“I’m not worried about the deficit. It’s big enough to take care of itself.” – Ronald Reagan
The stock markets closed out 2024 with another strong year, the second consecutive year with an over-20% gain in the S&P 500 Index. It should be noted that such back-to-back strong years are the exception and not the rule. The last time it happened was during the late 1990s, when the markets managed four straight years of 20%-plus returns from 1995 to 1998, with one last gasp of 19% in 1999 before facing a brutal 40% washout over the following three years. The only prior spurt before that in the post-Depression era was 1954 and 1955 which was followed by two lackluster years. While the sample size is small, the adage “trees don’t grow to the sky” seems valid. We think it is wise to expect lower returns in the future after the couple of great years the market has experienced.
Much of this year’s optimism in markets was driven by the idea that the Federal Reserve would be cutting interest rates and perfectly orchestrate an elusive soft landing of the economy. While the Fed did indeed lower rates by 100 bps in three Committee meetings, it was quite a bit less than the six cuts the markets were pricing in at the beginning of the year. With stock markets near all-time highs, speculation in Bitcoin and other less known “digital coins of ill repute” everywhere, inflation running at a still-hot 3%, and the job market remaining relatively strong, we question whether this most recent cut was prudent. Easy money seems to be turning pockets of the market into a casino. Should inflation tick up on the back of too-loose monetary policy, new tariffs imposed by the incoming administration, or immigration policy changes that affect labor costs, the Fed could be forced to reverse course and raise rates again, an outcome the markets are unlikely to take well.
The fiscal situation is also delicate, with the U.S. government running a budget deficit equal to 6% of GDP and debt to GDP more than 120%, similar to many countries that found themselves with rapidly rising long-term interest rates during the European Sovereign Debt Crisis. Historically, once debt to GDP surpasses 90%, economic growth becomes significantly hindered. In terms of developed economies, only Japan has really run the experiment in modern times with debt to GDP in excess of 250%. The result, unsurprisingly, has been decades of slow growth.
Yet, there seems to be no appetite in Congress to raise taxes to address the deficit. With about 75% of government spending mandatory via programs like Social Security and Medicare or interest payments, there probably isn’t room to cut discretionary spending enough to dramatically reduce it. For example, if discretionary spending was cut a brutal 20% across the board, the deficit would still be greater than 5% of GDP. The only way to really address the problem then is to fix the mandatory spending programs of Social Security and Medicare that every politician is afraid to touch. For politicians, the “silent tax” of inflation is preferable to voting openly to reduce benefits and angering many constituents. We remain wary of making long-term commitments to fixed coupon dollar-denominated debt, as those fixed coupons may be worth a lot less in the future if we continue down the present course. At least companies can raise their prices and make decisions to enhance their business prospects.
With all of this in mind, you can expect us to make some adjustments to your portfolio in the new year. Some of the stocks which have been big winners but where valuations are now stretched may be trimmed. Market opportunities always exist. But widespread bargains from major sell-offs are rare, and we see no such fire sale happening today. We will selectively add to new positions as we find them, and we are seeing pockets of opportunity in global multinationals, energy, and healthcare. Even with recent rate cuts, short-term Treasuries are paying 4.3%, more than recent inflation of 2.9%. Consequently, we are comfortable patiently holding some cash and short-term Treasuries while we wait for more opportunities to present themselves. We have a new administration that we expect to be more volatile in its decision making than the current one. There is a good chance that volatility will present us with some decent opportunities in the coming year. It seems we aren’t alone in this sentiment as Warren Buffett’s Berkshire Hathaway currently holds a record cash position of $325 billion.
All this isn’t to be too gloomy about the U.S. economy. We still have the best, most dynamic economy in the world. The U.S. is home to many of the best businesses globally. Our universities are admired worldwide. Many of the world’s most talented entrepreneurs dream of the opportunity to immigrate here and setup a business. We are making incredible progress in dynamic areas like technology and healthcare. Our legal system is one of the best functioning and most developed globally. Eventually markets have a habit of forcing the politicians to do the right thing, and we think that the many advantages the U.S. economy enjoys will far outweigh the present dysfunction in Washington D.C. In sum, we continue to believe owning quality companies at reasonable prices remains the best path to preserving and growing your wealth.
Speaking of growth, the PDM family is growing. We welcomed Elizabeth (Libby) Trecartin, CFP® to our team in October. She has worked in financial services for 17 years and spent the last eight years at Schwab. Her focus is client service and financial planning. We are thrilled to have her on board and know you will enjoy working with her. Additionally, Hope Robinson gave birth to healthy twins, Cooper and Emma, in December. She’ll be on maternity leave until March, but Libby has been briefed on all client plans and stands prepared to help you with anything you need that Hope was working on until then.
As always, we appreciate the trust and confidence you place in us. Please don’t hesitate to reach out if you have questions about your accounts or any other financial topics. We always look forward to the opportunity to visit with you and review your individual situation. We wish you and your families a happy and healthy 2025.
Penn Davis McFarland, Inc.
January 2025