Investors’ love affair with past winners is insatiable. The ‘conventional wisdom’ on Wall Street is that semiconductors, US mega-cap growth stocks, and market cap-weighted strategies will continue to be the ‘big winners’ in 2025. Unfortunately, yesterday’s darlings seldom outperform in the future with the same risk-adjusted returns per unit of liquidity risk (this is important) as they did in the past. Paradigm shifts typically happen slowly and quietly, with most investors realizing after the fact.
Last year, we were bulled up in our 10 ETFs for 2024. This year, we are taking our bullishness down a notch. We find ourselves having to go into far corners of the market to produce an asymmetric risk/return (i.e., merger arbitrage, IPOs, spin-offs, banks, cryptos) given how expensive valuations have gotten in both equities (excluding US value, US SMID, and international) and fixed income. Outside of select pockets of the equity market, there are not many attractive opportunities in the US large-cap space. Hence, history suggests the market is overdue for a big, fat correction. The good news is that the Fed has a lot of levers to pull, with Fed Funds at the 4.50-4.75% range if the economy hits an air pocket.
The distribution of outcomes next year is much wider (valuations are largely expensive in the US large-cap index space, fixed income spreads are tight, multiple ongoing wars, strained relations between the two largest economies in the world, etc.). The US economy was improving (actually, it was getting stronger) before Trump’s red sweep, so the question now becomes how does the administration shift back to a pro-domestic policy without further increasing the deficit, sending bond term premiums higher, and reigniting inflation? It’s no small feat, and we believe it’s easy to see a scenario where left tail risks surface in 2025.
Owning Small Caps is a once-in-a-decade opportunity. The need to be more tactical is clear, with the S&P 500 Index forward PE at 22, and the index up over 59% from December 30th, 2022, through November 21st, 2024. It appears that the stars need to align for large-cap stocks to rally further (i.e., earnings have to be delivered). Estimate revisions will likely get revised higher now that election uncertainty is over. Companies have also piled billions into capex to not get behind the artificial intelligence movement, so productivity needs to increase, and margins improve accordingly.
The goal of this piece is to not only provide unique thought leadership but also to provide investors with actionable investment ideas.
Comments