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Greetings from the Northwest! With the new year beginning, it’s our usual practice to give a nod to the year past and an opinion or two about what’s to come. Underlying that habit is the concept that “what is done is done.” While this may be true, it’s also true that we are living in a continuous and unceasing flow of connected events that don’t always match up well with a year’s ending or beginning. Much is in play at the moment, and I find myself reluctant to express any firm predictions at this point. I enter this year with a simultaneous sense of optimism and caution. So much is happening so fast in the world and some of it might not work out the way we wish. I’m hopeful that Syria will begin to heal and that the larger conflicts around the globe will resolve into a peace that can last more than a few years, but each has the potential to become something worse than we imagined. Europe is in the throes of major political, economic and demographic shifts, and it feels like an inflection point is near; fingers crossed that they work this out sooner than later. It’s hard to imagine the Germans, specifically, not solving their energy and industrial policy difficulties, but they haven’t yet. Here in the United States, we’re so fortunate in our geography, our political legacy, and our amazingly creative private sector, that I cannot but help to feel a sense of optimism when considering the next year and those to follow. Our future is truly ours to create, and we have at hand the best tools on earth to make it happen. Sure, there are speed bumps and obstacles at every turn, but that’s the way it’s always been and always will be. We’ll continue to be challenged by the unequal exchange of technology and information with nations that don’t subscribe to our notions of freedom and openness, and we’ll self-impose limitations on our use of our natural and human resources, unlike some of our competitors. My optimism is not blind to the stock market risks, as we do need to work our way out of the extraordinarily high stock market valuations that we are seeing, and the highly priced and stagnant housing market, among many less obvious challenges, but that’s what we do, and it keeps us moving forward.
Truly, with a sense of optimism, I wish a Happy New Year to you all! Let’s see what Patrick has to offer on your investments, Patrick’s part: Patrick's PartCapital markets had a mixed finish to the year, with most indices, outside of the tech heavy S&P 500 and Nasdaq, flat or down. Even bonds showed weakness after the Fed cut rates in September, which might be counterintuitive since generally lower interest rates lead to higher bond prices (more on this later).  EquitiesIn our July letter, I wrote at length about a US equity market being characterized by high valuations and poor market participation. Market participation improved during the Q3, and I mentioned that was a silver lining for US stocks given the valuation backdrop we are working through. Well, that quickly reversed in November and we are now at levels we haven’t seen since 2008 when looking at the S&P 500 equal weight versus cap weight price performance.  Also, as the chart below shows, starting in October of 2022, there has been a widening disparity regarding valuations between the cap weighted S&P 500 and the equal weight version of the same index.  The same can be seen when looking at the performance and valuations of large cap growth versus large cap value stocks.  While we have no issue buying a company that is “classified” as a growth company (META in 2022, Booking in 2020, Alphabet in 2019) if the price it is being offered at reflects a margin of safety based on the fair value of the company. As the valuation chart below shows, that is hardly the case currently.  The lack of market participation outside of a handful of large-cap tech disruptors triggered a condition on 12/18 that we don’t witness very often. The chart below shows the S&P 500 with highlights of instances where the index was trading more than 5% above its 200-day moving average (positive trend), while less than 60% of its constituents trading above their own 200-day moving average (negative trend). Outside of 2000, 2007, and 2021 instances, severe market losses were avoided, but volatility increased.  Market participation can improve in one of two ways, either the majority of the index participants catch up to the few stocks that have been outperforming, or the concentrated winners catch down to the rest, dragging the rest of the index with it. While he would prefer the prior to happen, we must be prepared for either outcome with valuations sitting at such high levels. I have heard recently from pundits arguing that solid economic activity based on the boom in AI growth and more accommodative Fed policy justify high valuations. My observation is, yes, AI growth could shift valuation expectations if we reach a permanent higher level of economic activity based on technological advancements and productivity growth from those advancements. But looking at the chart below which measures the value of US stocks to our Gross Domestic Product, I think that is more than represented in current prices.  Most investors have already erased from their memory how 2022 was characterized by falling equity and bond prices as high valuations driven by the story of Covid, stay-at-home and disruptor stocks would escort a new era of growth, collided with a shifting narrative around the sustainability of the work-from-home transition combined with rising inflation. In fact, US small cap and international stocks have underperformed a simple money market fund since 12/31/2021, with the S&P 500 Equal Weight and Cap Weight indices taking until early 2024 to surpass it.  This euphoric environment has left retail investors the most exposed to risk assets that we have seen in the last 25 years. The chart below is a combination of investors’ allocations to stocks and their expectation for positive returns this year.  Not to say that equity investors will not experience positive returns in 2025, but historically, “above average” returns are born from environments of pessimism where valuations are low, allocations to stocks are low, and expectations for returns are dismal. We are nowhere near that type of environment. Fixed IncomeOn September 18th the Fed started its shift in monetary policy to be more accommodative by lowering the fed funds rate by 0.50%. Since then, lowered the rate two more times by 0.50% to a target rate of 4.50%. One might believe that lowering short term rates would shift all maturities of the treasury yield curve lower since historically lower rates are a byproduct of lower growth and inflation expectations. As the chart below shows, the exact opposite happened with the yield curve. Short term rates did in fact shift downwards, but in contrast to what many pundits anticipated, long term rates (10+ years) have moved upward in dramatic fashion signaling that the bond market is not convinced inflation has been tamed enough to warrant cutting interest rates and we can’t say we disagree. As I wrote about last quarter, the shift upward in long-term rates potentially poses a large risk to US government spending as over $7 trillion in bonds mature over the next three years. The benefit of higher long-term rates for investors is you can now earn a more competitive return for taking on the risk of holding longer dated bonds then you were just a few short months ago.  As the US treasury bond market has become more attractive, the same cannot be said for the corporate bond market. Yield spreads remain at historically low levels (see below), meaning investors are not getting paid a lot in extra yield to compensate for the credit risk that is taken by investing in lower quality bonds. Entering 2025, our fixed income portfolios reflect the current rewards and risks in the fixed income markets.  Portfolio PositioningAs we start the new year, portfolios still have a conservative bias for the reasons we have written about above and in other letters throughout the last 12 months. That is not to say we are not taking on risk in equity markets, we are just not fully invested. We still view international markets offer more compelling valuations than US markets, however, the US dollar strength has weighed on that opportunity over the last year. Also, high quality, value stocks offer good long-term returns when compared to other pockets of equity markets in the US. Our data driven process relies on understanding the price we are paying for a company or asset class and then buying those investments with enough margin of safety in case we are early or flat out wrong, so that downside risk can be managed. When the facts change, we change our mind and with the allocation to cash and money markets, we can get more aggressive or more conservative based on what the data and market environment dictates. Risk management is a high priority right now which seems in conflict with what you read in headlines and see in the news. Unfortunately, most investors only buy insurance (i.e. get more conservative) after they have been in an accident, not before when it is needed the most. We are here to grow your wealth over time in a thoughtful risk-managed approach and will continue to do so. Thank you for your continued support and trust and please do not hesitate to reach out to me with any questions or comments. —Patrick Mason
Thanks Patrick, lots to consider as we move into the new year. Normally, I’d invite you down for a cup of coffee if you’re in the area, but that may need to wait a few months as we purge our decades-old furniture, remodel the office, and get everything redecorated. Hopefully, we’re done with all that by June, at which point we’ll be excited to have visitors.
Happy Trails, Tim Mosier, President Cairn Investment Group, Inc. Comments are closed.
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