Red, Blue and Green

“In theory, theory and practice are the same. In practice, they are not.” - Albert Einstein

As we round out a week full of red and blue, one cohort of investors saw a lot of green. U.S. equity markets are likely to end the week sharply higher following Tuesday’s presidential election, as the prospects of lower tax rates and less regulation seemingly led investors to regain their enthusiasm. As of the market close Thursday, the S&P 500 index had gained more than 4% this week alone. Shares of smaller companies have risen even more, with the Russell 2000 index up nearly 8% since Monday. At the same time, expectations of near-term market volatility fell drastically, as seen by the VIX index below. This tells a clear story: markets care less about who’s in office and more about stability, visibility and market integrity. As political uncertainty faded earlier than many anticipated this week, investors piled in to risk assets in a clear vote of confidence.

Adding to the good news for equity prices was the 25 bps (0.25%) interest rate cut that the Federal Reserve announced on Thursday afternoon (in other words, a light news week.) From here, markets anticipate an additional 25 bps rate cut next month as the Fed continues its gradual decline towards a more neutral range, where monetary policy is neither stimulative or restrictive. As shown in the chart below, futures markets suggest about a 70% chance that the Fed will lower rates by another 25 bps in December, bringing the Fed Funds target range down a full 1% ?to 4.25-4.50% since the cutting cycle began in September. Of course, the future path of interest rates will, and should, heavily depend on the data: employment, inflation, and the like.

Like equity prices, U.S. Treasury yields also increased immediately following the election as investors digested the fact that higher levels of economic growth expected from less regulation and lower tax rates could also lead to reaccelerating inflation. The 10-year Treasury yield spiked nearly 20 bps from around 4.30% Monday morning to nearly 4.50% just 48 hours later. While this move in yields may not seem significant to the naked eye, the effect on other asset classes could be meaningful as higher Treasury yields typically weigh on asset valuations. This week proved an exception, as both stocks and yields increased in tandem, forcing investors to ask the question – what gives?

In theory, one of two things should occur: equity valuations should adjust downward to reflect the higher Treasury yields (discount rate) or Treasury yields should subside while valuation multiples remain elevated. But Albert Einstein put it best when he said “In theory, theory and practice are the same. In practice, they are not.” If U.S. equity investors have learned anything over the past year (perhaps even decade), it’s that just because valuations appear stretched doesn’t mean they can’t stretch further. During a period when equity market returns have been robust and other asset classes are offering attractive value, now is as good a time as any for investors to ensure their portfolio is thoughtfully diversified.

What’s Next?

Forecasting economic or capital market outcomes years in advance is about as useful as political polls. Now, with high expectations ranging from corporate earnings growth to policy objectives in Washington, the theme for 2025 most certainly will be “prove it.” Reality will need to match theory over the next 12-18 months. With many parts of the equity market “priced to perfection,” the lofty growth estimates will need to deliver or valuations could retreat. Likewise for policy, if certain agenda items fail to materialize in Washington, such as easing regulation or lower cooperate tax rates, current expectations could face significant headwinds. As always, the only way we’ll know for sure is to live through it and write about the outcomes in hindsight. But today, our team will take what the market gives us, prioritize humility over hubris, and let the future unfold while focusing on what we can control. Focusing on the fundamentals, keeping a long-term perspective, and maintaining discipline are the key components to a successful investment plan. For long-term investors, it’s important to zoom out every once in awhile.

?Reasons to Keep a Long-Term Perspective

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We believe the information contained within this material to be reliable but do not warrant its accuracy or completeness. Opinions and views expressed herein reflect our judgement based on current market conditions and are subject to change without notice. Past performance is not indicative of future results. Additional risk considerations exist for all strategies, and the information provided is not intended as a recommendation, or an offer or solicitation to purchase or sell any investment product or service.?