Equity investors enjoyed a great 2024 despite warnings at the start of the year of an impending bear market because of expensive valuations and an inverted-yield curve that foreshadowed a recession.
Monday’s sell-off in tech stocks, sparked by the emergence of a low-cost Chinese artificial intelligence model, should now serve as a wake-up call not to let complacency settle in as the new year unfolds. Even though talk of an equity bubble has diminished in recent months, overall valuations are still near record levels in the U.S. stock market. The odds of 2025 being a good year for stocks are lower than most years.
The S&P 500 Index returned 24.88 per cent in 2024, including dividends. This followed a total return of 26.08 per cent in 2023. Over the past two years, the S&P 500 returned 57.42 per cent. Over the past five years, the average annual total return for the index has been 11.43 per cent, or 95.64 per cent in total.
Given all the complaints that Americans and Canadians had about the economy, one could be forgiven for being confounded by the outsized returns of the markets. Yet again, we are reminded that the real economy and capital markets do not necessarily move in lockstep with each other.
What do investors do now?
Start with analyzing your asset mix – many no doubt haven’t done so in years. An investor with a 60 per cent/40-per-cent stock/fixed-income weight only two years ago might find that their current mix is 70/30 totally because of market drift. Does one let it ride, go back down to their previous target or take profits and become defensive?
Every investor is unique, but a realistic outlook and prudent risk assessment is a good idea.
There have been bearish forecasts for years that have turned out to be wrong, so skepticism about impending doom is understandable.
But U.S. equity markets are very expensive. Both of my favourite indicators, the Buffet Indicator (market capitalization divided by GDP) and the Shiller P/E ratio (a price-to-earnings ratio averaging profits over a ten-year period and adjusted for inflation), are at levels only seen before the dot-com crash of 2000 and the Wall Street crash of October, 1929.
Before you sell your entire stock position, remember that these are long-term valuation models and not market-timing indicators. Markets can be expensive and get more expensive for years and they can also indicate that the market is cheap when the end of a bear market is years away.
J.P. Morgan has looked at forward P/E ratios and subsequent returns. Statistically, forward P/Es do not correlate with the market return of the next year. The indicator does not give us a good signal of impending collapse. Nor does it forecast continued gains.
This latter point is important as the market goes up most years. The S&P has enjoyed 33 years of positive returns over the past 40 calendar years, or 82.5 per cent, and 78.8 per cent for all years since the end of the Second World War. However, it is important to remember that bear markets tend to be brutal and quick.
Valuation models like the Shiller P/E and Buffett indicators do have a high correlation with subsequent five and ten-year returns going forward. Although 2025 may turn out to be a good year, investors will likely be faced with weaker real returns in the next five to ten years. Annual returns, after inflation, will probably be less than 5 per cent, based on historical data.
Timing when to reduce equity exposure, however, is always difficult. As an esteemed colleague remarked a couple of years before the 2000 crash, when you’re in a bubble, you have no idea how close you are to the pop.
Historical data causes me to be even more sanguine about the longer-term outlook for equities, particularly in the U.S. Fundamentals in the economy are also a cause for concern. The market is discounting for unusually robust earning increases. Meanwhile, the Canadian stock market has lower valuations but earnings potential isn’t as attractive in the U.S., and when a bear market comes to the U.S., it will spread to this side of the border.
Demographic trends will provide a drag on earnings and stock prices in the long run. Western countries are seeing population declines. The average birth rate in industrialized countries is only 1.5, which is well below the replacement rate of 2.1. Corporations simply cannot rely on an ever-growing population to buy their products and services.
Immigration will not make up totally for this and we have large numbers of recent immigrants in Canada and Europe that are not correlating with growth as those economies struggle.
Another tailwind will be age demographics. About 80 per cent of stocks are held or accounted for by people over 55, and a third by people over 70, according to some sources. Whatever the actual figures are, the Baby Boomers are retiring or getting close to that great trading floor in the sky. There will be selling pressure and Zoomers and younger millennials lack the buying power to offset this inevitability.
Hopefully, 2025 will be a good year but investors should not expect large returns without serious sell-offs going forward. Portfolios should be adjusted for this new reality.
Tom Czitron is a former portfolio manager with more than four decades of investment experience, particularly in fixed income and asset mix strategy. He is a former lead manager of Royal Bank of Canada’s main bond fund.