Assessing Investment Risk Has Become Taboo
The post-election rally hit a speed bump last week, with most of the major averages ending the week in the red. The S&P declined -2.1% on the week and has retreated in three of the past four weeks. The Nasdaq Composite fell -3.2% last week (its second weekly slide in the previous three), and the hoopla of deregulation that has the small-cap index all jazzed up lost some of its luster with the Russell 2000 plunging -4.0% last week. Investors are in the process of digging a little deeper into the policy behind the early Trump winners, as many are in the process of round-tripping the initial move following the election results (more on this below).
As for the week ahead, it's pretty quiet on the data front, but on Wednesday, after the close, we get Nvidia’s quarterly results. Don’t think for a second that their results and guidance won’t have major implications for market cap-weighted indices, which MegaCap Tech now dominates. Nvidia’s stock is up almost 800% in the past two years, +180% in 2024, and now sits atop the podium as the world’s largest company by market cap. The results out of the Mag7 in Q3 were strong with earnings up +30% year-over-year compared to +4.3% for the other 493 companies in the S&P 500. While Wall St. gets all excited about markets broadening out and the 493 seeing a rate of change inflection in forward earnings growth, the equity market is still wedded to the success or failure of this small pocket of industry-dominating companies. According to data from Goldman Sachs, only 15% of companies globally outperformed the Mag7 in 2024, and just over 1 in 5 U.S. companies outperformed this group.
Back to the election results and the uncertainty facing investors as we wait to see what was just campaign talking points versus what will become actual policy. There has been a lot of ink spilled on this Red sweep and the “mandate” that it ushered in, but when you dig through the archives of history, it raises the question of whether ‘mandate’ should be ascribed to the 2024 outcome. Look, I’m just going to provide the data and let you decide for yourself – a sweep is a sweep and does say something, but compared to the 59 Presidential elections that came before this one – this pales in comparison when measuring via Electoral College votes (44th out of 60 for those counting at home):
Back in 2016, when Trump was elected for his first time, the common refrain from those who knew him was to take him “seriously” but not “literally”. However, given the second go around and full control of all parts of government, it seems as though the investment community is taking him both seriously and literally, even though there were numerous campaign promises back in 2016 that went unfulfilled: the U.S didn’t pull out of NATO, the Mexican Wall didn’t get completed, and Mexico didn’t pay for it, Hilary never got locked up, and a major global trade war did not take place. I’m doing a bit of cherry-picking here, and admittedly some of this was campaign hyperbole, but the point we should all take away is that the Founding Fathers did a good job of building checks and balances into the U.S. legislative and governing process. No, it's not perfect (what is), and having a one-party rule for the next two years does make it easier to get certain things passed, but anything extreme is unlikely to see the light of day.
Markets are rightfully focused on tariffs and the global dominoes they could potentially set off. While a tariff, on its own, is not inflationary as a one-off event, the size of what Trump has pledged is massive. It would represent a potential triple shock to the U.S. economy: 1.) a price shock (and on the part of society that has the highest marginal propensities to consume), a dollar shock (which would negate part of the benefit to the industrial sector from this form of trade protectionism), and a rates shock, because the Fed is hardly likely to sit idle if it feels that hiking tariffs in a 4% jobless rate economy will rekindle inflation expectations and higher wage settlements. Keep in mind other countries will react in some form or fashion to counter the impact of tariffs on their nations, whether that be currency adjustments, shifting supply chains/distribution channels, and/or putting on their own tariffs in a ‘tit for tat’ mini-trade war.
What I’m getting at is that while the election outcome has removed a key piece of uncertainty, it has also ushered in a new wave of uncertainty on the policy front. Keep in mind that markets are constantly arbitrating the probabilities and impacts of various scenarios as we are seeing play out with the U.S. dollar moving up to two-year highs and interest rates rising to near their highs for the year. These moves were already underway as far back as mid-September when the odds of Trump winning started increasing, but they’ve gone into overdrive following the election results. To be fair, a myriad of variables contribute to asset price movements; for instance, growth and inflation data have surprised to the upside over the past month. Taken together, this has caused Chairman Powell and the Fed to alter their dovish posture subtly, with futures market pricing down to 60% odds of another 25bps rate cut at the December 18th FOMC meeting (from as high as 85% in mid-October). Looking beyond the December meeting, market-based odds of there being just one or no rate cuts between today and June 2025 have risen to 28% from just 1% a month ago.
One of the biggest questions I find myself thinking about is how this administration's policies will impact inflation. On the surface, they appear inflationary, but we should all appreciate that it is never that simple. Moreover, I think one of the biggest takeaways from this election is the message from the American voters in that they have little to no tolerance for persistently high inflation. Inflation is a social disease that affects everyone but bites the hardest against the most vulnerable. Job creation during the Biden-Harris era was strong, but what really mattered was that while weekly wages in nominal dollar terms grew +18% over the past four years, consumer prices rose by +21%. So, on a real basis, earnings actually shrunk.
You would be hard-pressed to convince me that a President who made inflation a critical plank in the election campaign is going to aggressively embark on policies that will threaten his legacy—unless he wants to go down in the history books as an ousted leader presiding over an inflationary experience like Jimmy Carter and Joe Biden were (negative real wages over a four-year term also featured in both Bush eras).
All of this amounts to more unknowns, not less. Couple this with stretched valuations, sentiment, and positioning – regardless of favorable seasonality, with November through January representing the best part of the calendar for stock market returns – and we are looking at an investment environment where one should look for opportunities to take less risk, not more. Over the past decade, one of the greatest technological advancements for the investment industry has been the break down in information asymmetry. A decade ago, you had to be in the room or know someone in the room to get your hands on cutting-edge, actionable research that slowly matriculated its way around to the masses. Nowadays, you can get your hands on almost anything as soon as it becomes available, and sure, access to some of it comes with a price, but most of the time, you just have to be fishing in the right bodies of water.
I’ve become an avid podcast listener. Whether I’m making dinner, walking the dog, or waiting in line for an appointment… I can access conversations, research, and news from virtually anywhere. I say all that because I want to highlight a segment from two different podcasts I listened to over the past week from two very sharp market historians/technicians who both reached a similar conclusion as it pertains to where investors' mindsets are today versus the opportunity set they see in markets. Moreover, given the almost unprecedented compound annual return generated by the S&P 500 over the past fifteen years (495% or 12.6% annually), which has driven valuations to one of the most stretched levels in the index's history – investors seem to have become more greedy, not less. Additionally, investor's expectations for future returns have increased in both the level they anticipate earning and the likelihood of it being achieved. (These excerpts are taken directly from the transcripts of the podcast and not edited for grammar.)
The first is an interview of JP Morgan’s David Kell on the Meb Faber podcast:
JP Morgan's David Kelly - Spread Out or Miss Out: The Urgent Case for Diversification | #557
Meb Faber
20:44
But one of the things y'all been talking a lot about recently is kinda your annual state of the markets and, you know, your long term assumptions. And if we go back to our survey where everyone expects the stock market to go up, What are you guys thinking? We're gonna do 15% a year like we have been doing for the past 15 years or something more sober or something even better?
David Kelly
No. I think I think something more sober, to be honest. Now off the bottom of our literature, we we usually have some boilerplate which says your past performance is not indicative of future returns, which is actually not accurate. Past excellent performance is indicative of future mediocrity. Now the the better it's been, probably the worse it's gonna be.
And that's just a matter of valuations. Stocks selling at 22 times forward earnings. The top 10 companies in the S and P 500 are selling at almost 30 times forward earnings. That's expensive. That will tend to come down over time.
And in a slow growing economy, which starts out with full employment, I think that's gonna be a problem. So, you know, I think US stocks can still give you a positive return over the next decade. I think it'll be a positive real return. I would not be surprised, you know, if you and I are still in the business and talking 10 years from now, if we look back and said, well, that wasn't so great. We only went up on average.
A lot of bumps on the way, and we averaged, like, 5% total return out of US equities. That wouldn't surprise me at all. Now there are ways of beating that trap. How do you beat the, you know, the 4% or the 5% trap? You don't have to buy the whole stock market.
There are parts that are expensive, but outside of the mega caps, it's not expensive. It's it's just the mega cap stocks that are expensive. And then international stocks are significantly cheaper than US stocks. And then there are alternative investments, which also can be used to try to provide decent returns or better than returns you would get in public markets. So there are ways of getting a bit more return, but it gets trickier.
David Kelly
22:34
The more the market goes up, the harder it is to get good returns from here. And sometimes, you know, when you get wealthier, I think it's really important to think about, okay, now, you know, 5 years ago, I didn't have this money, and I had all these things I was worried about in terms of how do I save for retirement, what do I wanna do? If you're wealthier today, then maybe you should think about, well, you know, actually, I've got enough now, don't I? I've actually got enough so that I can actually take less risk. And what's actually happening is a lot of people are in that position because of how well the markets have done.
But if they actually look at their portfolio, they're not less risky than they were 5 years ago. They're more risky because they are overweightly overpriced, most expensive stocks in in in the market. That's something to think about is is, you know, this growth in wealth is a signal that you people need to reassess where their wealth is relative to their goals and relative to the amount of risk they ought to be taking.
The last point of this answer to this question is really important for investors to think about. Every client we work with starts with a plan, and then it’s a matter of measuring, adapting, and evolving that plan as time moves forward. I think investors have become so fixated on keeping up with their neighbor's returns or the returns of the best-performing global equity market in the world (see chart below) that they’ve lost sight of how much risk they are taking to achieve that return. Moreover, if they are ahead of plan, is it necessary to take undue risk at this juncture? If so, I hope you have a more prudent answer than the guy at the coffee shop said he returned X and I have to keep up with him.
The other podcast I wanted to highlight was Adam Taggart’s interview of Mike Green on the Thoughtful Money Podcast:
Where Will Stocks Go Under Trump? Watch Passive Capital Flows | Mike Green
Adam Taggart
54:02
Put yourself in the position of somebody watching this video right now who's just a regular investor they've just listened to this they said that Mike Green is a smart guy um you know I'm I'm concerned about the risks that he and Adam have talked about um but it looks like for the foreseeable future even though we're at these nose bleed valuation levels it could go even higher from here so what sort of investing strategy do you see as fitting this moment in time and where we are in this journey
Mike Green
54:33
the thing that I always remind people and most of your listeners will be very close to this point right is recognize that the majority of investors that you're now facing don't actually have the capacity to ask the question do I need this next dollar, right do I need this incremental return um and I see a lot of people that are basically trapped right now in a model of you know well my neighbor made 25% therefore I want to make 25%
um for most of your listeners who are going to be a little bit older and going to be closer to retirement really I would encourage you to start thinking about what are alternate things that I can invest in that will add significant value to me or to my family right I think we're seeing a lot of evidence of this this is families helping their children buy homes if they have the resources Etc replacing a mortgage that the child would have to take out at 7and a quarter % right now with
okay you know what I'll just give you the money from my money market fund or I will borrow money or you know I will lend you a down payment to allow you to get a better rate those sorts of components and charge them interest right
um I want to emphasize that like I'm not opposed particularly to small investors having access to the low cost tools associated with index investing up to a point it has very little impact on things like valuation separating the markets I just think we've gone past that point and one of the solutions that's associated with that for an investor is to start thinking about what does that money actually mean how can it impact my children how could it actually be used as compared to just kind of panic saving in the S&P
the second thing that I would would emphasize for people is on that same line like so much of what's being offered in financial markets and fixed income is being ignored because people are trained to think that that assets kind of have embedded returns right that equities are supposed to return 8% a year or 10% a year or 13% a year depending on the study that you look at and you can convince yourself of this
all you want part of my message is a lot of those returns are actually a byproduct of that price appreciation that valuation increase that I was sharing with you and those are likely to reverse going forward and so at some point you just have to look at the fixed income market and say can I achieve my results you know for my own objectives through fixed income markets
I'm not saying go out and abandon the stock market but simply realistically look at what you think the expected returns are going forward and understand that a lot of the behavior that we're seeing in terms of prices going up as rapidly as they are is not a signal that like the economy is going gang busters and you're going to be left behind if you're not participating it's a bit of a collective societal Mania that is caused by the form with which we've chosen to invest in these markets
It may not come through clearly in the podcast transcript, but Mike's point at the end is that given current valuation levels (at some point, they do matter), the expected forward returns based on fundamentals are not much above the mid-single-digit returns that high-quality fixed income markets are offering today.
I think a useful and important exercise for investors at this juncture is to reflect on their capacity, willingness, and need to take risks. My guess is that most investors are better off today than they expected to be at this point, but in the hysteria that is “number go up,” they’ve lost sight of what their financial priorities are. Trust me, I’m not advising investors to eliminate all risk, abandon the stock market, and put all their capital in T-bills (ironically, that might be more risky than owning stocks), but think about where you are, what you need, and what’s important to you.
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