Mega Caps Chuggin’: Can They Continue?
2024 was all about the Mega Cap stocks carrying the load. The top 10 S&P 500 stocks now represent nearly 39% of the index, an all-time high. The top 25 companies are over 50% of the index now. Concentration is increasing.
The investment in AI has carried the Mega Cap’s stronger fundamentals much more than the broad Market. Without the Mega Caps, earnings growth last year would have been barely up vs the +9% that is likely to be reported. These behemoths have been carrying the weight. Earnings growth was not widespread; in fact, Small Caps saw earnings decline last year. Concentration is a sword that cuts both ways.
The last time the S&P 500 outperformed the equal-weighted S&P 500 by this wide a margin was 1999. The subsequent years saw the Market Cap weighted S&P 500 down, while the equal-weighted index was up. As 2025 moves on, we will focus on the equal weighted and lower valuation areas of the Market. We view them as attractive opportunities.
Mega Caps will continue to lead until another growth scare rolls in. With valuation extremes in these names, a lot of anticipated optimism of future growth is priced in, and rightfully so as this has been the undeniable source of growth. Mark Twain still says it best: “History doesn’t repeat itself, but it often rhymes.”
The Street Forecasts
Wall Street analysts are clustering bullishly for 2025 forecasts with an average target of 6500 for the S&P 500, representing 10% upside from 2024 closing level. This is the exact opposite of last year when the Street was very conservative and wildly lower in their forecasts than what came to fruition. There are virtually no Bears to be seen, they are firmly in hibernation. This gives us a touch of pause. Earnings growth is estimated to come in at +15% or $275 for ’25 up from nearly $240 expected to have been earned for 2024. These likely prove overly optimistic as the year plays out.
Global Markets: Not Feeling the Love
Can the US continue to diverge from the global pack? That’s a big question entering 2025. With the European Union having stalled out economically in the back half of ’24 and now losing altitude, Canada already in a quasi-recession and the strong US Dollar hitting emerging markets, the global backdrop is not as rosy as the US. In fact, there was only one G20 country equity market that outperformed the US last year, Turkey. The Global ACWI-excluding the US index was up a muted +2.25% in 2024, highlighting a very divergent global landscape. China is stimulating just enough to keep growth where they want it, but with their consumer class reeling and the real estate market in tough shape, will it be enough? Throw in the added uncertainty of the uptick in China trade wars with the Trump administration and it looks to be a challenging backdrop. The global landscape leaves us more questions than answers entering the new year. We will be tracking closely.
The Fed: In a Pickle
With stubborn inflation and recent uptick closer to 3% than the Fed’s mandate of 2%, significant monetary easing has been priced out of the Market. The Market is only pricing in one Fed cut for 2025, not too long ago it was another 4 on top of that. The labor market remains firm, with small deterioration also giving the Fed less ammo to aggressively cut rates. The unknown impact of possible Trump tariffs and the Fed is on its heels entering 2025. The term “Fed pause” will likely gain momentum in 2025.
The pickle: With inflation not extinguished and re-emerging combined with labor markets, growth still strong and not slowing enough to provide the Fed cover; they can’t cut rates too fast or too much without risking another bout of inflation. However, if they keep rates too high for too long and the labor market and broader economy weaken more suddenly, then they overstayed their welcome with the tighter higher for longer policy and risk more downside to the economy. Quite a self-inflicted pickle the Fed finds themselves in.
Bond Market: Inflation, Growth and the Debt
The Bond Market will play a crucial role in 2025 and, in some big ways, call the shots for the Market.
Something that has never happened before: The Fed cut interest rates by 1% from September 2024 through year-end, while the benchmark 10-year Treasury yield actually rose 1%. Interesting lead into 2025 to say the least. Reminder: The Fed controls the front-end of the yield curve (short-term Bills to 2-year Bonds) while sentiment, inflation, growth and the burgeoning debt are responsible for the longer-end of the yield curve (10-year to 30-year Bonds).
The Bond Market’s recent rise in yields is a combination of all those. An unsustainable fiscal backdrop has seen outstanding debt breach $36 Trillion. Net interest on our debt is now running at an annual clip of $1.2 Trillion. Putting that in perspective, the US is estimated to have total revenues for 2025 of $5.5 Trillion. This means 21% of estimated ’25 revenue is being paid out in interest. Staggering.
Inflation is remaining sticky with headline CPI at 2.7% and 3.3% on core inflation (excluding food and energy), and real GDP growth for 3Q’24 at +2.7%; you get a sense of why Treasury yields are entering 2025 at 4.57%, up from their ’24 lows of 3.6%. Historically there has been a loose guideline of GDP + Inflation = 10-year Treasury yield. Until inflation or growth cools, rates are likely to remain in this higher range.
We are fans of the Bond Market. Yields are back to 2006-2007 levels; yes, it’s been that long! We continue to maintain a shorter duration, which has served us well, allowing us to compound the high coupons and interest payments on the front end of the curve. We are on the lookout for a buying opportunity to extend Bond duration in 2025. We think that will happen in the first half of the year on the back of some bad inflation readings. Bonds could be the big contrarian performer in 2025. Our eyes are wide open seeking out Bond opportunities.
Valuations: Extreme Relative to History
2024 was a year of multiple expansion. In other words, Markets grew more than their earnings or fundamentals did. We enter 2025 with some of the most expensive valuations in history on a number of metrics. Multiple expansion Markets are by far the toughest to navigate, because they can last against odds for quite some time, but if a catalyst arises to revert valuations to the mean, that’s when huge bouts of volatility and downside occur. Remember 2022?
If analysts are correct and earnings rise 15% next year the Market would be trading at 22x forward earnings. Around 18x is the average, dating back to the financial crisis. 17x is closer to the 20-year average. On a simple valuation basis, one could argue Markets are 15-20% overvalued.
If earnings continue to deliver, expensive valuations won’t matter as much. The Market could remain expensive for longer. In the event earnings disappoint, a reversion to the mean on valuation basis could be a painful correction for equities. We are paying close attention to valuations. Growth has outperformed Value and Market capitalization-weighted indexes have outperformed equal-weight indexes for quite some time. 2025 may see these revert to more historical norms.
The Consumer: Divergences Afoot
The high-end consumer was doing most of the heavy lifting to end 2024. Given higher wages outstripping inflation, real-estate prices, asset prices, and higher income from risk-free Bonds, one could argue the high-end American has never been better off and has provided real consumption growth, outpacing many expectations. The same cannot be said for the lower-end or middleclass. Americans whose wages haven’t kept up with inflation, don’t own a home, or hold assets, currently have consumer confidence amongst the lowest of all time. A wider gap between the groups has rarely been seen.
The labor markets remain secularly tight, with the unemployment rate at historically low levels. This backdrop keeps spending going and the economy on the right track. We’ve seen some cooling in the labor market around the edges, even Fed Chair Powell acknowledged as much, but nothing of yet to break the strong labor trend of the past few years.
Housing has cooled on transaction volumes to multi-decade lows with higher for longer interest rates. Until inflation returned more than expected to end 2024, a looser Federal Reserve and lower rates were believed to benefit the housing market in 2025. With higher for longer or a Fed Pause, the housing market likely remains cool in the new year. Rate locked homeowners and record-low affordability makes a housing recovery in 2025 unlikely. Housing has traditionally played a larger role in the business cycle; this cycle hasn’t seen that. AI overpowered housing.
Higher rates are starting to bite credit card and auto loan balances; we’ve seen an uptick in delinquencies of late. These are signs of modest stress under the surface for low and middle-class consumers.
If the labor market remains firm and asset prices hold in 2025, the consumer likely remains in good shape and provides a strong economic backdrop. However, if the unemployment rate ticks up and or asset prices correct, we could see a weaker consumption backdrop in 2025 which creates a touch of a negative feedback loop. Labor markets will play a crucial role in ’25 with consumption remaining a large part of the US Economy.
Unique Times: Create Opportunities
From Currency wars to potential Trade wars. From AI secular growth theme to the reeling lower-income US consumer. Strong domestic markets to lackluster international markets. Tight credit spreads to US consumer uptick in delinquency rates. From near-record-high real estate prices to the near-lowest transaction volume and mortgage applications on record. From the AI buildout requiring an incredible amount of Energy, but energy prices not reflecting it. The overspending in Washington to the lackluster small business confidence and investment plans.
There seems to be quite a few things that seem a bit “off.” We see it. We feel it. We sense it. You may too.
As a below-average volatility 2024 rolls into 2025, we expect higher volatility to return. Valuations will matter at some point. Both undervalued names returning higher to fair value and overvalued areas correcting lower to fair value. Cycles will cycle and we expect more of that in ’25 and beyond.
We are ready knowing attractive opportunities will arise in all asset classes. We remain long-term investors in key themes and sectors, while understanding quantifiable risks. We are confident that a quantitatively well-diversified portfolio with appropriate risk will get us through whatever “off” feeling materializes in the Markets. We enter 2025 with confidence and purpose, ready to navigate markets with our clients’ best interest always at the forefront.
Mike Harris
