It was an eventful news quarter – the last three months saw US elections, a narrowly averted government shutdown, two rate cuts to the short-term Fed Funds rate by the Federal Reserve, hurricane Milton, a brazen murder of the CEO of UnitedHealthcare, and an Iranian missile attack on Israel, just to name a few.
Still, market reactions were relatively muted. The S&P 500 posted a slightly positive quarter as large US stocks retook their leadership position from smaller companies which had led last quarter. Overall, market returns were decidedly mixed as international stocks declined and bond prices fell when longer-term interest rates rose.
The S&P 500 peaked on December 6th – coinciding with the end of Taylor Swift’s Eras tour (another major news event during the quarter!). After that, US markets fell back a bit as investors became more concerned that the Fed might not cut interest rates as much as previously expected, especially after their December 17-18th meeting. As a result, there was no Santa Claus rally this year.
Will the markets shake it off? Strategists think so – they are mostly expecting the 2023 and 2024 rally to resume in 2025. Of course, strategists are usually wrong about this sort of thing. In 2024, more than half of the major Wall Street firms polled by Bloomberg predicted the S&P 500 would decline – an unusually dour forecast. Instead, the index rose by +25%, a similar return to 2023. Back in 2022, almost every strategist had predicted a rise in the S&P 500, and the index fell more than -18%. So much for the strategists.
We’ll come back to the future at the end of this commentary. But first, a round-up of how stocks, bonds, commodities, and currencies performed in the fourth quarter and in 2024 overall.
Stocks
The AI rally resumed in the fourth quarter. Palantir, which makes AI software, jumped +103% in the fourth quarter, and gained +340% for the year. Nvidia, which makes AI chips, rose +11% for the quarter and +171% for the year, and Google rose +14% in the quarter and +36% for the year. Overall, large US stocks as measured by the Russell 1000 index were up +2.8% for the quarter and +24.5% for the year.
This year, large growth-oriented stocks outperformed smaller stocks as well as slower-growth companies that are considered value stocks. Large growth stocks, as measured by the Russell 1000 Growth index, gained +33.4% for the year, compared to a full year gain of +14.4% for stocks in the Russell 1000 Value index. Small stocks, as measured by the Russell 2000, were up +15.2% for the year.
International markets underperformed the US this quarter, with the MSCI EAFE index of developed international countries falling -8.1% in the fourth quarter, and the MSCI Emerging Markets index of developing countries declining -8.0%. For the year, developed countries added +3.8% and emerging markets picked up +7.5%.
Interest Rates and Bonds
The election of President Trump and a Republican US Congress has caused investors to drive up longer-term interest rates. Concerns about inflation and deficit spending has meant that investors are now anticipating higher long-term rates. The 10-year Treasury yield rose from 3.8% at the end of the third quarter to 4.6% by the end of the year.
The rise in long term rates occurred despite two rate cuts in the short-term Fed Funds Rate controlled by the Federal Reserve — from 5% to 4.75% in November, and then to 4.5% in December. These cuts had already been widely anticipated, and as investors reduced their expectations for future rate cuts to just one or two more cuts in 2025, longer term interest rates rose.
As a result of rising long-term rates, mortgage rates increased as well. The average 30-year fixed rate mortgage rate rose from 6.1% at the end of the third quarter to 6.9% at the end of the year.
Bond prices move inversely to interest rates, and therefore rising rates pushed bond prices down. The US Aggregate Bond return in the fourth quarter was -3.1%, although for the year the US Aggregate Bond index is up +1.3%. Shorter term bonds did much better, with short term bonds up +3.8% for the year (as measured by the Bloomberg Government/Credit 1-5 year Bond index), and short term inflation-protected bonds up +4.7% (as measured by the Bloomberg US TIPS 0-5 year index).
Commodities and Currencies
Oil prices rose slightly during the fourth quarter, with WTI crude oil prices starting the quarter at $68, but ending at $72 per barrel. Oil was relatively unchanged over the full year period. It is remarkable that oil prices have been so steady over the past several years, staying at roughly $70 per barrel despite the Russian invasion of Ukraine and the war in the Middle East.
Gold prices took a breather in the fourth quarter, ending almost unchanged from September 30th. For the year, however, gold was up almost +27% as international demand for the precious metal soared.
Looking Ahead
We have no prediction for stock market returns in 2025, but in the longer run, we think it’s safe to say that the US stock markets will not be able to sustain the pace of growth we’ve seen over the past two years. These recent returns were partly a comeback from a terrible 2022, partly an increase in the price of stocks relative to underlying company earnings, and partly a reflection of real growth in corporate earnings. Let’s take these in turn.
First, the comeback from 2022’s decline is a significant factor that is not given sufficient attention, but is now largely completed. Despite eye-popping returns of +25% in 2024 and +26% in 2023, the math is such that it takes a significant positive return to come back from a downturn of -18% like we had in 2022. For the full 2022 – 2024 period, the S&P 500 return is now -9% per year – close to equaling the long-term annual return of -10% since the S&P 500 was introduced in 1957.
The price of stocks is back to being historically high – according to one calculation it is right back where it was at the end of 2021 before the 2022 correction. Looking at stock prices compared to the previous 10 years of earnings (the so-called “CAPE” ratio, or “Cyclically Adjusted Price to Earnings Ratio”), stocks are trading at 38 times long term earnings, right about where they were three years ago.
Finally, corporate earnings have been quite strong recently, and investors are counting on even faster growth in 2025 earnings. Over the past 3 years, corporate earnings are estimated to have grown 5% per year and 2025’s expectations are considerably higher. Currently, analysts are projecting growth of almost 15% in the earnings of companies in the S&P 500 for this year. But this blistering pace will be hard to achieve and impossible to maintain, and investors are already becoming increasingly concerned that AI spending is getting well ahead of AI revenue.
Although it is a fool’s errand to estimate near term market returns, there is a very clear pattern of stocks’ long term (10 year) returns being related to the price of stocks at the start of that period. Large company US stocks are extremely expensive right now compared to historical averages, and long-term returns that are lower than the long-term averages are highly likely for large US stocks over the next 10-year period.
Our advice, as always, is to be careful of jumping on bandwagons and to stay diversified. International and small company stocks are much cheaper at the moment relative to their earnings. Bonds are offering decent returns. Nobody knows what will happen over the next year, but in the long run we believe a diversified portfolio will continue to stand the test of time.