“In previous bull markets the rise in stock prices remained in fairly close relationship with the improvement in business during the greater part of the cycle…But in the 1921-1933 cycle this “culminating phase” lasted for years instead of months. The ‘new-era’ doctrine – that ‘good’ stocks (or ‘blue chips’) were sound investments regardless of how high the price paid for them – was at bottom only a means for rationalizing under the title of ‘investment’ the well-nigh universal capitulation to the gambling fever.”
Benjamin Graham, Security Analysis, 1934
In the aftermath of the greatest stock market bubble in US history, the great Benjamin Graham chronicled the rise and fall of the euphoria surrounding US financial markets. As he describes it, there was a lot of excited rationalizing during the epic financial bubble years from 1922-1929, and a lot of bitter regret afterward. As the kids might say, there was some serious coping.
The Narrow Road of Reflection
We see now in a mirror dimly, but eventually we will see clearly (1 Cor 13:12). Human nature is finite. We see bits and pieces, but not everything. This is especially relevant when looking at the economy. Everyone has a narrative or opinion, but every narrative is simply a feeble attempt at putting things together to try and make sense of it all.
However, hindsight is 20/20. When looking back, it’s easy to see what we missed. Or at least, to think we see what we missed. And once we see “it”, we long for what could have been but isn’t. We notice missed opportunities and wish we had a do-over. Often (and especially regarding financial decisions), we covet the benefits of a reality that doesn’t exist. But the past cannot be changed any more than the leopard can change its spots. And to dwell on missed opportunities is no more useful than wishing you were two inches taller.
At the same time, as George Santayana once said, those who forget the past are doomed to repeat it. And while history doesn’t actually repeat, it does (as Mark Twain was supposed to have said) rhyme. Indeed, to attempt to change the past is futile. But to forget it is equally foolish. Rather than fall into either error, we ought to evaluate and learn from the past as we look toward the future.
What Happened In 2024
2024 began with serious doubts about the US economy. The Federal Reserve had lowered their forecast for inflation at the end of 2023 and implied that they might lower the federal funds rate seven times in 2024. Inflation had cooled significantly in the 4th quarter of 2023, and the bond market had rallied on the news. Further, bonds were pointing towards a recession as the well-known“yield curve” had remained inverted, a historically flawless indicator of future economic contraction. Meanwhile, stocks had increased about 25% – nearly three times the historical average – even though corporate America was busy trying to navigate higher interest rates, stagnant-to-lower earnings expectations and slowing business-to-business spending.
Internationally, a variety of headwinds faced the global economy as both the East (i.e., Japan and China) and the West (i.e., the Eurozone) were struggling with weaker currencies, weak business growth, and higher funding costs (i.e., interest rates) for their heavily indebted economies. All this pointed to serious concerns about the growth outlook in 2024.
Now in 2025, what can we learn from looking back? US stocks repeated their 2023 run with another 25% return in 2024, bringing the two-year return to nearly 50%. Meanwhile, the yield curve largely “un-inverted”, returning to a more normal shape associated with a growing economy. Inflation continued to cool, although (at least according to some official measures) not as much as the Fed had hoped. Thus they only cut interest rates four times in 2024 instead of their originally planned seven. The bond market struggled as a result and gave back much of the gains it had achieved at the end of 2023. In short, the US economy did much better than expected in 2024.
In contrast, the international economy was worse than expected. The US dollar continued to strengthen against all its major trading partners, reaching an all-time high just a few days ago. As I have explained in past posts, a strengthening US dollar is bad news for the rest of the world, as their currencies and their economies are both debt-based and dollar-dependent. They need a weaker dollar to function alleviate the stress on their currencies and business community. A strong dollar just tightens a noose.
As a result, much of the Eurozone continues to flirt with recession and many of the central banks across Europe are lowering interest rates much quicker than the Federal Reserve. In fact, the Swiss National Bank is heading back towards 0% and hinted recently that they may well take their risk-free interest rate into negative territory. In addition, the recent political turmoil in several countries is a quite visible indicator of the displeasure that the populace has with the current economy and social situation.
In the East, things are even worse. Japan is in the middle of a currency crisis, having lost 15% of its purchasing power compared to the dollar in just the last year, and nearly 50% over the past three years. China, meanwhile, is also struggling with a weakening currency, an imploding real estate market, and interest rates that are heading towards the 0% mark despite massive stimulus measures that have proven ineffective. And this isn’t even taking into account the pain of Trump tariffs on Chinese goods, if they were to be implemented.
In short, 2024 brought better than expected results in the US, and worse than expected results everywhere else.
Where Hindsight Meets Foresight
Rather than wishing we had just owned US stocks and nothing else in 2024, we need to consider what these developments mean for 2025. Will the US continue to do well, especially now that the pro-business Trump administration is set to take office? Will the rest of the world continue to struggle amidst the growing threat of a trade war and stronger dollar?
With these questions in mind, here are a few observations:
- US stocks continue to be over-valued compared to historic norms. As recent years have proven, this does not mean US stocks will go down this year, or any time soon for that matter. The recent two-year rise has moved the most accurate historic valuation metrics beyond the peak of the greatest stock market bubble in US history. In other words, US stocks are more expensive than they have ever been (at least by thesemetrics). Of course this is historical data. But it’s also based on the idea that when someone buys a stock, they think it has value precisely because there is an expectation of future cash flows. Without that expectation, it no longer becomes an investment. It simply becomes a bet.
- Coincidentally, the annual return for the S&P 500 in 1924, exactly 100 years ago, was 20%. In 1925, the returns were similar: about 20%. These two phenomenal years were followed by increases of 6%, 31%, and 42% respectively over the next three years. The “gambling fever” lasted years, not months. It sucked in nearly everyone before the peak in 1929. The aftermath, however, eliminated all gains in the stock market back to 1907 price levels in just two short years. While that spectacle may or may not be relevant 100 years later, it ought to be a cautionary tale for those who see the past few years’ returns as evidence that future returns will be similar. Such thinking has more in common with “rationalizing gambling fever” than it does with financial analysis.
- If anyone believes this “new era” of stock prices is being driven by future growth and not “gambling fever”, I would like to introduce you to Fartcoin. This is the latest “development” in crypto-currency technology. It does absolutely nothing. Yet, it’s market value recently reached $1.5B, which made it more “valuable” than 55% of US companies. If you are one to think markets are always rational, does this market-based “value” pass the sniff test?
- Some see the recent rise in US bond yields as indicating that US economic growth and inflation are set to surge in the next few years under a Trump presidency. But the same thing occurred when Trump first took office in 2016. Interest rates rose with the threat of tariffs and higher growth expectations. However, interest rates were significantly lower at the end of his term than when he took office, demonstrating that neither expectation proved accurate. And in 2016, Trump was taking over a much healthier economy than the one today, which is more in debt and with a much weaker job market and corporate growth prospects. Second, the normalizing of the yield curve (i.e., the “un-inverting”) usually occurs at the beginning of the Fed cutting cycle, which started 3 months ago. The past several fed cutting cycles have seen long term interest rates rise (and thus the yield curve normalizes) for several weeks or sometimes months after the fed’s first cut. But in every case both long and short-term interest rates moved significantly lower over the next 12-24 months.
- Inflation concerns seem to have reemerged recently, with Trump threatening tariffs on all imports and the official inflation rate seemingly stuck around 2.5-3%. However, once again we ought to consider the past with an eye towards the future. Trump imposed tariffs in his first term, and according to the Fed’s own reports those tariffs had negligible affects on inflation. Further, the official CPI rate continues to trend down, with semi-annual and annual rates continuing to decline towards the Fed’s 2% target. What’s more, the current inflation rate is heavily influenced by a shelter inflation component that is lagging real time data. If the Fed were using more accurate measures of housing inflation like ALNRR or Corelogic, the official inflation rate would be around 1.5%, well below their 2% target. This suggests that while 2024 continued to be a tough environment for bond prices, there is strong evidence that 2025-26 will see interest rates fall and bond prices rise significantly.
Portfolio Implications
Recent changes to our portfolios have sought to consider both our hindsight of 2024 and our forecast for 2025 in several ways. First, we have to consider that despite their record high prices, US stocks may continue to rise for several years. While we still think the risks are heavily to the downside, we simply cannot discount a variety of factors (some rational, some irrational) that could push US stock prices higher. As a result, we have sought to include hedged positions within the US stock market that will allow more participation on the upside while providing protection on the downside.
Secondly, we continue to see a massive downside risk in interest rates over the next 12-24 months as the market has mis-priced both inflation and growth prospects. While this move has already begun, the large moves we expect have admittedly taken longer than anticipated. Even so, the underlying fundamentals supporting this thesis have only grown more definitive over the last year. Considering that, we have worked to make our bond holdings more efficient. By allocating our bond holdings into positions with more potent relationships to interest rate moves, we can allocate less of our portfolio to bonds while still maintaining the same upside potential in the event that rates fall as much as we expect. One analyst refers to this as the “Walmart Effect”, essentially getting more for less.
Third, by making these strategic changes, we’ve been able to increase our allocation to gold, which is poised to continue moving higher over the long term. Further, over longer time periods, a 10-15% allocation to gold lowers portfolio volatility while increasing returns.
Fourth, by making our allocations more efficient, our retirement portfolios are now earning more income than they were a few years ago, providing the same consistent income to retirees who need stable cash flow. And this is despite enduring the worst bond bear market in history.
Conclusion
As we enter 2025, we continue to see great risks to the economy moving forward. There are no certainties in financial forecasts, only probabilities. And while investors have largely been rewarded for piling into US stocks for several years now, that is no reason to join them in the gambling fever or become complacent. Making decisions after looking at the past is no more helpful than attempting to drive while looking in the rear-view mirror. It is the road ahead that should grab our attention. After all, hindsight isn’t 20/20; it’s 2024. And we aren’t there anymore.