Market Averages Steady Upward Drift...
January 4, 2025
I am away, at physical remove from US equity and fixed income markets. In a prior age, it would really have been true in all respects. Nowadays, when I have a WiFI connection I can be ‘plugged in’ anywhere. Still, being removed from everyday routines affords an easier path to reflection.
As the new year begins, caution is warranted. After two years of excellent equity market returns, it is reasonable to question the likelihood of that continuing. Will the continuing development of AI and the expansion of its use be enough of a catalyst to drive markets higher? And if not, what would be the catalyst for further market gains? No longer are multiple rate cuts by the Fed a certainty. And the incoming administration has already created much chaos even before it has officially taken over the reins of government. That seems likely to continue and probably grow as so many appointees lack government and/or management experience. A challenging set of conditions at a minimum.
Stock market valuations are high. Some have suggested that changes in the companies included in the averages (see below) have led to higher valuations. The S&P 500, formerly dominated by manufacturing companies, is now more technology heavy. With that change comes the higher margins characteristic of tech companies... more than a third of companies in that average now have gross margins above 60%. Still, the risks seem to be more to the downside. Had I written this on Wednesday, I might have seemed prescient as I was going to suggest the likelihood of much greater volatility, another reason for caution and not overreacting. As it is, the market averages have already moved about dramatically during the first two trading days of the new year…QED.
With a reduced possibility of a third year of market gains and the risks to the downside (at least from this observer's perspective), one might want to question the oft repeated (including in this space) platitude that over the long run, stock market averages will consistently rise…until you deconstruct that a bit. The averages are not comprised of a permanent group of equities. They are dynamic entities, not static ones. Companies that have fallen out of favor because they have outlasted their utility/ingenuity, adopted mistaken strategies, or brought in ineffective management have had their share prices decline. The decline in their market valuations, often precipitous, leaves them below the standard for participation in one market average or another.
Reviewed periodically, the averages remove companies that have fallen on hard times (and also those that have been acquired), replacing them with growing companies whose prospects and valuations are rising, fueled by their inventiveness, timely creation of key products, particularly effective strategic initiatives, and superior management. If you remove the laggards, the acquired, and the failing, and replace them with the rising and the succeeding, it stands to reason that market averages will retain their steady upward tilt. It is not a parlor trick, it is not rigged. It is, however, clearly upwardly biased. To be sure, it is also not a guarantee that all share prices will rise. Attention to the particulars is still a requisite.
At the moment, I am suggesting being extra cautious...the markets are overdue for a meaningful correction before they continue on theior upward drift. Having some extra cash - earning over 4% - would be prudent. Do the same as the averages - flush your losers…everyone makes mistakes, accept them and move on. Be ready to redeploy your capital instead of stubbornly waiting for things to change.
A bit brief today, and no additional article suggestions, given the holidays and my travels. As 2025 begins, I remain grateful that you continue to read these missives and sometimes send me reactions…both really appreciated. I wish for all of you a year filled with good health, joy, mirth, good times with friends and family, and prosperity driven by wise investing…and for all of us, a kinder world with fewer wars. It is past time that we learn to live with one another. Our global future is increasingly at stake.