January 2025
Regime Change
Christopher P. Lorenz
Since starting in 1998, I’ve developed a list of portfolio management guidelines I follow when there is an unsettled economic landscape. Assessing the correlation between stock prices and earnings growth is among the first things I do (an exercise well-articulated here by investing legend, Peter Lynch https://www.youtube.com/watch?v=Na_W7ZU2xdU.) Because it is impossible to predict future macro-economic activity beyond six months, I always focus on earnings growth. Wall Street’s legions of economists and strategists may espouse their predictions, but ultimately have a track record that makes a New England meteorologist seem clairvoyant.
Next on my checklist, avoid changing your long-term investing strategy based on politics. Political winds are constantly changing and full of hyperbole and there is little difference in returns depending on which party is in charge. That said, there are exceptions to every rule. From time to time, we get changes in taxation and the regulatory environment that can impact corporate earnings. For the past four years corporate America has faced a hostile political environment with extreme regulation and anti-trust litigation. The economy and stock prices rose nicely despite significant government headwinds. The new pro-business administration in Washington could turn government headwinds into a tailwind, which is why there is new economic optimism for business leaders and investors. Pessimists will point to numerous political initiatives around tariffs and immigration, which they say will derail our economy, but it is my opinion that these concerns are overblown. President Trump sees the stock market as the primary benchmark for his success, which should safeguard investors from economic impact of his protectionist ideology. This regime change has the potential to unleash economic activity and earnings growth.
Economists and stock market strategists entered last year with recession fears and negative commentary but were left behind due to their pessimism. We didn’t see the negativity and kept growth-oriented asset allocations. Corporate earnings growth was over 10% and the economy picked up steam as the year went on, which bodes well for 2025. Corporate earnings are forecasted to grow 10 to 14% this year. If the Trump administration can deliver lower corporate tax rates, earnings estimates might be too conservative. Double digit earnings growth typically supports healthy gains in stock prices. The economy is expected to grow 2 to 4%, which supports positive market returns. The technology sector has driven earnings growth for the past few years, but recent data show an improvement in manufacturing and industrial activity that would broaden stock market gains beyond large-cap technology companies to other sectors. For this reason, we have trimmed our winners in the tech sector and added to out-of-favor sectors like healthcare and industrials.
Like 2023, the S & P 500 index was not a good barometer for the overall stock market. The giant technology companies have distorted the index, which calculates its returns based on a company’s size. The larger the company, the more it impacts the index. The average stock returned roughly 10% last year, but the market weighted S & P 500 Index was up 25% almost entirely due to mega-cap tech stocks. It’s not prudent for an investor to have excessive concentration in a few large stocks, like the S & P Index has. We prefer to look at the Equal Weight S & P 500 because it better represents a cross section of the broader market. We build diversified portfolios, which reduce risk and ensure you have exposure to growth sectors. If investors focus too much on the gains in the market cap, weighted S & P 500, one may think that the market has moved too far, too fast because that index shows two years of 20% gains. When we look at a broad-based index like the Equal Weight S & P, the gains are modest and we better recognize this year’s potential for additional gains.
That said, the stock market is priced for perfection, so we are likely due for a pullback. I believe a normal, annual 10% pullback would be healthy for the market, and it could serve as a pause that refreshes. The economic excitement around the administration change in Washington may have pulled forward future gains leaving investors disappointed if the growth initiatives fall short of expectations. We are taking a few chips off the table and adding to un-loved sectors and 2-year U.S Treasuries, while we wait for better entry points. These are modest changes, and we continue to hold our large technology stocks as well as our optimism.
You don’t need one of those clairvoyant New England weatherman to remind you to STAY WARM!