
Entering 2024, we were cautious about how stocks would perform for several reasons. Ongoing wars heightened geopolitical risks. Inflation fell from its high of 9% in 2022 but was still nearly twice the Fed’s target rate. The Treasury yield curve was still inverted, a near flawless historical indicator of recessions in the United States. Large-cap stocks were trading near historically high valuation levels, and the concentration of the S&P 500 was about as high as ever. Despite these risks, the S&P 500 once again posted significant gains, generating a total return of 25% for the year. U.S. small-cap, international, and emerging market stocks were also positive for the year, but only managed single-digit returns. Bond returns were muted as rising long-term interest rates pushed bond prices down and liquid alternatives continued to deliver a mix of exceptional returns. All in all, it was not a bad year for investors.

Large-Cap Stocks Lead the Way
The S&P 500 continued to beat other areas of the market in 2024. The excess returns were once again driven by the Magnificent 7 stocks, as these companies contributed to over half of the index’s return for the year. All but one of these seven stocks outperformed the S&P 500 and most by a large margin. It would have been beneficial to be undiversified and invest entirely in these mega-cap companies, however, the risks associated with this strategy only escalated. As of year-end, the cyclically adjusted P/E (CAPE) ratio of the S&P 500 now hovers around 38x, up from 31x at the start of the year. Looking back over 100 years, there’s only one time where valuations have only been higher: during the height of the Dot-Com boom, where the index peaked at 44x.
Not only are valuation levels high, but concentration levels reached absurd levels for large-cap stocks. The ten largest stocks currently make up over 37% of the entire S&P 500 index, which is far above the 25% level during 2000.
There are other parallels between now and 2000, chief among them is that anyone not holding large-cap growth stocks looks foolish. But stock market returns in the wake of 2000 are instructive. Large-cap growth stocks lost more than 4% annualized over the course of a decade while large-cap value stocks were positive. Small-cap value stocks outperformed small-cap growth stocks by nearly 10% annualized, and small-cap stocks outperformed large-cap stocks. Emerging market stocks dominated U.S. stocks by generating double-digit returns. Past performance is not indicative of future returns, so there is no telling if or when this period will follow suit. However, abandoning diversification now to jump on the Magnificent 7 bandwagon seems overly risky to us.
Fed Cuts Rates, But Longer-Term Yields Results
Among other considerations, including the recent decline in inflation data, the Fed decided it was time to reduce the Federal Funds rate in 2024. In September, the Federal Funds rate was 5.25% – 5.50%. By the end of the year, the interest rate range was reduced by a full percentage point to 4.25% – 4.50%. While this reduction caused the shorter end of the yield curve to fall, longer-term interest rates actually went up. The ten-year Treasury yield rose from 3.9% at the start of the year to 4.6%. This steepening of the yield curve was beneficial to those holding shorter-duration bonds. Not only did short bonds have a higher starting yield to begin the year, but they avoided the negative price impact that rising rates had on longer-duration bonds. The Bloomberg Aggregate Bond Index was impacted negatively by the increase in longer-term bond yields, as it only returned 1.3%. In comparison, cash had a return of 5.5% as measured by the yield on the 3-month T-bill.
So why did longer-term rates rise despite a reduction in short-term rates? Inflation expectations are likely a strong factor. While inflation did fall slightly from the beginning of the year, it is still a bit above the Fed’s 2% target. It also began to creep back higher in recent months. In December, the Federal Open Market Committee (FOMC) revised its expectation for inflation by the end of 2025 to 2.5% vs its expectation of 2.1% in its projections just three months prior. It also predicted two fewer rate cuts than previously expected in 2025, in case inflation is stickier than previously anticipated.
Expected policy changes from the new administration may play a factor in this, as an increase in tariff rates would likely lead to higher prices for some products. Reducing tax rates, while stimulative to the economy, may also be inflationary. If spending cuts and revenue from tariffs are less than the revenue lost from lower tax rates, the deficit will widen. This will likely cause debt-to-GDP levels to continue to grow, which is another factor weighing on longer-term interest rates.
Another Strong Year for Alternatives
Alternative investments once again posted notable returns for the year. The style premia strategy led the way with an impressive 21% return. Catastrophe bonds were also solid with double-digit returns. All other liquid and semi-liquid strategies (managed futures, multi-strategy, and alternative lending) had smaller returns but were all positive and all outperformed the aggregate bond index.
Over the past five years, these strategies all performed well, averaging an annualized return in the high single-digits. All have been much better than the aggregate bond index, which has had a negative return over the same period. Shifting a portion of a traditional bond portfolio into these funds has been beneficial in generating higher returns and offering downside protection. This was apparent in 2022 when stocks and bonds both fell, and alternatives held strong. As previously mentioned, there’s no way to predict if this will continue, but long-term data shows that substituting a portion of bonds for these non-traditional assets has been successful in generating higher returns and providing additional sources of diversification to an overall portfolio.
Looking Ahead
There is still much to be concerned with in 2025. It’s possible that mega-cap stocks will continue to leave all other companies in the dust, which the market seems to be predicting. However, it seems unlikely to us that they can defy gravity forever. When will the music stop? Unfortunately, there is no way to know. Predicting what will happen in the short term is futile. It may take an economic shock, a policy mistake, continued inflation, or some other catalyst for markets to revert. As we mentioned countless times, our portfolios are constructed in a way that has historically outperformed during market downturns by taking factor exposures, using safer short-duration bonds, and various alternative strategies. We hope for the best but are prepared for the worst.
Contact us for more information about our investment management philosophy and to learn more about how we can help you plan in 2025.