Investor Letter 1Q 2025

Investors & Friends,

My wife and I attended our twenty-year high school reunion in 2024. As I write this letter and reflect on this trip around the sun, I feel increasingly aware of the quickening passage of time—having a 5-year-old child will do that for you!

A sincere and heartfelt thank you to everyone reading for your trust and confidence. Cheers to your wealth, both financial and otherwise, in 2025.

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I find the following four points from Jeffrey Buchbinder, CFA, Chief Equity Strategist at LPL Financial, to be a solid starting point for considering themes for 2025:

1) No recession. The bull market, which has entered its third year, has advanced more than 67% since it began on October 12, 2022. History suggests that this bull market has a good chance of celebrating its third anniversary if the U.S. economy continues to grow.

2) A supportive Federal Reserve (Fed). LPL Research’s base case remains for at least two cuts next year as inflation comes down further, which should be good for stocks. The S&P 500 has produced modest gains of 5.5%, on average, during the 12 months following the initial cut of a Fed cycle, with gains typically double that in the absence of recession.

3) Strong earnings. When valuations are as high as they are currently, earnings growth is typically required to lift stock prices. Expect 2025 to be one of those years. Corporate profits carry the potential to grow at a double-digit pace, backed by steady but slower economic growth, limited wage inflation, artificial intelligence (AI) investment and related productivity gains, and deregulation.

4) Fiscal, trade, and regulatory policy offers more upside than downside. Markets are pricing in a lot of policy optimism for next year. Trump 2.0 is expected to reduce regulations and cut taxes while using the threat of tariffs more than tariffs themselves to achieve policy objectives. For stocks to enjoy a good year in 2025, policy from the Trump administration will have to deliver more benefits than costs.

Let’s explore each of these four points in more detail.

1) Momentum Matters.

One of the most powerful forces in markets is momentum. As the saying goes, "Bull markets don’t die of old age," and even if they did, this one would still be a teenager by bull-market standards. The chart below illustrates the sixteen bull markets since 1921, with the blue bars representing their length in months (left axis) and the yellow dots indicating cumulative returns (right axis). The current bull market is neither long-lived nor exceptionally strong. While every bull market remains vulnerable to an unexpected external shock, this one doesn’t appear to be nearing its natural end.

2) Interest Rate Roulette

This point is likely the biggest wildcard. Will tariff policy, immigration policy, and fiscal policy contribute to a resurgence of inflation, prompting the Federal Reserve to delay or reduce interest rate cuts further?

The chart below illustrates this uncertainty, comparing the Federal Reserve’s interest rate forecast (in blue) with the market’s expectations (in green). Notably, the market appears skeptical of the Fed’s projections, anticipating that rates will stay higher for longer than Fed officials currently suggest.

3) Time for Earnings to Shine

For the bull market to continue, corporate earnings will need to be strong. Valuations are already stretched above historical averages by 1 to 2 standard deviations, meaning the “E” in “P/E” will now need to drive further gains.

The good news is that consensus expectations support this outlook. The panel below shows EPS growth components on the left and corporate profit margins on the right. Current projections estimate year-over-year earnings growth of 15% in 2025 and 13% in 2026. To sustain the market’s upward trajectory, these growth targets will likely need to be met or exceeded.

4) Policy & Politics

We generally agree that the potential upside from policy changes is more impactful and likely than the downside risks. We expect tariffs to remain targeted, while deregulation and fiscal stimulus should provide tailwinds for economic growth. However, the greater risk may be that these tailwinds become too strong, reigniting inflation and prompting a resurgence of higher interest rates. A 10-year Treasury yield rising back toward or above 5% would not be supportive of either stock or bond prices.

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The S&P 500 closed the year at 5,881, up nearly 24% for the year, marking the first consecutive 20%+ annual performance since 1997-1998. Once again, this far exceeded the forecasts of every market analyst we reviewed last year. As a refresher, here’s where consensus expectations stood at the beginning of the year. Notably, Ed Yardeni from Yardeni Research, who was the most accurate in 2023, was among the closest again for 2024, predicting a double-digit gain, though still about 10 points below the final result.

An excerpt below from our 2023 year-end letter:

“I’ve highlighted Yardeni here again, as the most accurate analyst of 2023 predicts another big year in 2024.?We tend to agree.?You could highlight myriad reasons why the markets and economy will do well / poorly in the coming year but one of our biggest reasons for being positive is this:”

Last year, we highlighted the massive buildup of cash in money markets as a potential source of buying power, so let’s check in on this same data for 2024, did any of that money market cash get spent down or find its way into the equity markets, causing this year’s run-up in prices?

Answer: NO! In fact, there is now $1.25 trillion MORE in money market funds than there was this time last year.

Investors and pensions and institutions have been flocking to the safety of 4+% money market yields consistently all year long.

It is because of this that I am betting that any significant correction will still be bought and if the Fed continues to cut rates, eventually the money market will lose its relative attractiveness, and this mountain of cash will need to find a home.

Where do the analysts line up for 2025?

The consensus outlook is much more positive this time around, which, to be honest, gives me some pause—market forecasts are rarely very accurate! However, while we don’t expect to get through the year without experiencing another 10% drawdown, we do believe that dips will be met with buying, interest rates will trend lower as the base case, and the bull market will complete its third year.

Our projection puts the S&P 500 in the 6,200-6,400 range by year-end, though we anticipate a dip back toward the mid-5,000s at some point during the year. It would be highly unusual to go three years without a 10%+ correction.

What are some reasons to be positive?

Let’s start with the bedrock of the US economy, the American consumer. Our GDP is 70% consumer spending, it is the whole ballgame.?

Here, we see three panels on U.S. consumer finances: the balance sheet on the left, household debt service in the top right, and consumer debt delinquencies in the bottom right. Debt service is particularly informative, as it suggests households are not overly leveraged. While it has risen back to pre-pandemic levels, it remains well below the peaks observed prior to the Financial Crisis.

Flows into early delinquencies, which we've previously identified as a potential early warning sign, are currently flashing a yellow caution light. This will be an important trend to monitor closely.

Just as encouraging as the health of the U.S. consumer is the strength of the companies in our equity portfolios. Corporations are far more profitable, with stronger balance sheets and greater free cash flow than in the past—especially among larger and mid-sized companies.

Reasons to be cautious?

Perhaps most notable are the elevated valuations. Stocks are not cheap by any measure. We've discussed this topic several times on the Finance Footnotes podcast (find us on YouTube!), noting that the evolving market structure—more profitable companies (as mentioned earlier), a shift toward a service-based economy, and the increasingly top-heavy nature of the index—makes historical valuation comparisons less relevant. However, even adjusting for these factors, stocks still don’t appear inexpensive.

Below is a chart with two panels illustrating forward price/earnings (P/E) ratios. The left panel shows subsequent 1-year returns, while the right panel displays subsequent 5-year returns based on starting valuations. Each dot represents a year and the corresponding market performance since 1999 for each period.

What we can observe is that, over a one-year time frame, the correlation between forward price/earnings (P/E) ratios and market performance is relatively weak. At this valuation level, there have been years with returns exceeding +40% and others with losses around -30%, offering little predictive value.

However, over a five-year forward time frame, the correlation tightens, suggesting that historically, higher starting P/E ratios have tended to result in lower long-term returns. Since we are currently positioned toward the higher end of the distribution, with a P/E exceeding 22, it would be reasonable to expect muted five-year forward equity returns for the S&P 500.

In fact, Vanguard projects minimal 10-year annualized returns for U.S. growth equities, with their year-end 2024 forecast ranging from just 0.4% to 1.6% annually. For U.S. equities as a whole, Vanguard estimates annualized returns of only 2.8% to 4.8%—a significant decline from the nearly 10% annualized return seen over the past decade.

For what it’s worth, I disagree with this assessment, as I expect significant productivity gains from artificial intelligence in the latter half of this decade to drive growth. However, it would be unwise to ignore forecasts like these.

Looking across asset classes, there are areas of the market that are not as richly valued, including most of the fixed income market and international equities. However, when it comes to international stocks, we believe they are cheap for a reason. Factors such as low growth, burdensome regulations in the Eurozone, authoritarian policies in China, deteriorating demographics in most regions, a strong U.S. dollar, and the potential for ongoing geopolitical tensions make investing abroad far less attractive than focusing on domestic markets.

Despite elevated valuations, we continue to maintain an overweight position in U.S. markets.

Another, more technical reason for caution is the recent un-inversion of the yield curve. We have just emerged from the longest yield curve inversion on record, which, as we've discussed before, tends to be a reliable indicator of an impending recession—though a poor predictor of its exact timing.

As a refresher, the most commonly referenced measure of an inverted yield curve occurs when the 2-year U.S. Treasury rate exceeds the 10-year U.S. Treasury rate. Historically, as shown below, every time the yield curve has un-inverted since the 1960s, a recession has either begun shortly thereafter or was already underway.

Is it “different this time”?

Finally, another potentially concerning signal is the lack of broad-based participation in the market’s gains over the past two years. One way to measure this is by examining the percentage of stocks in the S&P 500 that have outperformed the index itself. Over the last two years, this figure has fallen below 33%, placing it among the lowest levels in the past 50 years—eerily similar to the narrow leadership seen in 1998-1999 (which, as we know, didn’t end particularly well).

This environment has historically been challenging for actively managed large-cap U.S. mutual funds that aim to outperform the index through stock selection. After all, it’s difficult to beat the market when only 3 out of every 10 stocks are outperformers.

Ok – now to the fun part of the letter; our 2025 predictions. But before we do that, let’s review our 2024 ideas and see how they landed.

We see a MAJOR breakthrough from Artificial Intelligence. CORRECT

It has been a wild year for AI and I could pick any of a number of examples, but for me it was the release of Sora, the text to video generator by OpenAI. It previewed back in February and was released just a few weeks ago to the public. If this isn’t categorized as a major breakthrough, I am not sure what will. If you haven’t seen it, visit the link below and see what users have created right on the home page. All these videos were created simply by text prompt. Click on each one to see the prompt that generated it.

https://openai.com/sora/

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The Federal Reserve raises the long-run inflation target from 2% to 2.25% - 2.50%. NOT YET

I am still convinced that this will happen at some point, but not in 2024.

The international geopolitical situation worsens… CORRECT

Ukraine seizing territory within Russia, the expansion of the Middle East wars to Lebanon, the largest war in Gaza in decades and direct missile attacks on Israel by Iran.

…but the US political season is surprisingly orderly. KIND OF CORRECT

Ok, so the political year was crazy. We had a sitting President drop out of the race halfway through, a new candidate installed without a primary, and dual assassination attempts. Clearly none of that can be defined as orderly. BUT the election itself was smooth as could be. No violence, no protests, no court cases, no confirmation struggles. So, I’ll peg this one as 50/50.

Now let’s turn the gaze to the crystal ball and fire off four predictions for the year ahead.

1) The geopolitical situation significantly improves

The opposite of last year. We think the Ukraine war ends, the Gaza war ends, the Lebanon cease-fire holds, and at the end of 2025 the world is more peaceful place.

2) Inflation does not reignite, and the Fed cuts more than twice.

We think that inflation continues to trend down (although not all the way to 2%), driven by the lag in housing market disinflation, and that the Federal Reserve can continue bringing rates down. We think that tariff and immigration policy ends up being more bark than bite, unemployment will tick up, and provide some cover for the Fed to continue normalizing.

3) Nuclear Energy Makes Waves?????????

We have already seen several big announcements in nuclear, including the re-starting of Three Mile Island through a deal with Microsoft, and in 2025 we think that this trend continues. We expect news from small – scale modular reactor buildouts, additional public/private partnerships, PR campaigns around safety and climate change impact, and regulatory reform to significantly build out the country’s nuclear portfolio in the coming decades.

4) Tiktok Survives

Absent a deal or Supreme Court ruling, the app is set to banned in the US on January 19th, a day before Trump gets inaugurated for his second term. We think there is simply too much money at play for the ban to go through. If we had to guess, we expect the ban to go in to effect on the 19th, Trump to suspend it on the 21st (which he is allowed to do for 90 days) and a deal gets made to sell it to an American Buyer before the end of the 1st quarter.?Gen Z rejoice!

***

And finally this quarter, the Voyager 1 spacecraft is gliding through interstellar space, moving away from our Solar System at more than 38,000 miles per hour, now almost 16 billion miles away from us. It has been traveling for 47 years, 3 months, 25 days, 11 hours, and 37 minutes as of writing and along with it, travels a gold-plated record, with the following message from our 39th President, Jimmy Carter, who passed away this month at 100 years old.

“This Voyager spacecraft was constructed by the United States of America. We are a community of 240 million human beings among the more than 4 billion who inhabit the planet Earth. We human beings are still divided into nation states, but these states are rapidly becoming a single global civilization.

We cast this message into the cosmos. It is likely to survive a billion years into our future, when our civilization is profoundly altered, and the surface of the Earth may be vastly changed. Of the 200 billion stars in the Milky Way galaxy, some--perhaps many--may have inhabited planets and spacefaring civilizations. If one such civilization intercepts Voyager and can understand these recorded contents, here is our message:

This is a present from a small distant world, a token of our sounds, our science, our images, our music, our thoughts, and our feelings. We are attempting to survive our time so we may live into yours. We hope someday, having solved the problems we face, to join a community of galactic civilizations. This record represents our hope and our determination, and our good will in a vast and awesome universe”

If you want to see where the various space probes are visit this pretty cool Eyes on the Solar System site by Nasa:

https://eyes.nasa.gov/apps/solar-system/#/home

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In Wealth,

Zachary S. Mineur, CFA, CFP?

Chief Investment Officer

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