Will Success Spoil the S&P 500?

Despite a minor selloff in the second half of December, the S&P 500 Index of U.S. large-cap equities posted an impressive total return of +25.0% in calendar year 2024. Indications of generally strong economic growth, myriad corporate opportunities related to Artificial Intelligence(AI), and expectations that Donald Trump’s second term will be friendlier to business and investors together drove the strong performance of U.S. large-cap stocks in 2024.

When 2024’s performance is combined with the S&P 500’s total return of +26.3% in the prior year, we see two-year cumulative compounded growth of 57.9%, yielding the best back-to-back calendar year performance of the last quarter-century. Looking further back, the S&P 500 has produced an annualized return of +14.5% over the Last 5 Years (2020-2024) and +13.1% over the Last 10 Years (2015-2024).

Several comparisons further illustrate the exceptional relative performance of large-cap U.S. stocks over the past decade:

• Relative to non-U.S. stocks: stocks outside the U.S. (ACWI Ex-U.S.) posted a return of +5.5% in 2024—positive for the year but far below that of the S&P 500—and continue to underperform U.S. large-cap stocks over the longer 3-Year (-8.1% annualized) and 5-Year (- 9.8% annualized) periods. Slower growth in the Eurozone and China, a strong U.S. dollar, ongoing debt burdens, weaker demographics, political instability and policy constraints, and regional military conflicts are assigned the bulk of the blame for the relative underperformance of non-U.S. stocks.

• Relative to U.S. small-cap stocks: small-cap U.S. stocks (Russell 2000) posted a respectable return of +11.5% in 2024, benefitting from better-than-expected economic growth in the U.S., somewhat lower interest rates, and hopes for regulatory relief in the second Trump administration. Yet once again, small-cap stocks underperformed their large-cap counterparts and continue to lag significantly over 3-Year (-7.7% annualized) and 5-Year (-7.9% annualized) periods. The idea that the benefits of Artificial Intelligence and its related applications accrue disproportionately to large and mega-cap stocks partly explains the lagging performance of small caps. In addition, the decline in the number of listed companies (down 43% since 1996) and the growing availability of private equity capital (venture, growth equity, buyout) imply a sizable portion of the earnings and enterprise values attributable to smaller companies now accrues to private equity investors rather than to owners of mid- and small-cap public equities.

• Relative to bonds and other asset classes: the benchmark Bloomberg Aggregate Bond Index returned +1.3% in 2024 after declining by -3.1% in Q4 as investors reset their overly-optimistic expectations regarding Fed rate cuts in 2025 and 2026. Looking back over longer time periods, intermediate-term investment-grade bonds have underperformed equities dramatically: -11.3% annualized over the Last 3 Years, -14.8% annualized over the Last 5 Years, and -11.7% annualized over the Last 10 Years. While Modern Portfolio Theory assumes de facto that equities should produce higher returns than investment-grade bonds over long periods of time (i.e., a positive equity risk premium to compensate for the higher risk of equities), the degree and durability of the spread between U.S. stock and bond returns has been surprising to most. Investors relying on fixed income for portfolio diversification and risk reduction would have been better off, in hindsight, allocating to a combination of cash and lower-volatility hedge funds which outperformed investment- grade bonds significantly over the last 3 and 5 Years.

• Relative to predictions: a comprehensive survey of stock market predications made by Wall Street firms and leading investment managers is beyond the scope of this brief market update, but it is safe to assume the majority of prognosticators were expecting large-cap U.S. equity returns in the range of 7-10% (per year) over the past decade. The fact that the actual annualized return over the Last 10 Years was +13.1% implies most forecasters were 300-600 basis points too low (per year) in their predictions, an annual forecasting delta which compounded and grew wider on a cumulative basis over the course of the last 10 years.

Investors owning large-cap U.S. equities—whether directly, via mutual funds & ETFs, or in managed accounts—cannot help but be happy with the performance of the S&P 500 Index. Yet, viewed from our current point on the timeline, January 2025, several risks are noticeable:

• Equity market concentration: the so-called “Magnificent Seven” stocks gained, on average, +63% in 2024 and accounted for more than half of the gains of the S&P 500 Index as a whole! The market capitalizations of Apple and Nvidia are each roughly equivalent to the combined market value of all 2000 mid- and small-cap stocks in the Russell 2000 Index. The U.S. equity market is exceptionally top heavy at present.
• Equity valuations: viewed as a whole, the S&P 500 is currently trading nearer the high end of its historical valuation ranges (e.g., Next-12-Months Price/Earnings Ratio, Shiller Cyclically Adjusted Price Earnings Ratio, Earnings Yield vs. 10-Year Treasuries), suggesting investor exuberance over Artificial Intelligence, the November elections results, and the extent of Fed rate cuts may be overextended.
• Debt outstanding: Total Public Debt owed by the Federal government now exceeds $35.4 Trillion, up from $23.2 Trillion in Q1 2020 and $12.8 Trillion in Q1 2010. Bond market analysts have noticed recently that while short-term interest rates are declining, the term premium demanded by investors on longer-term U.S. Treasuries has risen; this likely reflects investor worry over the amount of future Treasury borrowings and lack of a credible debt reduction plan by government leaders. A significantly wider term premium—were it to persist—has negative implications not only for longer-duration bonds but for most public equities as well.
• AI hype versus reality: it is by now clear that Artificial Intelligence is an important technology and will have a major impact on global business, work, and society. Less clear is its exact future path of development and its final form and applications. Along the way there are certain to be winners and losers at all levels: companies, industries, nations, demographic groups, consumers, etc. From the perspective of investors, however, the more immediate question is whether U.S. large-cap equity markets are currently experiencing what economist Carlotta Perez once labeled the“frenzy phase”¹  in her four stages of technological development. Time (and share prices) will tell.

In this context, how should investors position their portfolios? As you would expect, we remain believers in overall portfolio diversification with specific strategic targets for each asset class customized to the family’s goals, financial resources, and constraints. Many investors will need to consider rebalancing their portfolios back nearer to strategic targets on the heels of 2024’s investment returns, a decision likely to be impacted by current andanticipated tax considerations. We look forward to discussions with each of you and encourage you to share your thoughts, comments, and concerns with us in the interim.