Stocks And Bonds Through The Looking-Glass

Rather than the typical market outlook, fraught with all the dangers of being a soothsayer, this outlook will endeavor to take a journey like Lewis Carroll’s Alice to find some reality in markets that can sometimes seem unreal or irrational. Rather than looking into a crystal ball, examining what is currently priced in financial markets and whether it is reasonable can be more helpful.

After beginning the year with low expectations, the U.S. economy has outperformed expectations in 2024, with growth expected to be near 3% when the final numbers are tallied. While the forecasts for 2025 economic growth have improved, most economists expect growth to moderate to something close to the U.S. economy’s long-term potential growth rate of around 2%.

Looking at the change in last year’s GDP estimates tells you that they are rarely very accurate at the beginning of the year. Considering all the crosscurrents, one should look at them with a particularly jaundiced eye. Will the Trump administration’s removal of regulatory burdens keep the economy rolling, or could the potential implementation of tariffs produce a headwind? Will there be some external shock to the economy?

In the end, the 2%-plus economic growth rate is reasonable, but assigning a low conviction level to the forecast is proper. The U.S. economy has some momentum going into the end of the year, but there are some signs of softness in the crucial labor market.

If you don’t know where you are going, any road will take you there. – The Cheshire Cat

The Federal Reserve, observing some moderation in job growth and a tight monetary policy, began lowering short-term interest rates in September. After the latest 25 basis point (0.25%) rate cut on December 18, the Fed has decreased short-term interest rates by a total of two percentage points.

Following the Fed meeting, Chair Powell signaled that the central bank would likely pause rate cuts in January to assess expected economic conditions. Still, he noted that monetary policy remains tight, which implies that more rate cuts will come. In addition, the Fed’s median forecasts called for two 25-basis-point rate cuts in 2025. Fed fund futures have two rate cuts in 2025 as the most likely outcome. Both the Fed forecasts and Fed fund futures have been notoriously inaccurate, so it might be wise to assume it won’t be two rate cuts!

Why sometimes I’ve believed as many as six impossible things before breakfast. – The White Queen

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A reasonable model for the fair value yield on the U.S. 10-year Treasury is that it should approximate the nominal GDP growth, which is real GDP plus inflation. The ultra-low interest rate period following the 2009 global financial crisis through Covid showed 10-year yields well below fair value levels. Still, the Fed’s monetary tightening and more typical economic conditions have brought them back closer in line again.

With the 10-year Treasury yield around 4.6%, investors are back to receiving reasonable compensation for taking on interest rate risk. The bond market expects long-term inflation of about 2.3%, so investors are demanding a 2.3% real (after-inflation) return from the 10-year note. This 2.3% real expected return is close to the average from 1999 through 2008 and above the 2.1% median for that same period.

So, while bonds don’t appear extremely cheap, they are back to providing a reasonable risk/reward and should be a good diversifier if stocks decline due to an economic downturn. With consumer inflation (CPI) currently at 2.7% year-over-year, one needs to expect it to moderate over time. However, even if inflation holds steady, bonds should still provide a satisfactory after-inflation return.

Shifting our attention to U.S. stocks, the current situation is pricing in a benign, if not downright optimistic, economic backdrop. The more economically sensitive cyclical stocks have been trouncing less economically impacted defensives this year. Further, S&P 500 earnings are expected to increase by over 12% in 2025 after 9% growth in 2024. With such a positive economic outcome already reflected in the market, some allocation to the underperforming defensives like consumer staples and healthcare seems like an intelligent move for 2025. It isn’t that this economic outcome and economic growth aren’t achievable; it is that the hurdle is sufficiently high to want some cushion.

It would be so nice if something made sense for a change. – Alice in Wonderland

Interestingly, the increase in stock valuations makes more sense than it would seem on the surface. Based on a 22-times multiple of next year’s estimated earnings, also known as the forward price-to-earnings ratio, stocks do not look cheap relative to the past. However, historically, the price-to-earnings (P/E) ratio is correlated with return-on-equity (ROE), which measures how efficiently companies produce profits from the capital provided by their shareholders. Though ROE is down from its recent highs, it remains above average and argues for an above-average P/E ratio, assuming this elevated ROE is sustainable. Consensus estimates call for return-on-equity to rise to 19% in 2025, up from 2024’s 17.8%. To provide perspective, the S&P 500’s ROE was 15.1% in 2019 before the pandemic.

Like the exceptional return on equity noted earlier and supporting the rich stock valuations, profit margins are elevated relative to history. Profit margins measure the percentage of top-line sales that become bottom-line profits. As a business owner, higher profit margins, all other things being equal, are more valuable. Notably, the profit margins for the technology sector are close to double the market. In addition, technology sector earnings will likely grow at almost double the pace of the S&P 500 this year and are forecast to rise by about 20%, outstripping the S&P 500 again next year. This combination of better growth and profitability explains why the technology sector has soared by 39% this year and helped lift the S&P 500 to a roughly 29% total return year-to-date.

Warren Buffett says, “The value of a business is the cash it’s going to produce in the future, discounted back to the present.” Free cash flow measures the cash left over after a company supports its operations and maintains or invests further in its business. Thus, free cash flow provides a good measure of the money accruing to shareholders as owners.

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Free cash flow yield is the free cash flow divided by the stock price. Consistent with price-to-earnings, cash flow yield points to a stock market that is not cheap, though it has been more expensive at times in the past. This metric assumes free cash flow remains static, so it can also be interpreted as investors having more confidence that free cash flow will continue to grow. Indeed, investors should be willing to pay more for a company in which one can have high confidence that the corporate profits accruing to owners will continue to grow.

As a subset of the S&P 500, technology stocks are priced at an even lower free cash flow yield. This valuation premium reflects the optimism about the future of many of these companies and, in recent history, the superior fundamentals of the group. The profit margins and earnings growth rate for the technology sector have been exceptional, which helps explain the premium valuation assigned by the lower free cash flow yield.

Off with their heads! – The Queen of Hearts

Warren Buffett once said, “Interest rates are like gravity in valuations. If interest rates are nothing, values can be almost infinite. If interest rates are high, that’s a huge gravitational pull on values.” While bond yields are well above the pandemic lows, valuations have yet to feel any meaningful squeeze from this increase. This continued elevation of valuation is likely due to offsetting the gravitational pull by better profitability, optimism about artificial intelligence, and economic resilience.

What the wise man does in the beginning, the fool does in the end. – Warren Buffett

History has only a few past examples of back-to-back 20%-plus calendar year returns like those we will see from the 2023 and 2024 period. The 1935 to 1936 robust rally was followed by an ugly 39% decline in 1937. The bull market of 1954 and 1955 led to a subpar 1956, then a swoon of 14% in 1957. The monstrous rally of 1995 to 1999, which would come to be known as the tech bubble, imploded with three straight years of declines from 2000 to 2002.

There are three primary takeaways from this history. First, these rallies can go on longer than you think. The tech bubble, fed by the promise of the internet and e-commerce, is a prime example. While the internet did change the world, the valuations got too steep. Many of today’s technology giants are exceptional businesses and seem to be benefitting from the next big thing: artificial intelligence. So, there is no law that they must decline or falter in the coming year. Second, these positive results put us closer to rarified air, so it would not be shocking to see a more volatile year in 2025. Lastly, despite the pain of any market declines, stocks have always rebounded (eventually) and provided the highest return of any asset class over the long term.

Bond yields look to be reasonable compensation for the risk that inflation rises or fails to moderate. At these levels, bonds should be back to being able to provide their historical function of income generation and diversification in the case of a sharp decline in stock prices.

Stocks are priced for a benign economic outcome and support from the Federal Reserve. Further, improving corporate profitability and double-digit earnings growth are likely needed to retain elevated valuations. This outcome is certainly possible, if not the most probable, but investors should be mindful that the hurdles at these valuation levels are higher. Diversification with stock portfolios should be considered since technology and some economically sensitive stocks have been the outsized winners. So, looking amidst the wreckage in healthcare and consumer staples could prove fruitful, particularly if the economy disappoints or the artificial intelligence wave hits some turbulence.

As 2025 nears, investors should revisit their risk tolerance since the two-year robust stock rally has likely increased their allocation to risk assets. Rebalancing stock and bond allocations toward the target risk level is wise for many investors, especially once we turn the calendar to the new tax year. The key to successful long-term stock investing is staying invested during the tough times that inevitably come since the rebounds from those bear markets are typically massive and unpredictable in timing. Keeping enough investments in more stable or income-producing assets can provide enough comfort to help ride out rough markets without selling stocks at inopportune times.