Fourth Quarter of 2024

Business Confidence Surges

Before commenting on the market, please note that we will be hosting a luncheon for our clients and friends at the Briar Club in Houston on Thursday, January 23^rd. In the past few years, we’ve had an annual dinner event with a keynote speaker to cover a topic of interest. The feedback from those events has been positive, but we’ve also heard from some that you might prefer to have our session focused entirely on the markets. At this luncheon, we will have some time for fellowship, our outlook for 2025, a discussion of our investment philosophy, and individual stocks presented by our investment team. We hope to see you there. The invitation and RSVP details may be found here: Client & Friends Luncheon Invitation

Now, on to the markets. With the economy growing at an above-trend pace, a more accommodative Fed, and a healthy US consumer, 2024 marked the second strong year in a row for equities. The S&P 500 Index finished up 25%, but this magnitude of gain was not broad based as the largest seven stocks represented over ½ of the year’s gains for the entire index. Half of the S&P 500’s gains came from higher corporate earnings with the other half coming from the market becoming more expensive. Many letters like this, from active portfolio managers like us, will no doubt point to the equally weighted S&P 500 Index having gained far less, at 12.8%, with the Russell 2000 Index up 11.5%.

US equities continued their dominance over international stocks. On a rolling 10-year basis, the US has now outperformed international stocks for every period since 2013. Bonds, as measured by the Barclay’s Aggregate Index, added to its worst drawdown in history that started in 2022. Last year’s total return for that index was -2.4%, and to a lesser degree this has also been a headwind for dividend-producing stocks. In short, the best place to have been invested in again last year was a small handful of the largest US companies. This set up has created opportunities in other areas of the market.

With many of the indices only several percentage points below their all-time highs, we are mindful of history as three very strong years in a row are uncommon. Since 1950, there have been twenty-one instances of double-digit gains over two consecutive years. In only six of the previous twenty times did the market continue with a double-digit gain in the third year. The average gain in those third years is a more modest 6%. Still, there is more for us to like in this market than not.

One of the positives is a surge in small business confidence coinciding with clarity on the election outcome. Going into the election, we witnessed very high levels of business uncertainty which now likely reflects pent-up demand in the economy. Business confidence had been falling for the last six years and had been lower in the last few years than even the lowest point of the pandemic in ’20. This is certainly a welcome change if it can be sustained:

Unleashing of Animal Spirits

(Source: NFIB’s Small Business Optimism Index)

The sharp increase in business confidence has ironically not been reflected in consumer confidence. This measure has also gone down noticeably in the last few years and has likely been affected with inflation having outpaced wages since the pandemic. The good news on consumption, which is 68% of the US economy, is that it has been highly correlated to changes in net worth. According to the Federal Reserve, the net worth of US consumers as of the end of the third quarter sits at $169 trillion. This is an increase of 8% in the first nine months of the year and is up an astonishing 75% from a generation ago.

The economy in 2024 continued to exhibit terrific resiliency, especially in light of the historic Fed rate hiking campaign, that for this cycle, was completed two years ago and previously discussed here: Brasada Quarterly Update - 4th Quarter 2023. More recent inflation readings have been promising. Down from annualized gains of just over 9% at its most recent peak in 2022, headline inflation now rests at +2.8% over the last twelve months. The Fed’s preferred measure, the Core Personal Consumption Expenditures Price Index, has now fallen by three percentage points since its peak in 2022. Outside of wartime, never until now has such a significant decline in inflation occurred absent a recession. Our friends at Strategas Research Partners recently conducted a study on the history of inflation in two dozen countries over the last one hundred years. What they found was that once an economy experienced inflation of over 6%, the chances of a second wave of inflation were 9 in 10. With the Federal Funds rate having been reduced four times in 2024, and with further rate cuts expected in 2025, we are mindful of the risks of a second wave of inflation.

The greatest political volatility in the US since Reconstruction has continued with the reelection of former President Trump. The party in power has changed hands in ten of the last eleven elections, and with the upcoming Republican House majority being the narrowest in US history, chances are high this trend continues in the 2026 midterms. Trump 2.0 has a very different opening set up, and in many ways more challenging, than when he first took office. Compared to 2016, the S&P’s multiple to earnings is now more expensive by three points, 10 Year US Treasury yields have more than doubled, the top corporate tax rate is lower by forty percent, and the ratio of debt to gross domestic product (GDP) is higher by fifty percentage points. While we wait to see what the impact of tariffs and to immigration might be, the prospect of reduced regulation is bullish. Mergers and acquisitions activity, along with the issuance of initial public offerings, is set to explode. The ability for companies to more freely reorganize and transact helps to put a bid under equity prices. This should also help the stocks of smaller companies, where we have expertise, and which have lagged their larger counterparts by one of the worst ten-year periods in history.

Equity valuations continue to be expensive relative to history, although with the S&P 500 continuing to be the most concentrated it has ever been (see also, this note: Passive Perils - The Magnificent 7), we are seeing more reasonable valuations and opportunities in the broad market. Also noteworthy is the enormous amount of capital resting in money market funds. With the Fed having trimmed 1% from short-term rates in ‘24, and with another 0.5% of cuts now expected in ‘25, some of this capital is likely to find its way back into the market. We also are hopeful for continued improvement in the geopolitical arena.

We want you to know that we have been making every effort to keep down the realization of capital gains. This has been a challenge for us as many portfolios have almost no losses to harvest. It’s a problem that we’re quite mindful of, yet a nice one to have.

Our equity strategy returns, net of fees, are shown below. Our composite returns are audited each year and returns for 2024 are estimated. These are shown in accordance with the Global Investment Performance Standards, and your own returns may be different than these as our portfolios are customized:

We have been increasing allocations to income producing securities for many of you in the last few years, and 2024 saw a continuation of this trend. We are now investing in highly rated corporate bonds with yields in the upper 4’s, highly rated municipal bonds with yields in the upper 3’s, and preferred equities with yields above 6%.

We appreciate the confidence you have placed in us and wish you the best in 2025.

Sincerely,

Mark E. McMeans, CFA

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