CONTRIBUTORS
Sam Peters, CFA
Portfolio Manager
Key takeaways
- As they age, bull markets often find investor confidence increasing while valuation excesses remain hidden, but these excesses and related risks can quickly grow too large to ignore.
- Overall, we see three main scenarios for 2025: continued Goldilocks/soft landing, cyclical inflation upside and a recession.
- Our goal is resilience at every level by targeting companies with low absolute valuations and good compounding fundamentals that ask little of the future and which can thrive in different macro and market environments.
US value starts year at historical lows vs. growth
As they age, bull markets often find investor confidence increasing while valuation excesses remain hidden, but these excesses and related risks can quickly grow too large to ignore. There is a very good reason that valuation is being ignored by investors today: despite an absolute return for the Russell 1000 Value Index (RLV) of approximately 19% over the last two years, the Russell 1000 Growth Index (RLG) outperformed this by more than 4x for an absolute return of 87%. That makes this the worst two-year relative period for value in 45 years, comparable only to the two-year periods that ended with growth bubbles bursting in 2020 and 1999. This resulted in the total return ratio of value relative to growth dropping to 40-year lows.
Exhibit 1: Value to Growth Drops to 40-Year Lows
As of Dec. 27, 2024. Source: ClearBridge Investments, FactSet.
Absolute valuation measures of the market have also risen to historic extremes. One of our favorite measures of long-term valuation comes from Warren Buffett, who argued that the total value of equity market capitalization relative to the overall economy was “the best single measure of where valuations stand at any given moment.” That measure climbed to historic highs of 230% in 2024. However, given the extreme concentration of US markets in mega cap stocks, an arguably better measure narrows the Buffett indicator to just the 50 largest US stocks. By this measure, valuation extremes tower above the 2000 internet mega cap bubble and the growth liftoff during COVID.
Exhibit 2: Buffett Ratio Highlights Extreme Concentration
As of Dec. 31, 2024. Source: Kailash Capital Research, LLC. -6% total return includes dividends reinvested in the index for the period March 31, 2000, to March 31, 2010. 336% total return includes dividends reinvested in the index for the period Feb. 27, 2009 to Feb. 28, 2019. Gross Domestic Product (GDP) is an economic statistic which measures the market value of all final goods and services produced within a country in a given period of time.
When valuations have historically achieved extremes even below current levels, they have weighed heavily on forward long-term returns. If history is any guide, the next decade should generate passive US equity returns ranging from negative to low single digits—well below rising investor expectations of sustained double-digit returns from passive equity beta. But active managers like us need not accept extreme valuations; instead, we have the flexibility to hunt in areas of the market left behind by the AI momentum trade.
Three possible paths for 2025
We think 2025 will be full of surprises, with the contradictory nature of Trump policies likely at the center of them. Overall, we see three main scenarios for 2025: continued Goldilocks/soft landing, cyclical inflation upside and a recession. The first appears to be what the market is pricing, yet the others are both distinct possibilities.
- Continued Goldilocks: This is supported by a continuation of lower inflation and Fed easing and combined with a pro-business Trump agenda from tax cuts and lower regulation. We do think we will see increasing deal activity and that the animal spirits of optimism will continue. Look no further than the massive investment spending around AI. We are also seeing signs that bank loan growth is accelerating, which would further support growth. The true silver lining of this scenario is that we would expect the market to sustainably broaden out as the relative earnings growth of the market outside of the Magnificent 7 is positioned to accelerate meaningfully. This is also where our own material earnings and free cash flow growth advantage versus our index could really matter in driving absolute and relative returns.
Exhibit 3: Earnings for the S&P 493 Are Set to Accelerate
As of Dec. 31, 2024. Source: FactSet, Russell, S&P. Magnificent 7 data refers to the following set of stocks: Microsoft (MSFT), Amazon (AMZN), Meta (META), Apple (AAPL), Google parent Alphabet (GOOGL), Nvidia (NVDA), and Tesla (TSLA).
- Inflation upside: It wouldn’t take much for the economy to run too hot. Inflation seems to have bottomed well above the 2% Fed target and, in addition to its already moderately rising, many of Trump’s policies including tariffs and immigration are directly inflationary. Additionally, we think it will be very difficult to contain the fiscal largesse that a dysfunctional political system has become addicted to. In addition, the animal spirits and accelerating loan growth mentioned above are both inflationary impulses that have been missing over the last few years. The market is not positioned for inflation risk, and we are concerned that higher long-term Treasury yields in this scenario would start to weigh heavily on market valuations. Our insurance against this scenario is our overweight to commodity sectors, with energy being our biggest overweight, and why we own names that are beneficiaries of higher rates, like life insurance.
- Recession: A recession seems like a low near-term probability given current observation. However, the main paradox in Trump policies is if the Department of Government Efficiency (DOGE) has any success in cutting the US$2 trillion in government spending they are targeting, the economy would slow dramatically from much lower fiscal spending. The ability to meaningfully cut deficits and withstand resulting political pain seems quite remote, but how much are you willing to bet against Elon Musk if his support from Trump holds up? Fortunately, we do not have to make a major bet against Musk’s efforts as defensive sectors and low-volatility stocks have all fallen out of favor given the recent jump in animal spirits. Many defensive sectors, as highlighted by health care being the worst performing sector in 2024, have surfaced good absolute value that we are taking advantage of. Adding to defensive names on sale accounted for most of our portfolio activity in the fourth quarter.
While we consider these scenarios in our process, we do not position the portfolio for any one of them. Our goal is resilience at every level, starting with low absolute valuations and good compounding fundamentals that ask little of the future. We then add a critical layer of diversification by owning companies that would thrive in different macro and market environments. This positions us well to adapt to the inevitable surprises that 2025 will surface.
Definitions
S&P 493 is known as the S&P 500 Index excluding the seven technology stocks (Magnificent Seven). The S&P 500 Index is an unmanaged index of 500 stocks that is generally representative of the performance of larger companies in the United States.
The Russell 1000 Value Index measures the performance of the large- cap value segment of the US equity universe.
The Russell 1000 Growth Index measures the performance of the large- cap growth segment of the US equity universe
The Russell 2000 Index is an index of domestic small-cap stocks that measures the performance of the 2,000 smallest publicly traded US companies in the Russell 3000 Index.
The stock market capitalization-to-GDP ratio is a ratio used to determine whether an overall market is undervalued or overvalued compared to a historical average. It is also known as the Buffett Indicator—after investor Warren Buffett, who popularized its use.
The Department of Government Efficiency (DOGE) was created by US President Donald Trump via an executive order on his first day back in office. Trump put technology billionaire and adviser Elon Musk in charge and vowed to use the unit to cut government waste and slash federal regulations.
WHAT ARE THE RISKS?
All investments involve risks, including possible loss of principal. Past performance is no guarantee of future results. Please note that an investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges.
Equity securities are subject to price fluctuation and possible loss of principal. Large-capitalization companies may fall out of favor with investors based on market and economic conditions. Small- and mid-cap stocks involve greater risks and volatility than large-cap stocks.
Commodities and currencies contain heightened risk that include market, political, regulatory, and natural conditions and may not be suitable for all investors.
US Treasuries are direct debt obligations issued and backed by the “full faith and credit” of the US government. The US government guarantees the principal and interest payments on US Treasuries when the securities are held to maturity. Unlike US Treasuries, debt securities issued by the federal agencies and instrumentalities and related investments may or may not be backed by the full faith and credit of the US government. Even when the US government guarantees principal and interest payments on securities, this guarantee does not apply to losses resulting from declines in the market value of these securities.