“People are trying to be smart – all I am trying to do is not to be idiotic, but it’s harder than most people think.” – Charlie Munger

Note that the contents of this memo are all my thoughts, and not the views of RBC Dominion Securities. As well, no part of this content was AI-assisted or created.

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Friends & Partners,

As we awake from our holiday season-induced slumbers, many are grappling with a dichotomy of views on the outlook – things ‘feel’ like they could be bad (or risky), while markets are as optimistic as we have almost ever seen. The answer, in my view, is where it often lies – the truth lies somewhere in the middle.

So, as I do in most Partner Memos, I will lay out the case for both arguments (with lots of pictures which I use a lot of as you know, as I truly believe one picture is worth a thousand words). ‘Tis the season for strategist/firm outlooks, as everyone and their brother has one (the best one in my view is likely KKR’s outlook piece which you can find HERE).

But I will start with my conclusions and give my view (as I don’t see a real concrete ‘view’ offered by many pundits, which drives me nuts):

The main takeaways are that even though markets are priced aggressively, there are a number of cross currents out there and there are pockets of speculation at a minimum, ultimately the US economy is growing, the labour market is still relatively balanced, disinflation is underway, and Fed policy is aiming to get to neutral within the next two years (rate cuts are still coming, though at a slower pace than anticipated by markets until recently). Interest rates are higher today, but positive real rates are not to be feared; they are normal and reflective of this healthier balance between growth, labour and inflation. For 2025 (and beyond), the importance of asset allocation, high free cash flow/yield investments, and quality exposures should prevail (i.e. avoidance of multiple expansion as a source of return expectations – companies have to earn their way to improved stock performance). Returns are likely not going to be what we’ve experienced the last couple of years, however.

Bottom line is that when it comes to the economy, short term path of markets, or Trump’s policies, I don’t know, neither do you, and neither does Trump. Markets go up, and markets go down. If you do this long enough (meaning, be invested in risk assets more than a few months or years), I promise you that a -5-10% drawdown will barely register as a drawdown over time. There are risks ahead and far bigger upside ahead than most realize, and the second part that is made possible by the first part. We can tactically position for strategies that offer the best risk/reward, and minimize the noise along the way, but investors who understand both of those things are going to be the winners.

Markets are pricing in a lot of optimism, that’s for sure. The Chair of Rockefeller International wrote an FT column titled The mother of all bubbles which is worth a quick read. Optimism abounds in both stock and fixed income markets today – for obvious signs of this, look no further than the massive growth in U.S.-listed bitcoin ETFs and the plethora of specialized ETFs that use options and leverage to define specific outcomes. The top 3 specialty ETFs this year are the 2x Long Nvidia ETF, the 3x U.S. Long Bond ETF, and the 3x Bull Semiconductor ETF, which have collectively attracted $7.2 billion in inflows in 2024! Signs of euphoria aren’t hard to find. Flows into levered single name ETFs have recently skyrocketed. This type of leverage is potentially financial dynamite if and when markets turn, so expect a few fireworks along the way.

This optimism may cause some noise out of the gate in 2025 I suspect (we got a taste of that in late December with some noisy days). We will enter 2025 with a much higher bar to surpass to send stocks and bonds higher.

Think of it this way: the rally in stocks in 2023 was driven mostly by hope of market-friendly events: The end of rate hikes and start of rate cuts, the economy slowing to a soft, not hard, landing, AI profit explosions and positive geopolitical resolutions. And the rally in 2024 has been driven by the partial realization of those hopes: growth did slow but didn’t contract (soft landing), the Fed did aggressively cut interest rates, AI demand and excitement didn’t waver and geopolitical crises didn’t get worse (although they didn’t get better either).

As we enter 2025, the question for markets is whether the positive events realized in 2024 can last. Recent volatility may portend a snapshot of things to come - clear signal that the bar for more gains in 2025 will be substantially higher than it was in 2024. Put another way, the market has pulled forward a lot of future positives - the market got rate cuts in 2024 and now expects more of them, so the Fed cutting two times won’t propel markets higher from here (it’ll have to be more cuts than that). The market hoped for a “Red Sweep” in the election and got it, but now the new administration has to actually pass pro-growth policies and keep trade war headwinds and distractions low. AI expectations and optimism prevailed but needs to actually start boosting profitability for companies. Finally, investors priced in a soft landing in 2024 and it materialized, but now it needs to stay there and any undo slowing of the economy will spark hard landing fears while any surprise acceleration will re-duce the likelihood of any further rate cuts.

So, there are certainly reasons to be cautious, but supportive as well – for all the distractions out there (politics, trade, cabinet appointments, etc.) economic growth remains the key support for this ‘bull’ market and the data is showing that a soft landing (meaning no recession near-term) remains the most likely outcome as the hints of a more intense slowdown from the summer have largely been erased. While the underlying fundamentals of the market are positive, we need to brace for more volatility in 2025 and realize that volatility can exist in a still-positive market set up as long as growth is solid, the Fed is still easing, and there are no major political disruptions.

 

 

A Few Other Interesting Things To Highlight

Hoping it was a wonderful holiday season for all. We were fortunate to be in a position to donate to two charities close to our heart on behalf of our clients this year in both The Hanley Institute and Sick Kids.

And on this note, and coming out of the holiday season, it is important to highlight that making charitable donations provides individuals with a chance to give back to their community and receive tax incentives at the same time. When you donate certain securities, such as publicly traded shares, in addition to getting a donation tax receipt for the fair market value of the securities donated, any capital gains you’ve accrued on the donated securities may also be eliminated. There is also a Charitable Gift Program that we offer that is an effective strategy on this front – I wrote about charitable strategies HERE.

I was proud to be the presenting sponsor for the Escarpment Corridor Alliance’s inaugural Summit – here is a great highlight video from the event HERE.

I will release my first podcast in January – I’m heading into the studio next week to record which I’m excited about (it’s been a few years since being in a studio, I recorded a few music albums many moons ago if you can believe it), stay tuned for that.

Finally, on a more personal note, my family took a trip to Minnesota in mid-Dec to get a best-in-class assessment for my son, as the diagnosis was a bit stark and partial here in Canada, with a specialist appointment many months off. The news was fantastic, and we can’t thank the Mayo Clinic, or recommend it, enough. There is much debate around which medical system ‘works best, but an element of a market-oriented healthcare system like that of the United States makes sense without question.

 

 

Don’t Fret, The Outlook is OK Here*

Art Cashin was a legend on Wall Street and recently passed away. One of his best quotes was “Never bet on the end of the world, because it only happens once.” That holds true today, and we need to recognize the wisdom in those words. I have written a lot about our debt problems, which will likely lead to a ‘reckoning’ in time – but they will not stop us from moving forward.

Art’s words remind us to stop and appreciate all the good happening in the world, of which there is plenty.

I speak to a number of clients and partners about the media’s tendency to only show (ie. ‘sell’) bad news – you have to go looking for the rest of the story. This is no less true in the financial media – doomsday predictions ‘sell’.

Here’s a timely list of some of the more positive data points of late from John Mauldin:

• Did you know that 937,000 people have permanently escaped extreme poverty every week, on average, for the last 25 years?
• Or that the US has reduced its carbon emissions by about 20% since 2005, while growing its economy in real terms by 50% and vastly increasing its energy production?
• Or that the death rate for cancer in the US has declined 33% since 1991?
• Starlink? Actually mapping the brain? Fusion now seems possible. Modular nuclear reactors? So many new materials and proteins? Progress is amazing, and is happening quickly.

Moving forward, even if we don’t see the outsized equity returns of the last few years, returns should still be respectable. We may even see low single digit returns for the S&P 500 in 2025 based on this back-of-the-envelope math: The S&P 500 trades at a forward P/E of ~22x, which is highly elevated by historical standards, meaning that earnings growth will have to do most of the heavy lifting if stock prices are to advance as I noted above. With no recession on the horizon for now, one can likely assume 8-12% earnings growth, which is roughly nominal GDP (3% real + 3% inflation) plus 2-6% margin improvement. Subtract from earnings growth of 8-12% a P/E compression of 1–3 multiple points, you arrive at slightly positive return expectations. But despite the overall market math (skewed by the large constituents), good managers can find pockets of opportunity. And there still may be some overall upside as well – the US market is traveling the expected return path given there’s been no recession thus far:

Wall Street strategists spent 2024 with targets well below the S&P 500. Next year, though, strategists are poised to lift their 2025 targets by 20% and 11% above the S&P 500 (~6,700). This is the largest surge in strategist optimism on record. Let’s see if their optimism proves correct.

Even the often-cautious economist and strategist David Rosenberg changed his view recently, and is now rather supportive of the outlook after being cautious the last number of years. It’s worth noting his revelation:

“That is the first part of this revelation: the fact that generative AI is a game-changer for the future. And if it is, then the multiples based on a long time frame may not be in a bubble at all. This comes back to the view that traditional valuations, at the least, are not that helpful right now. If it weren’t for the “Model Shift” generated by the AI boom, which is spreading to all sorts of industries and triggering a rare significant expansion in R&D spending (which shows up in GDP but not in the monthly durable goods orders and shipments data), it would be easy to label a 22x one-year forward P/E multiple as some sort of bubble. But I now realize that investors have shifted out their earnings projections way into the future, and if the technology experts are prescient, this will be a difference-maker from a productivity growth backdrop in years to come, and at a time when the pandemic has unleashed an unexpected upward shift in the productivity curve. One productivity enhancer followed by another.”

Many expect that year 3 of a bull market run can often be weak or long in the tooth, but this isn’t true. KKR notes the following:

And they also note that labour productivity is the driving force behind a business cycle that is also not long in the tooth at all:

The US economy is still chugging along nicely, as evidenced by the fact that bankruptcies are running slightly above average but don’t suggest a bankruptcy cycle any time soon:

Finally, with all the calls for 2025 being potentially quite volatile along the way (including me calling for that), evidence suggests that this may well not be the case – 2025 could in fact actually be a calm year for the U.S. stock market, as the Federal Reserve plans only two rate cuts, down from the four projected in September 2024. Historically, the S&P 500 tends to underperform when the Fed makes larger rate changes, suggesting limited cuts may help keep volatility low.

 

 

 

There Are Lots of Data Points Keeping Us Cautious And Defensive As Well*

There is a plethora or reasons and data points to give us caution here. Markets have seemingly gotten increasingly complacent, passive indexing is through the roof. Animal spirits are obviously evident, with the cost of hedging a portfolio with short dated options is at its lowest in three decades (aside from two very brief periods). Valuations are now stretched as we know, arguing that the good news may have been priced in here. Sure, valuation-based index investing hasn’t worked well over the past few years but data shows as multiples approach extremes, forward returns are muted at a minimum.

Source: Callum Thomas

Some tout that it’s only the ‘Magnificent 7’ US tech stocks that are expensive, but the stock market isn’t cheap even outside of the Magnificent 7. Combined P/E ratios are equally elevated outside of TMT (Technology-Media-Telecom):

One a price-to-book basis as well, the stock market is the most expensive it has been in history! And the problem is, relative to previous bubbles, a lot more people own stocks this time around than in previous episodes. Retail participation is much higher than it was during the dot-com bubble even.

All this while inflation expectations are increasing again:

Some are even talking about the fact that we have eliminated the business cycle, with AI and other efficiency improving stuff. That sounds like “it’s different this time” comments to me. Some of us have lived through the dot-com bust; the financial crisis; the European debt crisis; the US rating downgrade; ‘Volmageddon’ in 2018; the pandemic; and, of course, the rate hike cycle in 2022. These all seem like a distant memory at this point to most, but I will point out that the bear market in 2022 had stocks down 25%+ at one point and bonds got crushed to boot alongside that. Most people seen to have complete amnesia about it.

Someone told me that something like 65% of institutional portfolio managers weren’t working yet in 2008 – that’s scary. Sometimes pain needs to be felt for lessons to be learned.

Periods of excessive risk-taking are usually followed by periods of excessive risk aversion. And paraphrasing J.P. Morgan, nothing distorts your financial judgement so much as the sight of your neighbor getting rich (if this strikes a chord you may want to reflect on this).

Perhaps one of the biggest risks in front of us is driven by the ascent that the ‘Magnificent 7’ have been on the last couple of years, it’s virtually unprecedented:

While it’s hard to imagine the US mega caps shrinking into oblivion, it would be anomaly for them to remain the largest companies in the world a decade from now, which means they may be due to actually underperform. Time will tell.

If that happens, this may not seem so crazy:

Source: Callum Thomas

This speaks to sentiment and euphoria. And one of these metrics is currently off the charts. Sure, bullish sentiment is a condition indicator and not a trading signal and frothiness is only a warning, but be aware:

And as I noted in the opening monologue, Bloomberg points out that "assets in leveraged long ETFs exceed inverse products by a record." Yikes.

Much of this enthusiasm is focused on the Magnificent 7 which now trade at an average of 41x earnings! Outside of Nvidia, however, "the rest of the group is expected to post a measly 3% increase in profits in 2025" as per Bloomberg.

Consumer expectations for the stock market have never been higher as well. When the trade becomes consensus, the juice is normally squeezed…

Another interesting indicator is that most stocks are underperforming the S&P 500, a trend last seen during the dot-com bust.

So where do you position? There will be no risk premium for equity investors (based on forward-looking expected returns), meaning stocks are very expensive relative to bonds:

So bonds must be attractive right? There’s very little cushion on offer in credit either, credit spreads and stock market valuations are pretty much priced for perfection. Do you believe in perfect?

So you need to watch your US stock exposure. Lots of talk about ‘US exceptionalism’. This US Asset Premium – US assets (stocks, US dollar, housing market, credit spreads inverted, and US treasuries valuation inverted) are trading at their combined most expensive level on record. This is well beyond what we saw in 2021, and even handily eclipses the dot com and pre-Financial Crisis peaks. Meanwhile global assets are now apparently cheap (perhaps some opportunity to diversify for some…). This is either a generationally risky point in markets, or a generational opportunity …and perhaps both.

Finally, we need to touch on Canada. Unemployment situation in Toronto approaching levels not seen since the global financial crisis. How long until a recession is officially declared in Canada?..