Is the stock market soaring to unsustainable heights, or is it simply reflecting the incredible strength of a few dominant companies? This is the multi-billion dollar question on every investor's mind right now. Michael Batnick from 'The Irrelevant Investor' and I, as part of our quarterly market and portfolio update for Ritholtz Wealth clients, dive deep into this very issue.
We dissect what's been happening in the markets, explain the 'why' behind the headlines, and analyze the impact on client portfolios. This time, our amazing research team – Sean Russo and Matt (aka ChartKidMatt) – knocked it out of the park with some insightful charts and data. I felt compelled to share some of their work with a wider audience.
So, let's get to it.
The bull market continued its impressive run, but here's the thing: so did the underlying fundamentals of many companies. The market is becoming increasingly concentrated, and large corporations are getting even bigger. But—and this is a crucial 'but'—their earnings are also growing. In fact, it was another banner year for earnings growth, almost keeping pace with the gains seen in the S&P 500. That's objectively good news, right?
Speaking of fundamentals, take a look at the difference in forward Price-to-Earnings (P/E) ratios between the "Magnificent Seven" (think Apple, Amazon, etc.) and the rest of the S&P 500:
But here's where it gets controversial... Valuations for these big tech stocks are significantly higher than the rest of the market. Now, some argue that these companies deserve higher valuations. After all, they are the biggest, most profitable enterprises in history, driving innovation and shaping the future. Makes sense, right? But when does this premium become excessive? When does the risk outweigh the potential reward?
Honestly, it boils down to embedded expectations and future earnings performance. It might sound like a cop-out answer, but it’s the honest truth. If these companies continue to deliver exceptional growth, the high valuations might be justified. But if growth slows, watch out! The market can be unforgiving.
There's a significantly lower margin of safety baked into mega-cap tech stocks compared to everything else. Think of it like this: they have to keep hitting home runs just to maintain their current position.
Conversely, the strongest argument for smaller stocks lies in their lower valuations and, consequently, lower expectations. It won't take much positive news for smaller companies to bridge this valuation gap. Imagine a small company exceeding analyst expectations – the stock could really take off!
Maybe small-cap stocks will be the international stocks of 2025. Speaking of which, the country performance numbers from last year were quite surprising. As you may recall from my previous article ('6 Surprises from 2025'), the U.S. stock market was near the bottom of the list in terms of performance. And this is the part most people miss... Almost no one predicted this outcome heading into the year. Remember all the bullish sentiment surrounding US equities?
So, why did international stocks perform so well? Let's break down the contributing factors: fundamentals, currency movements, and investor sentiment:
A weakening dollar acted as a tailwind for foreign stocks, but strong earnings growth also played a significant role. Essentially, everything aligned perfectly for international stocks last year. But will this trend continue? I wish I had a crystal ball, but the truth is, I simply don't know.
It's also fascinating to observe the divergence in factor performance between U.S. and international markets:
Value stocks underperformed in U.S. markets last year, yet value, shareholder yield, and low-volatility stocks absolutely crushed it overseas! This vividly illustrates why diversification can be both frustrating and enlightening. You never know where outperformance will emerge.
Now, let's move on to the less exciting but equally important stuff.
The bond market is showing signs of recovery:
For the past few years, short-term yields have been higher than or on par with longer-term yields. This is an inverted yield curve, an unusual situation that often signals economic uncertainty. This isn't the normal state of the risk-reward relationship, where investors typically demand higher yields for lending money over longer periods.
The yield curve is gradually returning to a more normal shape, which is a positive sign for the overall health of the financial system.
It's been a challenging decade for bonds, but yields are currently at attractive levels for fixed-income investors. What does this mean for you?
Well, returns for bond investors going forward should be respectable, as starting yields are generally a good predictor of future returns:
Bond yields remain quite appealing today. Consequently, future returns should also be promising. Of course, past performance is never a guarantee of future results, but the current environment is certainly encouraging.
If you're interested in learning more about the Ritholtz Wealth client experience, please don't hesitate to reach out.
Further Reading: Historical Returns For Stocks, Bonds, Cash, Housing and Gold.
Now, I'm curious to hear your thoughts. Do you believe the high valuations of mega-cap tech stocks are justified, or are we heading for a correction? Are you optimistic about international stocks and small caps in the coming year? Share your perspective in the comments below!
