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Good morning and happy new year. The stock market dipped a touch while we were away. Investors locking in 2024’s profits? A bit, perhaps, but this was no rush for the exits, making for a relatively peaceful holiday season. Will the calm continue in 2025? Send predictions: [email protected] and [email protected].
Where stock market dollar returns came from in 2024 (and where they might come from in 2025)
Last year the total return on the S&P 500 was 24.5 per cent. That’s a great year, and the fourth 20 per cent-plus year in the last six. Are we in for a stinker in 2025, then? It’s natural to think so. Trees don’t grow to the sky, and all that.
Stocks are not, however, trees. While there is a sense in which above-average returns in the past predict below-average returns to come, this is true only in the long term. Extended bull markets lead to very high valuations. Very high valuations are correlated with returns over the next decade or so. But this tells us nothing whatsoever about a single year.
We might get a slightly better sense of what to expect if we look at exactly where those great 2024 returns came from. About 1.2 per cent of the S&P’s total return came from dividends last year. Another 10 per cent came from higher stock valuations (the forward price/earning ratio for the index went from 20.5 to 22.6). The final 13 per cent or so came from rising earnings expectations. That earnings growth outlook can in turn be broken down into revenue growth (about 5 per cent) and margin expansion (the remaining 8 per cent).
What bits of that are likely to be repeated, or improved upon? It would be natural to think valuations are reaching a point where they can go no further. We are near valuations’ historical peaks. But again, valuation and returns are related only over many years. There is no reason we might not get another 10 per cent bump to P/Es next year. Or, for that matter, a contraction.
It’s margin expansion that is the higher bar. S&P net profit margins were expected to come in at 12 per cent for 2024, according to FactSet. This would have been a 10-year high if not for the extraordinary post-pandemic year of 2021, which came in at 12.6 per cent. Consensus calls for 2025 to surpass even that year, hitting 13 per cent. Absolutely possible, but what explains it? Yes, the US economy is expanding at about 3 per cent, but it is not accelerating. And the rest of the world, which accounts for 40 per cent of index revenues, is in poor shape. This then is the question that bulls must answer about 2025: Why should margins continue to expand?
I can’t think of a good reason why they should (AI? A few years down the road, maybe, but not in 2025). So, as Unhedged discussed last year, a likely scenario is revenue growth in the recent range of 3 per cent to 5 per cent, another per cent of dividends, and a little, if anything, from margin expansion. On top of that, it’s anyone’s guess on what valuation multiples might do.
The Merton share
One of the best things I read over the Christmas break was a piece in the Economist about the advantages of dynamic asset allocation — of changing a long-term portfolio’s mix of risky and safe assets as conditions change, rather than rebalancing to maintain a fixed mix of, say 70/30. The article focuses on a formula for finding the right allocation through time, developed half a century ago by Robert Merton.
The formula for the “Merton share” is the excess return provided by the risky asset (stocks, for example) over and above the riskless asset (such as inflation-indexed Treasuries), divided by the product of the square of risky asset volatility and a measure of the risk appetite of the investor. This is a lot to hold in one’s head, but the idea is very intuitive. How much risk you should take is a function of the extra returns available, the riskiness of those returns, and how much risk you are willing to take.
The Economist piece, good as it was, left me with two questions.
First question: how do investors who actually use dynamic allocation determine the numbers in the denominator of the formula? The numerator is straightforward enough. Looking at a stock index, you could take the earnings yield (earnings/price) and then subtract the real Treasury yield. Right now that figure (using the S&P 500 index and 10-year Tips yields) would be 2.1 per cent (4.3 minus 2.2). But how to put a number on risk aversion? And which measure of risky asset volatility to use?
Second question: what does the Merton approach tell us should be the risk asset allocation right now?
I put both questions to Victor Haghani, founder of Elm Wealth, an asset manager which puts Merton’s ideas into practice.
Quantifying risk aversion turns out to be relatively straightforward, if you know the math. Without going into details, it can be derived from what trade-offs an investor is willing to take. Would you take a 50-50 bet where winning means a 30 per cent gain in total wealth, but losing means a 20 per cent loss? What about 40 and 20? And so on. More interestingly, there are lots of ways to calculate market volatility — from the Vix index to long-term options to price momentum — but which one you use doesn’t turn out to matter that much. A basic distinction between low-risk, normal, and high-risk markets is enough for dynamic allocation to produce better returns over time, Haghani argues. The key thing is having a good enough risk measurement system in place, and obeying the signals it sends.
As for what the Merton approach says about allocations right now, the answer is clear. If your core risk asset is large-cap US stocks, your allocation should be much lower than usual. The excess expected return on US stocks is very low. That is to say, valuations are unusually rich, and the real yield on Treasuries is very high (about as high as it has been in 15 years). So whatever your risk appetite is, and whatever your volatility estimate is, the Merton formula is going to spout out a below-average risk share.
It’s fine to run a long-term portfolio built around US stocks. It’s been a good bet for a long time. But if you do, you should be holding a significantly higher proportion of risk-free assets than usual. Yes, 2025 might well be another good year. Take a few chips off the table all the same.
GDP growth
After our predictions letter, one reader asked whether there was “a magic real GDP growth number out there, above which the deficit actually starts to shrink” relative to GDP. A timely question — the next few years will probably be characterised by battles over the budget, and the growth impacts of regulatory, tax, immigration and tariff policies.
The Congressional Budget Office in June estimated the US deficit would be 6.7 per cent of nominal GDP at the end of 2024. Using the CBO’s projections for the deficit from 2024 to 2034, we calculated the nominal and real GDP growth necessary to remain at that ratio at the end of a decade.
The “magic” number, in real terms, is 2.1 per cent. That is significantly higher than the CBO’s current projection of 1.8 per cent (and still implies we hit a whopping annual deficit of $2.8tn in 2034).
The CBO’s deficit projections vary a lot year to year, and economic trends can surprise. Just since June, GDP growth has surprised to the upside, and Donald Trump was elected on what appears (to us) to be a fiscally expansionary platform with potentially positive near-term impacts on growth. The bitter reality, however, is that absent a significant change in demographics, productivity or fiscal policy, the US is not on course to outgrow its deficit. That will have implications for the bond market, and all markets, for years to come.
(Reiter)
One Good Read
Thin management.
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