High Altitude: Week of 3/10/25

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Stick with the Math

Corrections and volatility are the price that investors have to pay for superior returns, and we have reached that moment again when investors near and far are worrying about losing their gains. ??Remember, the market has historically gone up 60-70% of the time, which means it has gone against us 30-40% of the time. ?Maintaining our composure during that 30-40% is what separates the compounders from the whipsawed. ?

It’s an uncomfortable feeling not knowing whether a 5% drawdown will turn into a 25% bear market, but some things in life are unknowable.? Actually, most things are. ?All we can do is construct and calibrate our portfolios so that we can optimize risk-adjusted returns without losing too much sleep.? It helps knowing that the markets have always recovered from drawdowns, usually quickly but sometimes slowly, but its during drawdowns when our reptilian brains threaten to overrule our rational minds.

For many investors, risk is the permanent loss of capital, but another way to think of it is as a time factor: knowing that the markets have always recovered, will they do so before we need to draw on our savings?? That’s where portfolio constructions and the efficient frontier come in, as well as regular portfolio rebalancing.

For now, the S&P 500 is down 7.8% from its recent all-time high.? Since 1927, corrections of 5% have happened 57% of the time, while 10% drawdowns have happened 37% of the time.? In fact, we had one just last summer following a growth scare and the unwinding of the Yen carry trade.? Bear markets (20%) have happened 20% of the time, yet over the long-term, the stock market has compounded at 11% per year.? Investing is about cold-blooded math, and these are good stats historical to keep in mind while we worry about what comes next.

It Feels Worse than It is

The price action has been interesting, to say the least.? While you can barely even spot the correction on the chart below (which shows the cap-weighted S&P 500), it somehow feels worse than it is so far.

Maybe it’s a function of the market’s altitude, not only in terms of price but also valuation and positioning.? After all, the equity risk premium is in the bottom decile going back 100 years.? Or maybe it’s the knowledge that this cyclical bull market has now reached its median age of 30 months, while only half the stocks in the S&P 500 are in uptrends.?

Or maybe it’s the domination of the Nifty Fifty (or Mag 7), which have dominated the market since 2014, and are now so top heavy that the market likely can’t zig if those few stocks are zagging.?

Finally, if the current secular bull market started in 2009 (an assertion that I admit is not widely shared), then we are in year 16 of the super-cycle.? The last two (1949-1968 and 1982-2000) didn’t last a lot longer.?

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A Contrarian’s Market

What seemed like a confident post-election playbook a few months ago, consisting of a stronger US dollar, higher rates, US outperformance, and higher crypto, has so far become a contrarian head fake.? Non-US markets are outperforming while the Mag 7 has crumbled and Bitcoin is selling off even though its advocates are finally getting that strategic reserve. The chart below shows how dramatic the unwinding of the Mag 7 vs ex-US pair trade has been.? The narrative has gone from US exceptionalism to European revival.

Bookends

What is particularly interesting is that the downside leadership in the US is not just the Mag 7 but also small caps, while the middle of the market is treading water.? That’s a barbell trade that I did not see coming.

Here is the Mag 7, which is down 19% from its December high.? This last down leg looks a bit like a 3rd wave (which tend to be impulsive), suggesting that the decline is not done yet.

And here is the Russell 2000, which is down a similar 18% from its November high and now sitting on support.? So far at least, small caps have not benefited from the rotation out of the mega caps.

Left in the middle is the equal-weighted S&P 500, down 7.6% from its high. The SPW (S&P 500 Equal Weight Index) is also sitting on support, as measured by the December lows.? The middle of the pack is so far winning the relative performance race.

A Bump in the Road?

Of course, in the grand scheme of things, a 19% drawdown for the mega growers is not that meaningful, and it has barely put a dent in the long-term trend (both absolute and relative to the S&P 500).? So maybe this is all noise, much like last summer.

European Revival

On the other side of the return spectrum is the MSCI Europe index, fueled by geopolitics as well as the German election, leading to the prospect of a fiscal impulse as Europe beefs up its defense and infrastructure.

China & EM

It’s interesting that emerging markets equities have not really participated in the global broadening trade, except for China.? It’s a battle between the deep cyclicals and mega growers.? Note at the bottom the turn in the CRB (Commodity Research Bureau Index).? That’s a good proxy for global reflation.

Bitcoin: Selling the News

Meanwhile, despite the announcement of a Strategic Bitcoin Reserve, the crypto tourists have been selling, as evidenced by outflows from ETPs and a decline in open interest.? “Buy the rumor, sell the news” is a cliché that’s grounded in truth (as they all are).? ?Perhaps this correction will set up for the next launch, but for now, all eyes are on support at the $70k.

Whether Bitcoin got extended at $109k depends on what adoption curve model you use.? My two favorites are the internet S-curve and the power curve of Bitcoin wallet growth.? Per the chart below, we seem to have returned to a more grounded valuation level.

A Changing Leaderboard

The contrarian rotations above have significantly reshuffled the leaderboard, at least for now.? On top are the “reflation trades” of China, gold, commodities, and Europe.? At the bottom are the Mag 7, S&P 500, Bitcoin, and Ethereum.? The battle between trend-following and mean-reversion is amply on display here.

Efficient Frontier

The following chart (showing annualized volatility vs annualized return since 2020) shows just how outsized the Mag 7 and Bitcoin’s returns have become during the past 5 years.

Earnings & Valuation

What’s next for the “Mag 7 vs everything-else” trade?? In my view it comes down to earnings as the catalyst for relative performance, and valuation as the amplifier.? Below we see that a convergence is happening between earnings estimates for the non-US developed equities vs the US.? It’s what you want to see if you are bullish on non-US equities.? ?The reversal in the relative performance between the S&P 500 and MSCI EAFE index in recent weeks is just stunning.

Pass the Baton

We know that in the US the baton has been passed to earnings, which are now growing at double digits.? The P/E side, which had been contributing to the market’s return, is now starting to detract from it.? This is normal during the later stages of a bull market.

Valuations

The good news is that valuations are indeed coming down now, which of course is by definition true when price corrects while earnings are growing.? Below we see that the S&P 500 cap-weighted price to free-cash-flow (FCF) ratio is down 5 points, while the equal-weighted P/FCF ratio is down more than 3 points.? Progress.

The Dollar

One of the more stunning reversals has been the US dollar, which seems to be borrowing from the 2017 “Trump Trade” playbook.? This certainly helps the global rotation and commodity rally.

The Fed

For the Fed, renewed fears of a possible growth scare stemming from cuts in Federal spendings and a possible trade war have lowered the expected terminal rate from around 4% to 3.6%.? With the recent PCE (personal consumption expenditures) inflation report providing some good news, there is some added scope for another rate cut this year.?

However, the 5-year PCE rate remains very high at 3.8%, and if the natural rate is 1%, I don’t see the neutral rate falling much below 4% anytime soon.

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