Market Recap

The U.S. economy and the stock market proved much stronger than many had anticipated in 2024, with the market marching higher throughout the year finishing up 25%, while notching 57 new all-time highs, the sixth most since 1928. The robust gains in U.S. stocks were driven by a healthy U.S. economy, moderating inflation, and widely expected rate cuts from the Federal Reserve. Within the U.S. stock market, larger-cap value stocks and smaller-cap stocks lagged ending the year up 14.4% and 11.5% respectively. Overseas, returns were not nearly as strong, as foreign stocks posted a modest 3.8% gain. Foreign markets were dragged down by fourth-quarter losses following the Trump presidential victory, which sparked fears of a widespread economic slowdown due to tariff risks and a stronger U.S. dollar. Within the bond market, the benchmark 10-year Treasury yield experienced significant volatility. After starting the year with a yield of 3.88%, the 10-year Treasury ended the year higher at 4.58%. Against this backdrop, the broader bond market was just slightly positive at 1.3%.

Investment Outlook 

Looking ahead, we remain cautiously optimistic as we enter 2025, as our base-case is that the U.S economy will continue to grow, albeit slower, with a low probability of recession. This should be a supportive backdrop for both bonds and stocks, although we expect the pace of gains to slow. While there are promising signs of growth and resilience in the economy, we are also acutely aware of the potential risks that could negatively impact market stability. For example, the U.S. economy will likely downshift into a slower gear. We do not believe this slower growth, in and of itself, will cause a recession, but it does leave the economy more vulnerable to shocks, including significant policy changes from the new administration. Furthermore, the past two years of strong returns leaves valuations elevated.

While our economic outlook is generally positive, there are plenty of risks. For starters, following two consecutive years of strong returns for U.S. stocks, valuations are expensive and reflect a significant amount of investor optimism. Current valuation levels—particularly for large-cap growth stocks—suggest that there is less room for upside, and there is more downside risk if expectations are not met. Another consideration is a high level of concentration in top-weighted stocks, which could magnify volatility if any of these companies disappoint. The weight of top 10 stocks in the S&P 500 index have reached an all-time high at nearly 39%. While this narrow market leadership could persist for some time, the generals cannot lead the market higher into perpetuity. The infantry must join the battle for a healthy bull market to continue. Otherwise, the failure of a few companies to meet extremely optimistic expectations will drag down market cap weighted indexes. Outside of expensive starting valuations and market concentration, there are the usual suspects that could cause market volatility, including inflation, monetary policy, and uncertainty surrounding incoming President Elect Donald Trump’s fiscal and global trade policy. Investors should be prepared to weather occasional storms in 2025.

Within the bond markets, uncertainty has led to a very volatile year for the 10-year U.S. Treasury bond, reflecting the market’s sensitivity to economic conditions in an uncertain environment. In the first three months of the year, inflation pressures proved persistent, prompting the Fed to keep interest rates elevated. But as the year progressed, inflation began to trend lower, and the Fed delivered its first rate cut in four years in September. Since the Fed started cutting rates in mid-September, interest rates have increased by roughly 100 basis points (see chart). Looking ahead to 2025, the U.S. bond market is stuck between the Fed’s plans to cut interest rates and the risk of higher inflation and dramatically increasing federal debt levels. As was the case in 2024, we think 2025 will be another bumpy ride for fixed income. Regardless, today’s starting higher yields will result in competitive bond returns over the long run.

Portfolio Positioning

We continue to think it’s likely that the market will broaden out beyond large-cap growth stocks to include small and mid-caps and non-tech sectors of the market. As of year-end, our portfolios have a full strategic weighting to stocks, and we remain diversified across geographies, including the U.S., developed international, and emerging markets. Within our global equity allocation, we also remain neutral relative to our growth and value tilts. In fixed-income we continue to be underweight core bonds and interest rate risk relative to a traditional bond benchmark, while emphasizing exposure to flexible, shorter-duration and credit-oriented fixed-income allocations, which we think will generate better yields over time. Importantly, we are not “stretching” for yield, i.e., taking on excess risk to achieve attractive returns. Many of our exposures are investment-grade or are conservatively positioned within the high-yield space.  All in all, we are cautiously optimistic in the outlook for balanced portfolios, given reasonable valuations for the average stock and attractive 5-6% yields in intermediate-term bonds.

Closing Thoughts

Our investment approach attempts to navigate uncertainty rather than trying to predict precise outcomes. Instead of relying on pinpoint forecasts, we focus on understanding a range of possible scenarios and analysing their potential implications for our portfolios. By evaluating risks and opportunities across different economic and market conditions, our goal is to stack the odds in our favor, even in complex and volatile environments. Our focus will continue to be on identifying opportunities to improve long-term returns while being vigilant of the risks we are taking. By staying disciplined and opportunistic, we aim to navigate the complexities of the market and position our investments for long-term success.

As always, we appreciate your trust and wish you and yours a blessed new year. Please find the enclosed economic newsletter from Dr. Ray Perryman.

The Water Valley Investment Team