The Financial Markets: Last Year and This
In the last issue of Seasonal Musings, we discussed the prospect of a "lost decade" of returns in the U.S. stock market. Is that what we're starting to experience? Either way, the best way to protect your portfolio against the possibility of a lost decade is to diversify it into other asset classes and into less expensive sectors. Read on for more details.
Please NOTE: The following article was distributed to clients on February 27, 2025.
In many respects, 2024 was a very unusual year in the financial markets.
For the first time in modern history, long-term U.S. Treasury bonds fell in value (rose in yield) for a fourth consecutive year. This despite the fact that the Federal Reserve began to lower its policy rate in September for the first time since 2020.
In contrast to the poor performance of U.S. long bonds, our stock market as measured by the S&P 500 index generated returns in excess of 25% for the second straight year, a feat which it has accomplished only 3 other times in the last century, the last time being during the formation of the dot-com bubble in 1997-98. And last year's gain was achieved without investors having to endure a "correction", a 10% retracement in the stock market which has happened historically about once a year.
But this rosy picture of the surface of U.S. stock market performance in 2024 disguises a variety of unusual divergences that occurred beneath the surface. While the very largest stocks in the S&P 500, the so-called Magnificent 7 (Microsoft, Apple, Alphabet, Meta, Amazon, Nvidia, and Tesla) returned more than 60% on average last year, if you had equally weighted all of the stocks in the S&P 500, your return would only have been about 12%. To highlight this narrow market leadership another way, less than 30% of the stocks in the S&P 500 beat the performance of the index last year, the second straight year this has happened, and again bringing back memories of the dot-com bubble in the late '90s. And while U.S. large-cap tech stocks soared, small-cap U.S. tech stocks actually fell 1% in 2024, a never-before-witnessed divergence.
And it wasn't just size that mattered in 2024; investing "style" and geographic location played large parts in determining stock market outcomes. The S&P 500 Growth index returned 36% last year, leaving in the dust the S&P 500 Value index's 12% return. And late in the year, at the same time as growth stocks continued to surge to all-time highs, value stocks endured a correction, falling for 14 straight days - a historical first.
Similarly startling divergences occurred between our stock market and those abroad. In local currency terms, foreign developed stock markets and foreign emerging stock markets generated returns of 12% and 14% respectively, about half the return of our stock market. Throw in the effect of the dollar's strengthening during the course of 2024, and U.S.-based investors fared even worse with their international equity exposure on a relative basis, 4% in developed markets and 8% in emerging markets.
So where does all of this leave us now? For one thing, by virtue of our stock market's remarkable performance during the last couple of years, investor sentiment has risen to extreme levels of optimism. Every month, the Conference Board's Consumer Confidence survey asks respondents whether they believe the stock market will be higher 12 months from now. The past 3 months' readings show a level of confidence in the stock market never seen in the survey's history dating back to 1987. As a result, retail exposure to stocks is near the highest level since 1997. And as I've written before: "... investors as a group becoming more optimistic about the stock market is likely to be predictive of poor returns going forward."
For another thing, the stock market's valuation as a whole here in the U.S. has become very stretched. As an example, for the first time in history, the total market capitalization of all active stocks in the United States is more than twice the nation’s Gross Domestic Product, its economic output. This is one of Warren Buffett's favorite stock market valuation indicators.
And finally, investors both here and abroad seem to be giving up on portfolio diversification and crowding into U.S. stocks (and the largest U.S. stocks in particular) at the worst possible time. While it's true that the U.S. has 4% of the world’s population, and generates roughly 25% of global GDP and 33% of global profits, our stock market now accounts for a whopping two-thirds of the MSCI World index’s market capitalization. This dynamic has led to the coining of the phrase "American exceptionalism" in reference to its stock market performance, and in response a recent editorial in the Financial Times called American exceptionalism "the mother of all bubbles", saying that "the US has never been so overhyped, relative to the rest of the world".
As another measure of this, the market value of the top 15 U.S. stocks by market capitalization is almost as large as the combined value of the entire equity markets of Japan, Europe and the emerging markets. This reminds me of my business school days in the late '80s when it seemed clear that Japan was in the process of taking over the business world, and 8 of the 10 most valuable companies in the world were Japanese (and that didn't end so well for the Japanese stock market).
But all is not lost. Because of the dramatic differences in valuations between asset classes, between our stock market and those abroad, and even between classes of stocks within our stock market, the potential benefits from portfolio diversification have rarely been greater. Well-respected investment management firm GMO has said in recent months that these financial market conditions "... present us with the best relative asset allocation opportunity we’ve seen in 35 years." And echoing this, Vanguard recently published its own projections for 10-year returns for a variety of asset classes and sectors, in effect arguing strongly for diversification away from U.S. stocks, and from our large-cap growth stocks in particular.
About the Author
Paul Winter, MBA, CFA, CFP® is a Fee-Only financial advisor and fiduciary in Salt Lake City, UT. His independent wealth management firm, Five Seasons Financial Planning, provides professional portfolio management and objective financial planning services to individuals and families, and to their related entities including trusts, estates, charitable organizations, and small businesses.