Before we start off this quarter’s Compass, I wanted to share a quick personal update.
In mid-November, I suffered a bout with a ruptured appendix which left me in the hospital for the better part of 8 days in very serious condition—thankfully recovery has been swift, and I am feeling like my old self once again!
Most importantly, I want to thank everyone who has offered words of support and well wishes. Also, I want to thank those clients whose calls and meetings were disrupted by my sudden illness for their understanding and patience. Finally, I want to thank the whole team (Kyle, Scarlett and Jordan) for making sure that where possible meetings happened, advice was given, and service continued uninterrupted—I am grateful you are all here standing with me.
As always, if you have any questions about the Quarterly Compass Newsletter or anything else in your financial life, please use our Calendly link to set up a time to talk or reach out to Jordan or Scarlett, and they will be happy to set up a time! Also, our video content (webinars, monthly update videos etc.) are available on our website or our X and YouTube channels.
For those that believe “brevity is the soul of wit”, here is the Quarterly Compass Newsletter in four key points:
- Despite a weak end to December, Q4 was an extremely strong quarter. October, a traditionally volatile month, ended up, and November was a “blockbuster” month for portfolios.
- Markets were led by “Growth” style stocks which include sectors such as consumer discretionary, technology and communication services.
- With the U.S. election past, there is still a large “wall of worry” for equity markets to climb as evidenced by the current Trump/tariff/inflation narrative.
- Our outlook remains positive for the next 12 months based on a host of technical/quantitative and fundamental factors. Although it is far too early to act, we want to acknowledge that some of the ingredients for more significant market turbulence are now beginning to coalesce in the distant horizon.
Quarterly Compass Newsletter – December 31, 2024
Q4 2024 saw a positive performance from most major indices. The NASDAQ-100 and S&P500 gained 4.91% and 2.41% respectively (in U.S. dollars) while the Canadian S&P/TSX Composite gained 3.76% (in Canadian dollars) and international markets, as measured by the MSCI EAFE Index, fell 8.67% (in U.S. dollars). Q4 started on a strong note with markets gaining through the traditionally weak October period. Post the U.S. election, there was a very powerful rally in the equity market which continued into December. This rally was led by the consumer discretionary, communication services and financial sectors. Many of the “Magnificent 7” names (Alphabet, Nvidia, Amazon etc.) were strong as were U.S. banks such as JP Morgan. Lagging sectors in the U.S. included the materials, healthcare, and real estate sectors. In Canada, the technology, financial and consumer staples sectors led. All figures are per Refinitiv.
Per Refinitiv, key global fixed income benchmarks, such as the Bloomberg U.S. Aggregate Bond Index posted negative returns during Q4 as interest rates continued to be volatile and rose due to strong U.S. economic data. In its December meeting, the U.S. Federal Reserve (the Fed) reduced its key overnight interest rate and indicated that it may slow down the pace of future rate cuts. In Canada, the Bank of Canada (BoC) continued to cut its key overnight rate with another 0.5% decrease. The markets are currently pricing in further cuts in the next year from both the BoC and the Fed.
During Q4, commodity prices initially rose very early in the quarter but then fell into quarter end per the Bloomberg Commodity Index. The price of gold was flat in the quarter after a substantial run in 2024. The price of oil initially rose in the quarter but then retreated to where it started the quarter. Furthermore, as per Refinitiv—market-based expectations of inflation remain well-contained with longer-term inflation “break-even” rates ranging from 5 to 30 years, all remaining near 2.30% at the time of writing.
Based on questions from clients I have collected a few thoughts:
In many of our client conversations this quarter we encountered some variant of the question: things have gone great, I read this article that said the market is expensive/market is high/about to drop etc.; is it time to get out?
Putting aside perspectives on market timing and the 2025 outlook (more on that below), the prevalence of these types of questions is completely understandable. The last 73
months starting in December of 2018 have been very challenging for investors. There has been an enormous amount of volatility in both directions including 3 >20% market pullbacks—December 2018, COVID and 2022. All of this contributes to a phenomenon known as “bull market stress” which can be summed up as a fear that recent past gains will suddenly turn to loss. This fear is not totally irrational as markets can be volatile and market cycles do shift.
The first remedy in this situation is to remember that unless your time horizon for investment is short (in which case equities may not be appropriate at all), then no matter what happens time has tended to heal all wounds—even in the last 73 months with the three corrections mentioned above, equity markets such as the TSX60 and S&P 500 have been up double digits on a compound basis based on Refinitiv data.
In terms of the argument that I frequently see that the S&P 500 has hit new highs and that it is expensive vs. very long-term average valuation metrics and thus due for a major drawdown—this reasoning misses a few key points. First, early in my career, when I was an associate equity analyst helping to research junior energy sector stocks, a senior analyst wrote: “Valuation is not a catalyst” in giant letters on the inside of the office windows to remind us all that events happen because of other events, not valuations that are either low or high. Secondly, Charles Schwab recently put out a study that indicated that from year to year, valuations are not correlated to returns. Strong markets with high valuations can, and often do become stronger and more expensive; the opposite is also true.
Furthermore, the composition of indices changes. For example, the S&P 500 currently has a substantial number of major constituents with a consistent high earnings growth rate vs. historical norms. Companies with consistently high earnings growth should attract a premium valuation. Due to this, comparing valuation averages from 10, 20 or 30 years ago when the S&P 500 was dominated by lower growth rate companies is comparing apples to oranges. The market should be, on average, more expensive because the average growth rate is higher. Finally, it is very easy to underestimate the compound impact of earnings growth. In the previous cycle, the S&P 500 valuation peaked in May of 2021 with a 33x trailing Price Earnings (PE) multiple. Currently, the S&P 500 has a trailing PE multiple of ~27x which means the S&P 500 is up 40% since May 2021 and is 18% cheaper. Index levels or numbers outside of full context can be very misleading. All of this is not to say that one should ignore valuation but that using historical precedents is a mix of art and science.
This “bull market stress” and the plethora of negative punditry, is exactly why we have a disciplined system for investing and risk management. I do not know the future and that is why we incorporate multiple proven long-term strategies for success including:
- Rebalancing client portfolios back to their target asset allocations and objectives. It is prudent to periodically trim your winners and reallocate funds to other parts of the portfolio. These reallocated funds can then be used in future volatility to do the opposite.
- Focus our equity holdings across a diversified portfolio of high quality “blue chip” companies that have a track record of innovation and growth.
- To add further value, we are also always looking for signs that we need to reduce/increase portfolio risks within your objectives and risk tolerance. One never wants to go all in or all out—market timing does not work, but modulating risk within the confines of existing objectives can help you to “be greedy when others are fearful and fearful when others are greedy”.
Another common question that we encountered post U.S. election dealt with what we saw ahead from the incoming president-elect Donald Trump Administration. Before touching on this topic, I want to emphasize that my comments are meant to provide observation not opinion.
It appears that Trump 2.0 will be a very focused administration that seems to have a very clear operating focus going forward including: growing the U.S. out of debt, improving productivity, making the U.S. a leader in crypto and initiating a fundamental structural shift in the size and role of the federal government in U.S. life.
One very clear area of policy focus that has been articulated is controlling the deficit and dealing with the U.S. national debt. Incoming Treasury Secretary Scott Bessent has been clear about the intention to bring the deficit down to 3% of gross domestic product (GDP), increase the long run average after inflation GDP growth to 3% and increase domestic energy production by 3MM barrels of oil equivalent. This “game plan” is very similar to how the U.S. dealt with its debt post Second World War when the debt to GDP ratio stood at similar levels. Deficits that are smaller than nominal GDP (real growth plus inflation) create a shrinking debt/GDP ratio. Low energy prices keep inflation down—there is a 72% correlation between gas prices and consumer price index (CPI) inflation which keeps interest rates low. Low rates then make the total debt cheaper to service which in turn helps to further suppress the deficit. If this “game plan” is combined with an industrial policy that allows for a shift upward in productivity through the harnessing of artificial intelligence (AI) and blockchain technology, then we could see the beginnings of an enormous positive shift in the long-term U.S. economic outlook and continued de-coupling from the rest of the world.
A lot of media attention is currently directed towards tariffs and foreign policy items. Because of this, it seems to me that the longer-term potential for a substantial shift in the size and role of the U.S. federal government is underestimated. Although any attempt to reform a system as large as the U.S. federal government will be challenging there is a lot more flexibility to cut regulation now and the idea of a government efficiency push has been successfully enacted in the past. For example, recent U.S. Supreme Court rulings have made it much easier for administration officials to cut regulation and “red tape” where it has not been legislated explicitly by Congress. Also, under Vice President Harry Truman there was an efficiency drive that ended up finding the equivalent of U.S. dollar $1 trillion of spending efficiencies that were re-directed into paying for the Second World War.
Based on long form comments from administration insiders and influential donors—many of whom are former Democrats—it seems to be a common view amongst them that the incoming administration needs to be transformational to put the U.S. back on a path of fiscal and economic leadership. In their view obstructionist regulation needs to be cut, wasteful government spending needs to be reduced, and efficiency initiatives implemented to foster innovation, reduce debt and take advantage of America’s entrepreneurial culture. They all generally seem to see the current historical moment as being much like the moment when President Franklin Delano Roosevelt (FDR) came to power in the 1930’s and transformed the size and role of the federal government. In thinking about the incoming administrations chances of success it is important to remember that many of the “players” involved (Musk, Ramaswamy, Andresen etc.) are highly accomplished leaders and have demonstrated substantial capability to successfully take on seemingly impossible tasks. In saying this, I want to emphasize that there are a lot of unknowns, but it seems that the “table is set” and people with track records of completing Herculean tasks on compressed timelines have shown up. Whether any of this is good or bad history will judge but in the day-to-day headlines about the latest social media post we need to keep focused on the bigger picture that is taking shape.
There were also a lot of questions about Bitcoin (BTC) and the outlook.
Over the course of the quarter, BTC continued its volatile path upwards to finish the year around $100,000 U.S. dollars. As an asset, BTC is extremely “streaky” with most of its positive returns accumulating on a very small number of days. It’s also very volatile with 20% to 30% corrections happening frequently. Due to its volatile nature and tendency to rise and drop sharply, there will be a point in the coming months where we will want to trim back and then ultimately sell. In the meantime, however, there are multiple drivers that should continue to propel BTC high in the coming months.
- Historically BTC appreciates sharply during the five months before and 16 months after the “halving event”. This period ends in the fall of 2025—calendrically we are still in a positive time frame.
- The incoming Trump administration has been very direct in stating that they want to create a favourable regulatory environment for crypto currency. Other comments indicate a willingness to build a U.S. federal government BTC portfolio and potentially make it a reserve asset like gold or U.S. Treasury bonds/bills. Other governments have begun to mention this idea as a potential policy. Any of these initiatives would likely create new tailwinds for BTC.
- Many BTC miners and other companies are beginning to replicate the BTC treasury strategy followed by MicroStrategy (MSTR). This creates new demand and limits supply as the traditional sellers of BTC (the miners) become holders.
Last, but not least, I wanted to touch on our outlook for 2025:
There are factors that I am monitoring frequently that could cause me to change my opinion but as things stand, I am positive on the year ahead based on a combination of fundamental, quantitative and technical factors such as:
- The U.S. economy remains strong with many data points continuing to exceed expectations. This can be seen in the rise of the Citi Economic Surprise Index. A growing economy provides a tail wind for corporate earnings. Based on research from Morgan Stanley, growing earnings and falling interest rates have led to higher valuation multiples (i.e. higher stock prices) in 31/34 (91%) of prior occurrences.
- Based on data compiled by Fundstrat, “investors” still have a lot of buying power with margin debt levels well below May 2021 peaks and approximately USD $7 Trillion of cash sitting in U.S. money market funds.
- Although some optimism returned to markets late in 2024, that optimism seems to have dissipated rapidly with key measures such as the CNN Fear Greed Index and the AAII Bulls-Bears gauges indicating that fear/anxiety has returned to market. Furthermore, we are not seeing widespread speculation like we have at previous high points (e.g. electric car startups in 2021 etc.). The presence of some fear and anxiety, and lack of speculative activity are significant positives.
- Based on data compiled by Fundstrat, since 1950 when the first five days (FFD) of the year are positive for the S&P 500 then the year averages +13%. If the FFD are up more than 1% then the average return is +16%. This year the S&P500 was up ~0.60% in the FFD.
- Also, per Carson Research, since 1950 when you have a >20% return for the S&P 500 (21 instances) the market is higher 81% of the time by an average of 10.6%. Amongst those 21 instances of >20% returns—when you have two back-to-back >20% years, then the S&P 500 is higher 100% of the time in the following year (4 times), and up 20% on average. Admittedly 4 data points is a small sample size, but the 100%-win rate is remarkable as is the alignment with current patterns.
- Per Evercore (and many others), the technical chart trends of the S&P 500/NASDAQ 100 remain in a strong long term “bull” or upward trajectory. Longer term measures of market breadth also remain healthy and are nowhere near levels associated with a trend change from positive to negative. Until these longer-term trends roll over and start to reverse, they will remain a positive influence on markets.
- The reemergence of the fear/anxiety discussed in the third point combined with the fact the longer-term trends remain positive as discussed in the fifth point is also considered to be a significant positive by many technical analysts and suggests any short-term volatility is a part of a consolidation process in a longer term up trend.
Although potential tariffs and their potential impact on inflation are front and center of many minds as a risk now, the biggest risk to the uptrend that started on October of 2021 that I see is what seems to be a general underestimation of the potential effectiveness of the Department of Government Efficiency (DOGE). If successful, spending reductions identified by DOGE and enacted by the Treasury Secretary and President, will lead to a substantial reduction in U.S. federal government spending in the next budget cycle starting in September of 2025. This potential reduction in federal spending, absent a pickup in private sector spending, could move fiscal policy from being a tailwind to a headwind for growth thus creating recession fear or an actual recession at some point in 2026.
Coincidentally this potential “DOGE risk” which may emerge late this year aligns well with periods of relative weakness in several long-term calendrical cycles including the well-known U.S. Presidential election market cycle. It is important to note that market cycle studies are indicators of potential tendency not determiners and that the weak year in these cycles is not always negative. I can easily imagine several scenarios where, like the 90’s, the markets march relentlessly higher. To navigate the changes that we will be seeing, it will be important to remain alert and adjust accordingly!
We have taken several actions in the portfolio entrusted to us since our last update. First, we have conducted our annual portfolio rebalance to ensure your portfolio is inline with its stated objectives and risk tolerance. In addition to restoring the equity, fixed income and alternative strategy balance of portfolios, this rebalance involved removing an underperforming name (Lennar: LEN) and starting a position in Block Inc (SQ). In smaller accounts we also moved to a simpler solution via the Fidelity All in One exchange-traded funds (ETF). In addition to reducing the number of securities held, over the last few quarters, I have noticed that these ETF’s have provided better performance for small accounts than my own solution.
As always, the focus of the Kluge Wealth Advisory Group is on preparation and not prediction. Irrespective of any views, we always acknowledge and prepare for a wide range of events and outcomes.
If you would like to discuss anything relevant to your situation, please give us a call; here to help!
