INVESTMENT THEMES January 2025
Ignore Short-Term Market Forecasts; Focus on the Long Term:
At this time of year, investment firms often release stock market forecasts for the upcoming year. However, these short-term predictions are rarely accurate. At Paragon, we prioritize long-term investing trends and cycles. For example, over the past seven years, Wall Street strategists’ average forecasts have consistently missed actual market returns, sometimes by significant margins, as illustrated below. In 2024, while the consensus predicted a modest 2% increase, the S&P 500 delivered an impressive 25% return.
In the short term, market movements are inherently unpredictable. Despite robust economic growth and strong corporate earnings, current investor sentiment shows mixed signals.
Professional investors remain heavily overweight U.S. stocks, anticipating rising earnings, while retail investors exhibit high levels of optimism—historically a contrarian indicator for a potential near-term selloff. Additionally, third years of bull markets, like the one we are in, tend to show weaker performance historically. Looking to 2025, there are arguments for both strength and weakness. For the record, the Wall Street consensus is projecting an 8% increase in the S&P 500.
On average, the U.S. stock market experiences a 14% intra-year decline and three 5% pullbacks annually—healthy and normal corrections. In 2024, the market’s largest decline was only 8.5%, marking a relatively calm year. However, increased volatility is likely in 2025.
Focus on Quality for Long-Term Success:
Research by Hendrik Bessembinder at Arizona State University reveals that nearly 60% of stocks underperform Treasury bills annually. This underscores the importance of focusing on quality companies and long-term investing, helping avoid many underperforming stocks.
Over a short time frame, valuation has virtually no impact, explaining only 0% to 20% of returns in a single year. Over the long term—10 years or more—valuation becomes a dominant driver, explaining approximately 80% of returns.
Despite challenges such as recessions, wars, pandemics, and other global crises, the stock market has grown 20,000-fold over the past century, delivering an average annual return of about 10%. This remarkable growth highlights the resilience of quality companies over time, as illustrated below.
Long-Term Market Projections:
Using historical data and valuation metrics, Vanguard projects 10-year returns across various asset classes. These projections largely align with our outlook, with stock returns below long-term averages due to high valuations, particularly among U.S. growth stocks.
Opportunities in Small-Cap Stocks:
High valuations among the largest growth-oriented stocks contrast sharply with smaller companies trading at significant discounts. The valuation gap between the ten largest stocks and all other stocks in the S&P 500 is shown below.
Small-cap stocks, which stand to benefit from economic policies under the new administration, have demonstrated higher earnings growth than their large-cap peers over the past decade but achieved only half the price appreciation. Over the past two years, however, small-cap earnings growth has lagged behind large-cap earnings due to greater susceptibility to inflationary cost pressures and rising interest rates. Looking ahead, small-cap earnings are expected to rebound significantly and surpass large-cap earnings growth over the next two years, as outlined in our Economic Review. This shift presents creates attractive valuation opportunities within the small-cap segment.
Bond Market Update: Rising Yields Amid Rate Cuts:
In our last update, we predicted rising long-term interest rates driven by increasing budget deficits and higher bond issuance, despite the Federal Reserve’s rate cuts. This has played out, as the Fed has cut short-term rates by 100 basis points since September 2024 while the 10-year Treasury yield has increased 100 basis points, leading to a more normal upward-sloping yield curve. Notably, rising yields after the start of a rate-cutting cycle are atypical.
Conclusion and Strategy:
Paragon’s strategy centers on building globally diversified portfolios of primarily high-quality stocks and bonds, emphasizing less speculative assets. After the November election, we increased allocations to U.S. small-cap stocks, which offer strong potential growth at attractive valuations, and reduced our international small-cap positions.
Our bond holdings remain concentrated largely in high-quality credits with short-to-intermediate maturities.
As we anticipate increased market volatility in 2025, staying invested through market cycles is critical to long-term success. Our disciplined approach aims to deliver solid returns while effectively managing risk.