Market Commentary Q4 2024

Inflated Expectations

As we cross the halfway mark of the decade, we find it worthwhile to consider how far the pendulum has swung in terms of the economy and sentiment in such a relatively short span of time.

The S&P 500 produced an annualized total return of 14.5% for the five years ending 12/31/24, a period that included two separate market declines of more than 25%, one triggered by a global pandemic and unprecedented economic standstill, the other by the inflation surge that followed. In a period not devoid of reasons to be cautious, the S&P 500 was able to post total returns greater than 25% in three of those five years. 

It is a reminder to us that investors seldom “earn” their equity returns by experiencing a bunch of average years in the stock market. They typically do so by living through the volatility of many above-average years and some below-average years, with plenty of reasons to be skeptical along the way.

Just two years ago, the consensus heading into 2023 was for an imminent recession that never materialized. Instead, economic growth consistently surprised to the upside, and the S&P 500 posted its best back-to-back years since the late 1990s. We are reminded of the old joke that macroeconomists have successfully predicted nine out of the past five recessions.

The U.S. economy remains the beacon of strength globally, supported by a resilient consumer and, in our opinion, structural advantages for capital formation. This has led to capital inflows and persistent strength in the U.S. dollar, despite what we see as an unsustainable level of deficit spending from the U.S. government, typically reserved for an economic crisis.

Moving forward, we believe that growth will be dependent on improvements in economic and corporate productivity, at least partly supported by success in technological innovations such as artificial intelligence (AI). As of now, those benefits have primarily flowed to companies benefiting from the buildout of AI infrastructure, with the return on these investments still in question. Corporate earnings estimates for 2025 and 2026 are well above historical averages, and to us, somewhat contingent on these investments paying off, through AI or otherwise.

Stock market leadership has remained historically narrow with U.S. large cap technology companies taking an increased share of both earnings and index weightings this past year. While we would expect participation to broaden out, the rest of the market has recently disappointed relative to earnings expectations, and relative to the financial performance of the market’s leaders. As a result, the average stock trades at a considerable discount compared to the market as a whole, and we continue to find better value in deploying capital down the market cap spectrum, while keeping a bias towards quality.  

The bond market has started to discount the possibility of interest rates staying higher for longer. Despite the Federal Reserve cutting the Federal Funds rate a full percent from September through December, the 10-year Treasury yield actually increased nearly a full percent from the September cut through the end of the year. Expectations for future rate cuts have come down, while the long-term “neutral” rate from the Fed has ticked higher.

We anticipate trade, deficit spending and other policy risks, as well as the general momentum of the economy will likely drive the direction of interest rates next year. As it stands today, Treasury yields trade near our estimate of fair value, with resurgent inflation as a primary risk for bondholders.  

Overall, risk premiums have narrowed across the investment landscape. Corporate credit spreads hover near 25-year lows and the S&P 500 trades for 22x forward earnings estimates, well above its long-term average.

In our opinion, the increase in both absolute and relative U.S. large cap equity valuations can be at least partly explained by the improving profitability and constituent makeup of the S&P 500 index. Even so, the implied hurdle rate is much higher, broadly speaking, with valuations where they are today. As a result, our own base return expectations are now meaningfully lower for the back half of this decade. While our overall expectations are somewhat muted, we also believe that strong businesses tend to surprise to the upside over time. We remain focused on owning businesses with sustainable competitive advantages, long reinvestment runways with above-market growth, and reasonable valuations.

As always, thank you for your confidence and should you have any questions, don’t hesitate to reach out.

Sincerely,

Jack Holmes, Chief Investment Officer

Market Commentary Disclosure

Market Commentary Q3 2024

Market Breadth Improves as the Fed Pivots

For the first six months of the year, the stock market rally was relatively narrow, driven by superior earnings strength and performance of mega-cap technology stocks. In the third quarter, we saw early signs of a potential shift in leadership with cyclicals and small caps outperforming. Only 25% of stocks in the S&P 500 managed to outperform the index in the first 6 months of the year, the lowest since 1999. Over 60% of stocks outperformed the index in Q3, the highest level since 2002. 

We would attribute at least part of this change to interest rates moving lower, as rate-sensitive sectors tended to outperform. In any case, this looks to be a healthy rotation in what has been a very strong two year run for the stock market. As we look out into 2025, earnings growth is expected to broaden out, which may support more expansive market participation, assuming results live up to expectations.

The 2-year Treasury yield dropped more than a full percentage point from July through September, as anticipation for rate cuts gained momentum. The Fed may have had sufficient rationale to lower rates in July following tepid inflation and employment reports, but instead opted for a 50 basis point reduction in September, forecasting another half percent reduction by year-end. Regardless of the timing of future rate moves, we would expect yields on cash to be much lower by the end of 2025, unless inflation resurfaces or economic activity materially accelerates.

Now that we have the long-awaited first interest rate cut of this cycle, many investors may be wondering what that means for the stock market going forward. Looking back to prior cycles would tell us that the subsequent results are mixed, but the economic environment in which the Fed shifts to accommodation seems to matter. 

Since 1970, there have been seven instances in which the Fed started cutting rates when the economy was not in a recession. The S&P 500 was higher a year later in all 7 instances, by an average of 15.8%. In the 5 instances in which the Fed started cutting rates during a recession, the S&P 500 was lower a year later by an average of 2.3%.

While things can change, we do not believe the U.S. is currently in a recession, nor on the immediate verge of entering one. Economic growth continues to surprise to the upside, with Q2 gross domestic product (GDP) recently getting revised upwards to 3% growth year-over-year. As of September 30th, third quarter GDP was also projected to grow between 2-3%, according to the Atlanta Fed’s GDP Now indicator.

As pandemic-era stimulus benefits continue to fizzle out, the consumer is starting to face some headwinds, evidenced by rising credit delinquencies, especially on the low-end of the economic scale. Thus far, economic growth has remained resilient, and loosening of monetary policy may slowly help to ease the interest burden for those needing to borrow. Two likely beneficiaries are small companies, who often rely on access to financing tied to floating rates, as well as homebuyers who have stalled on purchasing from the combination of higher rates and rising home prices. 

Less clear to us is how the U.S. government ultimately handles its own massive debt burden that continues to compound from rising interest costs and deficit spending. Historically, running such large fiscal deficits has been reserved for emergency responses to recessions, not when economic conditions are as healthy as they are today. The annualized net interest cost on the nation’s outstanding debt recently surpassed the annual defense spending budget for the first time ever. This seems unsustainable, but we don’t see this changing in the near-term, regardless of who wins the election.

“Buy into a business that’s doing so well an idiot can run it, because sooner or later, one will. The U.S. is sort of like that.”

-Warren Buffett

This Buffett quote is more akin to the evaluation of economic moats for businesses, but we might consider that appropriate when evaluating the implications of policymakers overseeing the U.S. economy. Regardless of who wins the election, we still believe the U.S. holds structural advantages for investors over the long-term. American businesses have demonstrated over time that they can adapt and thrive regardless of who is in public office, as evidenced by stock market returns under both republican and democratic leadership.

The upcoming election will likely take at least some of the spotlight for investor sentiment in the near-term. And while elections matter, we believe they matter less as it relates to forecasting expected returns for the stock market. Investors would be better served to leave politics out of their investment decisions, in our view.

Overall, the S&P 500 is off to its strongest 9 months to start a year since 1997. We believe this is driven by above-average earnings growth that has so far lived up to expectations. Expectations are even higher as we look forward into 2025, with stock valuations presumably discounting substantial earnings growth to come.

This sets the bar very high for upside surprises moving forward, likely requiring more expansive participation across the market, supported by a healthy and growing economy.

In conclusion, I would like to take a moment to express my gratitude for your ongoing support of Bridges Trust. As I move forward in my new role as Chief Investment Officer, I am committed to providing valuable insights as we navigate the evolving capital market landscape together. If you have any questions or would like to discuss this further, please don’t hesitate to reach out to your Relationship Manager.

Sincerely,

Jack Holmes, Chief Investment Officer

Market Commentary Disclosure