December 2024 Market Commentary

December 2024 Commentary

It’s interesting how December of 2023 and December of 2024 were similar. Like 2023, the S&P 500 was up over 20% going into December 2024 and we are wondering if 2025 can be positive. In 2023, we wrote that there was no reason to believe that we couldn’t have an average return year in the S&P 500 for 2024 and we were rewarded for staying the course in our portfolios. Going into the holidays, we could celebrate that not only did we get a positive year, but we also got another strong year of performance with the S&P 500 up 28.05% as of November 30th. While 2024 and 2023 were remarkably similar in terms of US equity market returns, some trends made December 2024 significantly different than the prior year. We’d like to briefly touch on those trends and share some of the things that we are thinking about going into 2025.

State of the Economy

At the end of 2023, our concern was whether the Fed could engineer a soft landing; that is, would the 2023 series of rate hikes be able to dampen inflation without serious damage to the labor market and US economic growth? In 2024, inflation remained stubbornly above target but continued to trend lower. We did get a bit of a labor market scare in August when the unemployment rate accelerated to 4.3%, but since the Fed initiated a series of rate cuts that began with a 50-basis point cut in September, the subsequent readings were stable around a relatively low 4.2%. As of December 2024, our outlook included a very stable unemployment rate and real GDP growth of just under 3% for 2025. This relatively optimistic outlook has been reflected to some degree in the shift in expectations for further Fed rate cuts. We do warn that there is potential for the market to be disappointed by slower and fewer subsequent rate cuts.

Valuation

While you might argue that the general economic outlook isn’t terribly different, market valuation was significantly more stretched at the end of 2024. At the end of November 2023, the S&P 500’s price/earnings ratio was 22, just about average. The rolling two-year S&P 500 return at that point was only 3.32%. The point is that 2023 was largely a retracement of a very negative 2022 where the price/earnings ratio dropped to 17.2 in September of that year. Fast forward to the end of November 2024, the rolling two-year S&P500 return was 52.36% and the price/earnings ratio was 27. So as of December 2024, we were coming off two very strong years of market returns, and multiples have expanded significantly. To put the current price/earnings level in context, Exhibit 3 shows that the current price/earnings ratio is currently 1.52 standard deviations above average.

Exhibit 1

Source: Bloomberg, AAFMAA Wealth Management & Trust

Historically, when the price/earnings ratio exceeds two standard deviations above the mean, it is generally followed by lower-than-average returns and has sometimes signaled more significant selloffs. We know that this extreme level of valuation in the S&P 500 is more concentrated in certain sectors, and we will be taking this into account in our portfolio construction going into 2025.

Trends in Sector Performance

Exhibit 2 shows the extreme sector return dispersion that existed at the end of 2023. The average sector return was 18.6% with a standard deviation of 22.9%. Most of the return of the S&P500 was concentrated in Information Technology (+57.8%), Communication Services (+55.8%) and Consumer Discretionary (+42.3%). The remaining sectors were all below average with Utilities (-7.1%) and Energy (-1.4%) being negative.

Exhibit 2

Source: Bloomberg, AAFMAA Wealth Management & Trust

As of November 30^th, 2024, we had a much different picture. The average sector return is 24.7% with a standard deviation of 10.3%. Financials (38.0%) was the strongest sector year-to-date. 2023’s weakest sector, Utilities (34.1%), was the fourth best-performing sector. In 2024, the contribution by sector to the total return of the S&P 500 was much more balanced than in 2023, but what is most interesting is that much of the gap between relative sector performance has been closed in the last three months, driven by interest rate cuts and election results.

Exhibit 3 shows the S&P 500 sector performance since September 1^st, 2024. Consumer Discretionary (+19.6%) has been the strongest sector in the last three months, largely driven by a 37% rally in Tesla Inc. Financials also closed the gap on leading sectors with banks rallying significantly on the expectations of a more friendly regulatory environment under a Trump administration. Although Information Technology (+6.2%) has had a solid quarter, notice that it has been a below-average performer over the period. We also see that real estate (4.0%) has been a below-average performer since the beginning of September which has been a surprise to many who thought the initiation of rate cuts would be supportive of the sector. The 10-year US Treasury yield was 3.70% on the date of the first rate cut (September 18^th) and yielded 4.19% as of 12/9/2024. 30-year Mortgage Rates have generally traded in line with the move in the 10-year and are now 0.60% higher than they were back on September 18^th. So, to date, rate cuts have not boosted real estate through lower mortgage rates.

Exhibit 3

Source: Bloomberg, AAFMAA Wealth Management & Trust

Small-Cap Versus Large-Cap Performance

In 2023, the S&P 500 outperformed both the S&P 400 Mid-Cap Index and the S&P 600 Small-Cap Index by about 10%. This outperformance continued into 2024 but Exhibit 4 shows that since September, the cumulative performance between large- and small-cap has narrowed.

Exhibit 4

Source: Bloomberg, AAFMAA Wealth Management & Trust

In fact, since Sep 1^st, small- and mid-cap have outperformed the S&P 500 by around 2%. We know from previous research that small- and mid-cap sometimes outperform large-cap in the aftermath of a rate cut, but that outperformance is often short-lived. Turnover and tax considerations may suggest that a brief allocation shift into small- or mid-cap is not consistent with our strategy. Small- and mid-cap valuation (and valuation in general) is currently much more compelling as you move away from the mega-cap stocks that have driven market performance over the last two years; we will continue to monitor this trend in the performance of size as we move into 2025.

Conclusion

Although we are arguably more confident of a constructive economic outlook this December than last, we are definitely more concerned with valuation going into 2025. 2024 was another year where growth outperformed value significantly; we will not be looking to increase exposure to growth going into 2025. We are seeing more breadth in market performance, and we will look for opportunities in lagging sectors to gain exposure to securities with attractive valuations that are consistent with our philosophy. The recent outperformance and more compelling valuations of smaller capitalization will keep our portfolio skewed toward a smaller size than the benchmark going into the new year. Finally, we will be watching closely for opportunities in international after another year of lagging performance.

We are grateful for a successful 2024 for our clients as well as our team here at AAFMAA. Wishing you continued success in 2025.

Yours in trust,

Parker

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© 2024 AAFMAA Wealth Management & Trust LLC. Information provided by AAFMAA Wealth Management & Trust LLC is not intended to be tax or legal advice. Nothing contained in this communication should be interpreted as such. We encourage you to seek guidance from your tax or legal advisor. Past performance does not guarantee future results. Investments are not FDIC or SIPC insured, are not deposits, nor are they insured by, issued by, or guaranteed by obligations of any government agency or any bank, and they involve risk including possible loss of principal. No information provided herein is intended as personal investment advice or financial recommendation and should not be interpreted as such. The information provided reflects the general views of AAFMAA Wealth Management and Trust LLC but may not reflect client recommendations, investment strategies, or performance. Current and future financial environments may not reflect those illustrated here. Views of AAFMAA Wealth Management & Trust LLC may change based on new information or considerations.