Part 1: Looking back at 2024

Part 2: What actions did we take in McKinley Carter portfolios last quarter?

Part 3: A look ahead - our outlook for 2025

Looking back at 2024

In the 2000 film, Meet the Parents, actor Robert De Niro played Jack Byrnes, a retired CIA officer and father to Pam Byrnes, the girlfriend of character Greg Fokker, played by actor Ben Stiller. In the film, Jack Byrnes describes to his potential son-in-law, Greg, the importance of being part of the family’s “Circle of Trust.”

Much like in the movie, we are continually assessing which investments qualify for our “Circle of Trust.” 2024 saw investments related to Artificial Intelligence (AI) as trusted members of that circle. AI investments in semiconductors and software joined power suppliers (think utilities) and power management companies as winners in 2024 as the artificial intelligence theme saw robust investor interest in what is perceived as the next great frontier of investment opportunity. In addition to AI, companies that are involved with infrastructure did quite well as the world’s aging roads, bridges, utilities, airports, etc. will require years of upgrades. Also, with the Federal Reserve cutting interest rates beginning in September, many bank stocks and retail stocks like Walmart and Costco found success in the fourth quarter of the year. In the final section of this report (A look ahead - our outlook for 2025), we’ll address which investment ideas might warrant inclusion in this year’s “Circle of Trust.”

In our third quarter investment report entitled, “The Revenge of the 493,” we indicated that in the quarter we began to see wider participation in the stock market’s rise and less of a focus on a select group of larger cap technology-oriented companies known as the “Magnificent 7.”

However, in the fourth quarter, according to Morningstar data, the Magnificent 7 components of the S&P rose 10% for the period as investors returned to those larger companies that were associated with the Artificial Intelligence theme and were perceived as having more predictable earnings outlooks. These seven stocks were responsible for the S&P 500’s gain in the quarter as the index only rose a modest 2.4%.

Underperformance by large cap equal-weighted indexes in the period reflected investors’ concerns over rising long-term interest rates due to plateauing inflation data and a Federal Reserve that hinted at being less accommodative with future rate cuts in 2025.

Fewer short-term interest rate cuts by the Fed would be a negative for smaller companies as they tend to borrow money at higher rates than their larger counterparts. As a result, small cap stocks only rose 0.3% in the quarter and were down over 8% in the month of December according to Morningstar¹.

International stocks, despite trading at much lower valuations than U.S. stocks, declined over 7% in the fourth quarter as a strong U.S. dollar negatively impacted performance.

On a positive note, the S&P 500 rose to an all-time high in the fourth quarter and extended 2024 gains as the election results raised expectations for tax cuts and other pro-growth policies in 2025, the economy remained on solid footing, and the Fed continued to cut interest rates. The S&P 500 logged an annual return greater than 20% for the second straight year.

The Key Events of the Quarter

While the fourth quarter was positive for most of the market, it didn’t start that way as anxiety over the election and an increased focus on the fiscal state of the U.S. weighed on sentiment in October. Presidential polls tightened materially in October and left the race too close to call, increasing political and policy uncertainty. Additionally, much of the financial media’s focus in October was on the potentially negative fiscal consequences of both candidates’ policies. Specifically, a Wall Street Journal article focused on possible large future increases in the deficit and national debt that could cripple future economic growth. Those fiscal concerns, along with stronger-than-expected economic data, pushed Treasury yields higher and the 10-year Treasury yield rose from 3.75% at the start of October to over 4.20% by Halloween. That rise in yields combined with political and policy uncertainty pressured stocks and the S&P 500 finished October with a modest decline, falling 0.91%².

Those headwinds on stocks were short-lived, however, as Donald Trump convincingly won re-election while Republicans took control of both houses of Congress, completing a Republican sweep. Reminiscent of 2016, the Trump and Republican victories proved to be bullish catalysts as investors embraced the idea of future tax cuts, deregulation, and a pro-business administration. That helped the S&P 500 rise above 6,000 for the first time. Shortly following the election, however, investors were reminded of the volatile nature of a Trump presidency, as the president-elect nominated several unorthodox supporters to prominent cabinet positions. These surprises caused investors to contemplate policy risks to the pro-growth agenda and stocks dipped mid-month. However, the withdrawal of Attorney General nominee Matt Gaetz and the nomination of Scott Bessent as Treasury Secretary helped to calm investor nerves about the president-elect’s cabinet and stocks resumed their rally in late November and closed the month near all-time highs.

In December, renewed focus on the potential economic benefits of an incoming Trump administration combined with the “Goldilocks” economic environment of solid growth and continued Fed rate cuts to send the S&P 500 to yet another all-time high near 6,100. However, that rally stalled mid-month as President-elect Trump doubled down on his support for other unorthodox cabinet nominations and lobbed tariff threats at major trade partners including Canada, Mexico, and China. Market volatility increased as the Federal Reserve cut interest rates at the December meeting but also reduced the number of expected cuts in 2025 to just two (from four). That sparked a sharp selloff in stocks that continued into year-end, causing the S&P 500 to finish slightly positive for the month, but well off the highs.

In sum, 2024 was a strong year for the broad markets as the Fed seemingly achieved a soft economic landing and aggressively cut interest rates, while foreign and domestic political risks and drama failed to derail the rally.

Q4 Performance Review

Despite the late year dip in stocks, all four major U.S. stock indices finished the quarter with a positive return. The Nasdaq was the best performing major index in the fourth quarter and outperformed the other three major indices on a combination of earnings-driven AI enthusiasm combined with growing uncertainty on when future pro-growth economic policies could be enacted. For the full year, the Nasdaq also was the best performing major index although it only slightly outperformed the S&P 500, as that index benefitted from the large weightings to tech stocks and financials. The Dow Industrials and Russell 2000 both also finished the year with solid gains, but they relatively underperformed the Nasdaq and S&P 500.

• By market capitalization, large caps outperformed small caps in the fourth quarter and for the full year, thanks mostly to strength in large-cap tech stocks on the AI enthusiasm and strong earnings. Small caps did see a solid rally initially in the fourth quarter on hopes for pro-growth policies from the incoming administration, but the Fed’s guidance to fewer rate cuts in 2025 weighed on small caps later in December and the Russell 2000 finished the quarter with only a slight gain.
• From an investment-style standpoint, growth significantly outperformed value both in the fourth quarter and for the full year. The reasons were familiar: Artificial intelligence enthusiasm powered tech-heavy growth funds early in 2024, while in the fourth quarter solid AI chipmaker earnings extended those gains. Additionally, doubts about the timeline for implementation of pro-growth policies from the incoming administration weighed on value stocks late in the year.
• On a sector level, only four of the 11 S&P 500 sectors finished the fourth quarter with a positive return, although all 11 sectors ended 2024 with gains. The Consumer Discretionary sector was, by far, the best performing sector in the fourth quarter thanks in large part to a big Tesla (TSLA) rally and as the outlook for consumer spending remained solid, with low unemployment and the prospects of tax cuts and other pro-growth measures coming in 2025. The Communication Services and Financials sectors also performed well and benefited from expectations for less regulation given the incoming administration. For the full year, Communication Services and Financials were the best performing sectors and both benefited from strong earnings as well as general AI enthusiasm and an un-inversion of the yield curve, respectively.
• Looking at sector laggards, Materials was the worst performing sector in the fourth quarter and posted a substantially negative return while Healthcare also declined sharply. Those two sectors were the worst relative performers for 2024 as the Materials sector was only fractionally positive for 2024 while Healthcare logged a small gain. Concerns about regulation and poor earnings results weighed on the Healthcare sector in 2024 while the Materials sector was consistently pressured by concerns about the Chinese economy, tariff, and trade risks as well as general global demand concerns.
• Internationally, foreign markets badly underperformed the S&P 500 in the fourth quarter and produced solidly negative returns thanks to lackluster growth prospects and surprising bouts of political uncertainty in developed and emerging markets. Emerging markets and foreign developed markets saw similar negative returns in the fourth quarter as the South Korean political crises and worries about Chinese growth pressured emerging markets while political turmoil in France and Germany weighed on developed market performance. For the full year, foreign markets again badly lagged the S&P 500 but did finish with modestly positive returns. Emerging markets outperformed developed markets on a full-year basis thanks to Chinese stimulus announcements in the second half of 2024, which raised investors’ hopes for an economic rebound and boosted emerging market performance relative to those foreign developed markets.
• Commodities saw mixed performance in the fourth quarter as a late surge in the U.S. dollar weighed on parts of the complex. Gold finished the quarter with a slightly negative return thanks mostly to a drop in December as the U.S. dollar rose to two-plus-year highs. Oil, meanwhile, saw a solid gain in Q4 thanks to some better-than-expected Chinese economic data, which boosted future demand expectations. For 2024, most commodities saw modestly positive returns on rising demand expectations following global rate cuts. Gold logged strong returns on the year thanks to consistent geopolitical uncertainty and sticky inflation, while oil also rose slightly on OPEC supply discipline and more optimistic global growth estimates in 2025.
• Switching to fixed income markets, the leading benchmark for bonds (Bloomberg US Aggregate Bond Index) realized a moderately negative return in the fourth quarter as concerns about U.S. federal deficits combined with expectations for fewer rate cuts in 2025 to pressure bonds, although the benchmark did log a slightly positive gain for 2024.
  • Looking deeper into fixed income, longer-duration bonds declined solidly in the fourth quarter while shorter-duration debt logged a small positive return. The outperformance by shorter-duration debt was driven by continued Fed rate cuts as well as more resilient inflation and growth metrics (which weighed on longer-duration debt). Shorter-duration debt also outperformed long-term bonds on a full-year basis thanks to the start of the Fed rate cutting cycle, while U.S. fiscal concerns and the resilient growth and inflation outlook weighed on the longer end of the yield curve. Short duration debt finished the year with solidly positive returns while longer duration bonds posted a slightly negative annual return.
  • Turning to the corporate bond market, high-yield bonds outperformed higher-quality but lower-yielding investment grade debt in the fourth quarter as the election results boosted investor confidence for continued economic growth, resulting in investors accepting higher yields in exchange for greater risk. For the full year, high-yield bonds logged a solidly positive return while investment-grade bonds were only slightly positive, again reflecting investor preference to take on more risk in exchange for a higher yield/return, given underlying economic confidence.

What actions did we take in McKinley Carter portfolios last quarter?

In our tactical sleeve, we increased our allocation to financial stocks and reduced our technology stock weighting as the Federal Reserve began to cut short-term interest rates in September. Additionally, regulatory relief for the banks and other financials is expected in the next administration.

We introduced a hedged equity investment program that allows clients to hedge up to 15% of the downside risk to equity positions in their portfolio.

We maintained a bond duration that is short of the Bloomberg Agg Bond Index during the period to reflect our concerns about static inflation data and a less accommodative Fed going forward.

A look ahead - our outlook for 2025

Markets begin 2025 with great expectations of tax cuts and pro-business deregulation and a continued economic soft landing. Fed rate cuts helped propel stocks higher throughout 2024 and the S&P 500 completed the best two-year run since the late 1990’s.

Investors are now awaiting the implementation of pro-growth policies from the Republican Congress and Trump administration, which includes an extension of the 2017 Tax Cuts and Jobs Act and possible additional corporate and personal tax cuts, along with sweeping deregulation. If executed, those policies should result in increased corporate earnings, personal incomes, and spending (all of which are positive for stocks). Recently, the NFIB Small Business Optimism Survey showed a spike in the “animal spirits” optimism that might lead to better outcomes for our critically important small business operators in the U.S.

Politically, Republicans hold small majorities in the House and Senate and large, complicated tax cut bills could easily be delayed (or derailed). Additionally, while investors have focused on potential positives of pro-growth policies, increased trade tensions and possible tariffs could create unanticipated market and economic headwinds.

As we reflect on what investments might be in 2025’s “Circle of Trust,” we are focused on the stability of the market’s “three-legged investment stool.” Those legs are inflation, interest rates, and corporate earnings, and relative changes in each impact the overall health of the stock and bond markets.

Looking at inflation trends in the third quarter, the Federal Reserve’s favorite inflation gauge, the Core Personal Consumption Expenditures, or PCE index, reported mixed results. Through November, the year-over-year change in the Core PCE was 2.8% and the three-month increase was 2.5%, both failing to make progress towards the Federal Reserve’s 2% target. We continue to monitor inflation very closely as market expectations are for a persistent easing in inflation trends which then contributes to moderating interest rates and ongoing support for stock and bond prices. However, potential tariffs and immigration reform could negatively impact inflation.

Regarding the interest rate outlook, the 10-yr. U.S. Treasury bond yield, which impacts mortgage rates and also affects stock market sentiment, rose from 3.8% at the beginning of the fourth quarter to a year-end level of 4.6%. Likewise, the 2-yr. Treasury bond yield rose from 3.7% to 4.2% during the period. Rising interest rates present an opportunity for bond investors to lock in higher yields on new bond purchases, but also act as greater competition for stocks.

The Federal Reserve’s guidance for 2025 is for another half of one percent drop in the Fed Funds rate (to 4%) which should bring the 2-yr. Treasury yield down from here. The 10-yr. Treasury yield may remain range bound unless economic activity and inflation markedly accelerate or decelerate as the year progresses. While our clients have benefitted from shorter maturities this year as rates have risen, we are maintaining our shorter bond duration as we feel greater opportunities can be found in short-to-intermediate bonds in the corporate, high yield, mortgage, and government agencies markets.

On the earnings front, Zacks Investment Research expects total S&P 500 earnings for the fourth quarter of 2024 to be up 7.4% from the same period last year on 5% higher revenues. Looking at the calendar year 2025 picture, total S&P 500 earnings are expected to grow by nearly 14% with projections of 13.4% growth in 2026. The “Magnificent 7” and their large cap technology brethren should produce market leading earnings growth again in 2025, but their advantage over the remaining portion of the S&P 500 (the 493) should narrow as the year progresses. Projected earnings are also expected to be strong for small cap and international stocks. For small cap stocks, any drop in the Fed Funds rate from here will be welcomed by the markets and would likely lead to good performance by that cohort after years of underperformance. Additionally, corporate profit margins for companies remain elevated as productivity expands. The stock market will likely respond well should these estimates be maintained.

We believe that market participation may broaden out in 2025 as companies beyond the “Magnificent 7” (midcaps and small caps) benefit from a more benign regulatory environment and strong earnings coupled with less expensive valuations. Opportunities can be found in financial stocks and infrastructure investments as well as retail stocks that benefit from a consumer and service-driven economy. International stocks have underperformed their U.S counterparts for quite a few years now but do represent historically inexpensive valuations. However, any further increases in the U.S. dollar from here may put downward pressure on the dollar-based performance of foreign stocks.

Taken together, the three legs of the markets’ investments stool serve to support our positive thesis on the direction of stock prices despite the elevated valuations of the largest companies found in the S&P 500 index. Bond prices may be range bound this year but provide good income streams at current levels. Slowing inflation data and unemployment above 4% are likely to allow the Federal Reserve to cut the Fed Funds rates again before year-end 2025³.

Finally, by historical standards, the length (26 months) of the current bull market that began in 2022 is not unusual. In fact, it lags well behind the 67 months average duration of previous bull markets. As these rallies typically don’t “die of old age” but end due to recessions or interest rate increases by the Federal Reserve, we feel confident that 2025 will be a positive year for both stock and bond investors and that both will remain in our “Circle of Trust.”

Resources:

• ¹ https://www.morningstar.com/etfs/arcx/iwm/performance
• ² https://www.koyfin.com/
• ³ https://www.cnbc.com/2025/01/10/jobs-report-december-2024.html