Bouncing Balls and Laser Lights

Santa Claus was supposed to rally in December and leave us with a good feeling heading into the new year. Unfortunately, however, Santa brought us a laser cat toy. You know, one of those penlight type things that puts a red dot out wherever you shine it, and you can use it to drive cats crazy as they try and catch the dot. Kind of like trying to catch a bouncing ball with one hand tied behind your back.  It is easy if the ball is right in front of you, bouncing at a steady rate and altitude, and in one place. But once the ball starts bouncing around, it becomes dramatically harder to catch. Last year did its best to drive investors and economists crazy as Fed expectations, market volatility (both bond and stock), inflation expectations and results, and more gyrated all over the place. The markets rose dramatically in November after the election but fell precipitously in December as the Fed put the damper on investment expectations by limiting the number of times it expects to cut rates in 2025. Making economic forecasts at the beginning of the year proved to be nothing more than an exercise in futility. Will we be chasing the ball or the laser this year? Probably, unless conditions settle down. The usual suspects will play a role – inflation, the Fed, jobs data – but so will other variables such as AI, market valuations, government policies, and so on. All of these will be considered as we work through this commentary and try to make sense of where we might be headed in 2025.

Financial Markets

Santa came early in November, but the Grinch arrived in December, helping keep the monthly up and down pattern in place. The Santa Claus rally fizzled when the Fed announced that they were reducing their expectations for rate cuts in 2025 from four 25 basis point cuts to just two. Volatility returned and most indices gave up some ground. In December, the S&P 500 lost 2.38%, the Dow lost 5.13%, the EAFE lost 2.33%. NASDAQ bucked the trend as it gained 0.55% during the month.  Unfortunately, the S&P 500 equal-weighted index lost 6.26% during December as the broader market rally lost steam. While the year ended up being a very good one for the equity markets (S&P 500 up 25.02%, NASDAQ up 29.57%), it was another year driven by a handful of stocks.  Bonds suffered during December as the Bloomberg US Aggregate Bond index lost 1.64%, although the index did eke out a gain of 1.25% for the year. Like other forecasts, market prognosticators did poorly, as stocks rallied beyond most expectations and bonds underperformed expectations. The outlook is cloudy as we chase down the bouncing ball or laser light, as equity markets (primarily large-cap U.S.) are overvalued, but also driven by the magnificent stocks and their leadership in technology, AI, and ability to generate earnings. Conditions seem ripe for stocks to face a tougher year and bonds to be dependent upon inflation and the Fed. Smaller cap and international stocks are undervalued, but the impetus to push them higher may not be there this year. Dividend payers and more defensive equities could be a safe play but will underperform again if growth exceeds expectations. In any event, we will try and capture the ball or track down the laser light. For additional data, please see the end of this commentary.

The Economy

Economic growth surprised to the upside in 2024 and that has led many to lower already low expectations for 2025. While there are certainly challenges facing the U.S., there are signs of strength as well. Unemployment remains low, inflation, while stabilizing is lower than last year, corporate earnings are growing, and companies are increasing their capital spending. Much of the optimism comes from the potential for less regulation and taxes from the Trump Administration. All of which is good news for the markets. Offsetting some of the optimism is the threat of increased tariffs that could lead to higher inflation, a still recessionary manufacturing climate, and the feeling that the Fed will cut interest rates only once or twice this year. The impact of these issues will weigh on markets. The optimistic side is reminiscent of the Reagan years, but the big difference is market valuations.  When Reagan took office in 1981 the P/E ratio for the S&P 500 was at about 8 whereas it is above 25 today. Certainly, there are some differences due to technology, energy, the rate of inflation, a recession, etc., but the market is overvalued now versus undervalued then, making oversized gains less likely. Should the more pessimistic view win out, the result will be a recession, a market sell-off to some degree, and a Fed forced to lower interest rates faster than desired. There are a lot of bouncing balls and laser lights to watch here.

GDP (Gross Domestic Product) – While the mood was decidedly less than exuberant in 2024, the nation’s GDP outperformed even the most-rosy of forecasters. The third estimate for the third quarter showed an upwardly revised rate of 3.1% (from 2.8%), and initial fourth quarter estimates are coming in at a range of 1.5% to 2.5%, although the Atlanta Fed’s GDPNow forecast stands at 2.7% as of 1/7/25. That has brought full-year estimates to 2.7% or better. Estimates for the new year range between 1.5% and 2.5% as the economy is expected to slow. However, this is again like chasing the ball or the light as much may depend upon policies out of Washington and how fast they might impact the economy. These estimates certainly don’t portend a recession, but, if we do fall into one, it is expected to be short-lived and relatively shallow and then perhaps we would still hit the lower end of the estimate range for the year anyway.  Maybe the ball or light will be a bit easier to catch in 2025.

Inflation – Inflation, like every other economic variable over the past year, bounced again in November to 2.7%. Truflation reported a 2.97% reading as of January 7^th, which does not exactly give off a warm and fuzzy vibe. The numbers are a bit tricky when it comes to inflation because the monthly adjustment may or may not change, while the annual rate may stay the same, move in the same direction, or even move in the opposite direction. From July through October, the monthly rate stayed the same at a 0.2% increase while the annual rate of change ticked lower from 3.0% in June to 2.7% in November. Some of that was expected based on the numbers over the past year or so, but hopes were that we would be much closer to 2.0% than we are today and that the goal of 2.0% was well within reach. Seems like the cat laser toy got us in 2024 and may do so again in 2025, as forecasts are all over the map. Some argue that inflation will reignite due to new policies from Washington such as tariffs, the rising money supply, and steeper government deficits. Others see inflation settling down as service prices soften, housing prices moderate, and a soft landing ensues. What seems likely is that inflation will continue to be stickier than anticipated but will not move dramatically from where it stands today. If inflation does stay higher than desired, do not be surprised to hear calls for a new target rate of 3.0% inflation instead of 2.0%. That would allow the government to cut rates instead of keeping interest rates higher in the fight against inflation. The inflation bouncing ball and laser lights will undoubtedly continue to catch our attention, but whether we can catch the ball or just bat at the laser light remains to be seen.

Unemployment – One of the few economic variables that did not follow the laser light bouncing around all over the place was the unemployment rate. While the rate did tick higher during the year, it never approached levels that triggered recessionary fears and allowed the Fed to focus on the fight against inflation. The latest data shows the unemployment rate at 4.2% (November), which is in the ballpark of the Fed’s maximum employment mandate. The broader job’s picture is a bit murkier and is more subject to the bouncing ball syndrome. Per ADP, December saw companies add a seasonally adjusted 122,000 jobs, which was less than November and less than expected, and wages grew at their slowest pace since 2021, as they grew by 4.6% from a year ago. Both data points should not add to inflationary pressures. Monthly employment estimates vary widely, and so do their revisions, and job gains over the past two years have primarily been in the government and healthcare sectors. It is likely that government related job gains will be harder to come by under the Trump Administration and hopefully the private sector will step up and fill the void. That would be better for the economy too. This bouncing ball and light show may get a bit more volatile in 2025.

The Fed Watch

In the book and movie “A Christmas Carol,” Scrooge initially turns away a visitor seeking to raise funds to help the poor. But, after his experience with the three spirits and altering his character for the better, he sees this gentleman again and upon approaching him, the gentleman asks, “Mr. Scrooge?”  To which Scrooge replies, “Yes. That is my name, and I fear it may not be pleasant to you….”  Well, that name seems to fit the Fed right now, as their post December meeting comments killed off the Santa Claus rally. It remains to be seen if they change their course in January, like Scrooge did when he followed up his comment by stating “…. Allow me to ask your pardon,” and then offered up a generous donation, proving his changed character. Will the Fed change course in January and offer more encouragement to the markets by indicating more rate cuts in 2025 than proposed in December? Inflationary and jobs data, as discussed above, do seem to indicate the need for the Fed to continue the fight by not lowering rates too far or too fast. On the other hand, should the data turn negative, they may need to cut rates faster and deeper than desired to boost economic activity. In other words, follow the bouncing ball and laser light and see if the Fed can catch them. For now, expect the Fed to take a measured approach and continue to be short-term data dependent.

Outlook/Summary

When the markets move in one direction for an extended time – especially if the degree of movement is quite strong – there tends to be a period where momentum carries the day. But, at some point fundamentals take over, momentum slows, and a reversion to the mean occurs. When that reversion occurs, it is either positive because markets have become undervalued, or negative, because markets are overvalued. The one to be concerned about, especially in today’s market environment, is when markets are overvalued, and the potential for a sell-off rises. The reversion does not just have to be a sell-off, but could include stronger earnings growth, less reliance on a small number of stocks, and a strengthening economic environment. Plus, momentum can carry the day longer than expected if market conditions are right. After two straight years of strong stock market performance, due primarily to the Magnificent Seven stocks, we need stronger earnings growth from other elements of the stock market and an improving economy to keep the rally going. There have been periods like this where the third year is still strong, such as 1952 and 1997 but the third year has generally been much weaker. Without the improvements described above, this year could be the start of a reversion to the mean for large-cap growth stocks but other areas, such as small- or mid-cap stocks and international stocks, could finally revert to the mean, resulting in a strong rally in those areas. So, it is a case of choosing which bouncing ball to try and catch or which laser light to follow.

When conditions are like this, meaning uncertainty, our approach can shine. Our process has not changed, as we do not time markets, but take a consistent approach that seeks to protect the downside and then seek upside returns. To that end, we continue to look for opportunities in both the fixed income and equity markets, while staying true to the process. Sticking to a plan, investing to the level of risk you are comfortable with, and not letting the bouncing ball or laser light drive you crazy is what we feel is the best way to be successful over time. To discuss your portfolio, call the Wealth Management division of Lake Ridge Bank at (608)826-3570. We look forward to speaking with you.

Market/Economic Data

As of December 31st, 2024…. Unemployment data is through November for national, Madison, and Wisconsin (both preliminary), inflation data is through November:

Thank you for your business – we look forward to speaking with you soon. (Note – this commentary used various articles from JP Morgan, Morningstar, the Wall Street Journal, Investor’s Business Daily, Northern Trust, CNNMoney.com, msn.com, Kiplingers.com, nytimes.com, Fidelity Investments, American Funds, LPL Financial and other tools as sources of information.