a caveat to what follows

The 1990s were a devastating period for traditional value investors, many of whom lost their jobs at the end of that decade because of their chronic underperformance of broad equity benchmarks like the S&P 500. As typically happens with this sort of thing, the first several years of this century were marked by wild outperformance of value over growth. This allowed many of the just cashiered value investors to reestablish themselves as hedge fund/private equity gurus catering to pension funds desperate for any kind of magic bullet to prop up underfunded traditional pension plans. As far as I can tell, however, traditional Graham-and-Dodd value almost immediately reverted to its 1990s form …and has continued to underperform to this day.

relative performance as a tool to achieve absolute performance

As deep value investors understand all too well, it’s much easier to say that stock A is cheaper than stock B than it is to say that stock A is flat-out cheap. So most professionals I’ve worked with/for structure their portfolios with a close eye to the structure of the index, most often the S&P 500, that they are benchmarked against. Here’s what that index looks like today:

Information Technology 31.3% of the index

Financials 13.9%

Consumer Discretionary 10.7%

Health Care 10.6%

Communication Services 8.9%

Industrials 8.6%

Consumer Staples 5.7%

Energy 3.4%

Utilities 2.5%

Real Estate 2.2%

Materials 2.1%.

We can sort these broadly into defensive, meaning whose profits are not very sensitive to changes in the business cycle, and aggressive or cyclical, meaning profits will respond strongly to changes in economic conditions.

Defensives (18.8% of the index) and the easiest group to categorize, are:

Health Care 10.6%

Consumer staples 5.7%

Utilities 2.5%

Traditional cyclicals (40.9%)

Financials 13.9%

Consumer discretionary 10.7%

Industrials 8.6%

Energy 3.4%

Real estate 2.2%

Materials 2.1%

IT cyclicals (40.2%)

Information technology 31.3%

Communication services 8.9%.

the US

Treasuries vs. the S&P 500

Putting on my pedant hat for a moment, there is in theory–and also in the real world–strictly speaking no demand for stocks. There is demand for liquid long-term investments, however. The principal two LTIs are the stock market and Treasuries. The Treasury bond market is much larger, more straightforward, and a highly regulated instrument of government policy. So in lots of ways it’s the dog and the S&P is the tail.

As I’m writing this, the PE on the S&P 500 based on anticipated 2024 earnings is about 27x. The ten-year Treasury is yielding about 4.2%. The standard way of comparing the two is to look at the bond yield vs. the earnings yield (the notional return in terms of an index holder’s share of S&P earnings (the “earnings yield”), or 1/PE. That’s 1/27 = 3.7%. If we assume earnings growth of, say, 10% for the index in 2025 (the Wall Street consensus is for +15%), the earnings yield on year-ahead results is about 4.1%.

In other words, stocks are roughly fairly valued right now vs. bonds.

As we now know, this time a year ago, stocks were substantially undervalued. Yet the Wall Street consensus back then was that a recession was imminent, corporate profits would contract, and therefore stocks would decline–a lot.

With 20/20 hindsight, we can see what brokerage house strategists missed:

–the huge earnings growth driven by AI, something like +40% for AAPL, META, GOOG, MSFT, NVDA, AMZN, driving these stocks substantially higher

—TSLA, up by about 70% post-election after having been flat for the year through Halloween–apparently on the idea that Trump will block companies like BYD, that have superior EV offerings, from entering the US market.

For 2025, it seems to me that:

–AI will continue to drive 2024 winners upward, but the bar for what will surprise the market on the upside will be considerably higher. So I’d guess that the AI universe will broaden and some money will flow from the 2024 winners to smaller-cap names

–the S&P 500 Value index is up by 28% ytd vs. +40% for S&P 500 Growth. My hunch is that 2025 will be a catch-up year for Value

–Trump is a wild card. It’s hard to know how much of his tariff and deportation rhetoric is calculated to achieve change by itself or whether the Republican party will actually raise tariff barriers and start deporting large swaths of the domestic work force. Either will doubtless damage economic growth in the US. But will, say, China begin to dump goods slated for the US into the EU, depressing growth there? Will that cause the dollar to rise, negating part of tariff impact but slowing growth here as “cheap” imports flow from Europe?

One thing appears to me to be certain, though. Trump seems so deeply beholden to ultra-wealthy individual backers that further personal income tax cuts for them will probably be high on his agenda.

It seems to me that a reasonable starting-out question is whether I expect the world in general to be expanding economically in the coming year or contracting.

My preliminary guess is that we’re going to be going sideways. Here’s why:

–we’re at the outset of the northern hemisphere winter, a typical period of strength for crude oil, as the heating fuel supply chain does its annual seasonal restocking. The oil price should be rising. But it’s not and OPEC is talking about reducing production in order to counteract the demand weakness. Some of this may be due to the fight against climate change, but I take it also as a sign that the developed world isn’t exactly lighting up the economic growth scoreboard

–Europe appears to be stagnating, with companies in the the largest country, Germany, talking about layoffs and restructurings. We’re approaching year nine since the Brexit vote and year five since the UK actually withdrew from the EU, and the UK still hasn’t come to grips with how horrible a mistake this was (as it watches company after company move headquarters (and stock listing) elsewhere). Arguably, Scandinavia and Ireland are the only bright spots

–Japan’s working population peaked about thirty years ago and has gone downhill since. So too its currency and its stock market. Maybe, like Europe, a source of special situations, but neither is going to be a locomotive of economic expansion

–Chinese premier Xi has been channeling his inner Mao for a considerable period of time, with the easily foreseeable (except apparently to Xi) economic disaster that this has created. Arguably, he has finally figured this out and the worst has passed. And there are a bunch of interesting multinational companies there–although Xi’s destruction of Hong Kong as an independent source of financial information has made investment in China riskier than it was under Deng.

–an investor might look at Singapore, Malaysia, Australia, or New Zealand, but none of these are big enough to move the world economic needle

–Africa, Latin America and the rest of Asia are the areas that will likely account for the lion’s share of the growth the world will have in 2025. Unfortunately, stock markets there I’ve found, generally speaking, to be opaque and not friendly to foreigners.

–this leaves the US.

…more tomorrow

an answer to a reader’s question

I think 2025 will be a tricky year. 

For the US, a lot will depend on policy from Washington.  Most of what Trump has promised to do during his campaign is damaging to the overall economy–and therefore bad for stocks.  Hard to know, though, what he really intends or how close to Biden he is in cognitive decline.  

As far as oil and gas are concerned, my guess is that we’re at peak usage now–both because of EVs (oil) and climate change (natural gas).  I can’t see any strong reason either for prices to rise or volumes produced to go up.  So I’m happy not to own anything in this sector.

Electric utilities have been in decline for almost all the 40+ years I’ve been in the stock market.  Recently, though, AI has been prompting a revival.  Utilities are weird beasts but I think they’ll be good next year.  Since they’re typically income vehicles, they are typically very defensive.

What we call industrials are mostly companies that produce big ticket items for consumers.  They do well when consumer spending is high.  Even more so, materials do best in a very strong economy.  Most of Trump’s stated economic policy is anti-growth.  Unclear whether he knows this or not.  And we do know that, even before his pandemic denial, the economy was ho-hum ex the (much needed) corporate tax rate cut. I find it hard to figure what will actually happen, but I don’t see a lot of reason to bet that the domestic economy is going to be strong enough for Industrials to do well.  For Materials, the world as a whole has got to be humming along at a high rate to lift demand for metals and industrial raw materials.

relative vs. absolute performance: a summary

Everyone wants absolute performance–stocks that will go up, so that at the end of the year we can look back and say that we have more money ( preferably, a lot more) now than then.

The common sense approach to more money is to pick stocks that will not only go up, but will go up more than the market.

It turns out that for basically everyone this is a lot harder than it might seem. Professionals deal with this by focusing on relative performance. Three tenets:

–stay fully invested

–concentrate on relative performance, that is, make “a is better than b” choices rather than “a (or b) is good in the absolute.” and

–stay in your lane. If you’re a growth investor, pick fast-growing companies, which is what you think you’re good at; if you’re a value investor, sift through the bargain basement for stocks whose price is (far, one hopes) less than the value of the assets they hold.

why write about this?

I’m a growth investor. Strangely enough, though, I spent the majority of my career in value shops–both GARP, where I got my first job, and deep value.

Right now, I find myself most attracted to value names. Valuation of growth names seems to me to be high–and therefore so too will likely be the penalty for earnings disappointments. And the macro environment seems at best opaque and not particularly good. Add to that Trump’s tariff agenda, his apparent intention to deport a significant chunk of the workforce and his apparent Biden-like cognitive decline and it’s not clear that we’ll be awash in positive earnings surprises next year.

I’m also beginning to reorient my IT holdings to a broader set of AI beneficiaries.

more on Monday