifts in markets to opportunistically incorporate into portfolios. There are many sectors and areas of the markets that have been stagnant for years. For example, interest if rates continue to move higher and we see a 5-6% interest rate in longer-term bonds, that would be very compelling to us. Alternatively, if there is a knee jerk growth scare (E.G. due to lower earnings guidance) in markets triggering a correction, strategically using that as a rebalancing opportunity. Never forgetting our primary goal today: protecting the downside to preserve the all-time high portfolio “waterlines” already achieved.

We are also in a leadership transitionary year in the U.S. Any time we have a transition of power it brings a great deal of uncertainty as to what the impact will be on the economy and geopolitics.

A historical comparison to this year’s election is 1980, when President Reagan defeated President Carter. The market had a similar reaction with an immediate celebratory surge, but then 1981 was a doozy of a year for the stock market, as the honeymoon period quickly wore off. President Reagan’s first year was extremely volatile and lower in the stock markets. But then markets eventually bottomed as Reagan’s policies took shape, and the next few years in the stock market were above average. This is a possible template to learn from to help shape an investment thesis for the next four years.

Here are some of the potential market-friendly policies of the new Trump administration:

• Tax reform/cuts
• Deregulation
• Government efficiency (reduction in head count and agencies, etc.)
• Mergers and acquisitions and more business confidence overall
• Lower oil prices via drilling (equates to lower immediate inflation)

Some less market-friendly risks:

• Tariffs have initial inflationary impact and uncertainty (Think Smoot-Howley Tarriff act of 1930)
• Government cuts can temporarily hurt GDP growth if private sector does not fill the void
• Inability to pass tax bills or other market friendly legislation through congress (this is the slimmest house majority since 1931)
• Geopolitical instability (like what is happening with Ukraine/Russia right now)

Additional potential risks:

• Recession (We must follow the private sector jobs market closely)
• Inflation resurgence (what if the fed raises rates?)
• Banking/liquidity crisis
• Federal debt concerns ($3 trillion in government debt maturing in 2025 in addition to a potential $2 trillion more in deficit accumulation)
• Earning slowdown/letdown, especially in AI spending

Circling back to what could be in store for 2025. Let’s look at the prior four instances in history when we had back-to-back years like we just did. And then what happened the year after. The 1929 and 1937 follow up years were horrific. It was after all, the Great Depression and stocks were decimated. In 1956 the market returned 3%, a below average year, but not the end of the world. And finally in 1997 the market returned 31%, a banner year.

What does 2025 look like? If we were to put odds at the beginning of the year:

• 1950s redux. 60% odds. Markets could experience a great deal of volatility including a decent sized correction (overdue) but then ending the year where markets are plus or minus 5% in returns (single digit positive or negative returns). Basically, ending the year close to where we started. There could still be great opportunities for rebalancing, including exposure to areas that have lagged over the last few years. Also, corrections would be fantastic “buy the dip” opportunities. And this could end up a decent portfolio return year, despite mediocre index returns.
• Late 90s fun. 20% odds. Markets continue to melt higher. If inflation stays contained (this is huge) and earnings grow as expected, this along with favorable economic policy changes could propel valuations even higher. This outcome could lead to market returns in the 15%-25% range. Keep in mind that markets would really be on borrowed time and 2026 would be a time to worry.
• High valuation meets recession (but not “D”pression) – 20% odds. A recession cannot yet be ruled out (some would say that we have already been in a “Vibe-cession”). We highlighted earlier how the economy has some vulnerabilities. A fragile economy is susceptible to shocks and events that can trigger recessions. There is a saying in economics that recessions don’t die of old age, they are murdered. In a recession scenario markets could easily suffer 20-40% losses. Remember markets usually overshoot to the upside and overshoot to the downside. This scenario could take back index returns many years. This is why decisive risk management would be needed to mitigate catastrophic losses. This is especially crucial for those in retirement with shorter time horizons and the dependency on the portfolio for their income needs.

In summary, we have illustrated three different scenarios with profoundly different outcomes. No one can predict the future, especially today, but if history is any guide, these templates can serve as a guide of what can potentially transpire. As investors and risk managers we must keep an open mind to a wide range of outcomes today. Given the backdrop of extremely high valuations in equity markets along with our more conservative philosophy, we are going to be heavily biased towards risk management today (versus chasing returns and a horse-race index competition approach). Not only will this help preserve long-term results, it will also position us to be more opportunistic for a time when valuations are more attractive (think Warren Buffet here).  It’s important to remember that market tops happen when everything is at its peak of enthusiasm. To quote the legendary investor Sir John Templeton: “The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell.” It is important to remember that in both extremes. And today regarding markets we are closer to the latter.

Thank you for your trust.

The Vigilare Wealth Management Team

IMPORTANT DISCLOSURES Vigilare Wealth Management is an SEC registered investment adviser. The information presented here is not specific to any individual’s personal circumstances. This is not an offer to buy or sell securities. No investment process is free of risk and there is no guarantee that the investment process described herein will be profitable. Past performance is not indicative of current or future performance and is not a guarantee. To the extent that this material concerns tax matters, it is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of avoiding penalties that may be imposed by law. Each taxpayer should seek independent advice from a tax professional based on his or her individual circumstances. These materials are provided for general information and educational purposes based upon publicly available information from sources believed to be reliable — we cannot assure the accuracy or completeness of these materials. The information in these materials may change at any time and without notice.