Commentary
With 2024 now in the books, it was certainly another good year for the S&P 500. The index gained more than 20% for the second consecutive year and the third time in the past four years. Interest rates moved higher throughout the year, which historically has been a headwind for stocks. But for whatever reason, that didn’t seem to matter to U.S.equity investors as markets rallied regardless. Returns were concentrated among the largest companies. The Magnificent Seven (consisting of Apple, NVIDIA, Microsoft, Amazon, Alphabet, Meta, and Tesla) continue to be written about because they continue to dominate markets. For good measure, and after a year like last, we might also include Broadcom with this group. These eight companies now account for more than 35% of the index. What’s more, in 2024, these eight companies accounted for more than 55% of the S&P 500’s return.
Source: FactSet
The concentration within the index is unprecedented. According to Goldman Sachs Global Investment Research, the 10 largest companies in the S&P 500 account for more of the total market than at any point in at least the past 45 years. That means that the S&P 500, which is often viewed as a diversified index, is becoming increasingly less diversified and increasingly concentrated. This period of heightened concentration coincides with a time in which the market has become historically expensive once more.
Source: FactSet, Compustat, Goldman Sachs Global Investment Research
Some are familiar with a P/E ratio as a measure of valuation. It simply divides price by earnings to help an investor determine how much they are paying for a stock given how much profit a company earns. A lesser-known valuation tool is the Cyclically Adjusted Price to Earnings Ratio, or CAPE. A CAPE ratio attempts to smooth the cyclicality of corporate earnings and the economy by dividing price by the 10-year average earnings for stocks. The accompanying chart illustrates both peaks and troughs in the valuation metric since the 1880s. The higher the CAPE ratio, the more expensive stocks are. Today’s CAPE ratio is only exceeded by the impressively high valuations of the late 90s, before the bursting of the Dot Com Bubble, and in 2021, prior to a 25% fall in the market throughout 2022.
Source: Professor Robert J. Shiller
Now, one might ask, why does this matter? The CAPE ratio was elevated coming into 2024 and we already discussed how great of a year it was for the index! The CAPE ratio is not necessarily predictive of anything. However, it can help identify risks and help define what seems reasonable in terms of return expectations moving forward. The following chart has taken the CAPE ratios from the chart above and plotted those points along the bottom x-axis with 10-year forward returns plotted across the leftward y-axis. The better the forward returns, the higher the dot. The more expensive the market, the more rightward the dot is. As one can see, the best returns occur from lower CAPE ratios. Some of the worst returns occur from higher CAPE ratios. The red vertical line marks today’s CAPE ratio. 10-year forward returns have never earned an annualized return better than 1% from this valuation level. If history is any indication of the future, then the index faces a strong headwind given present valuation.
Source: Professor Robert J. Shiller
The idea that future returns may be fairly limited is not news that I am breaking. Within the past few months, Goldman Sachs, Bank of America, and Vanguard have all discussed the possibility of lower returns over the next decade. Goldman predicted that the S&P 500 would deliver 3% annualized returns over the next decade. Bank of America suggested 1-2% annualized returns. Vanguard’s return predictions were a bit more optimistic as they forecasted annualized returns to be somewhere between 3.4% and 5.4% over the next decade. That may be a tough pill to swallow for many investors. The prospect of limited future returns can be scary.
However, it’s worth noting that Goldman, BofA, and Vanguard are talking about index level returns. They are not talking about the returns for all stocks. They are simply talking about what they predict will happen to the S&P 500 over the next decade. Let’s quickly recap – the S&P 500 is more concentrated than it has been in decades and is extremely expensive from an historical perspective. Now, we normally do not make any sort of predictions in this space, but it seems reasonable to think that the future returns may be more limited for these market leaders.
That is in part because the largest companies change naturally and consistently. Thirty years ago, the largest companies in the S&P 500 consisted of companies like AT&T, GE, Exxon, Royal Dutch Petroleum, Wal-Mart, NationsBank, Phillip Morris, and some of the Bells. By the turn of the century, some of the largest companies were Microsoft, Cisco, Intel, Lucent Technologies, IBM, and America Online. A decade after that, Exxon, Microsoft, Apple, Proctor and Gamble, Johnson and Johnson, and AT&T once more. Today, it’s the Magnificent Seven. My point is, leadership changes. That shouldn’t be shocking. It would be shocking to me if all of the largest companies today were still the largest companies 10 years from now though. What’s different today versus 1995, 1999, and 2009 is how concentrated the index is relative to those times. If the top stocks falter today, it will likely mean more pain for the index than it has previously because it is more heavily weighted towards those top names. That does not necessarily equate to more pain for all stocks.
This also need not spell doom and gloom for all equity investors either! It may not be great news for passive investors should Goldman’s prediction come to fruition, but it certainly does not have to be bad news for all equity investors. The last time we had a lost decade was during the 2000s. From December 31, 1999 to December 31, 2009 the S&P 500 had a total annualized return of -0.95%. For an entire decade, one would have been better burying cash in their backyard and digging it up ten years later versus being invested in the S&P 500. However, there were still plenty of money-making opportunities throughout the decade, despite the S&P 500 falling 49% from March of 2000 to October of 2002 and then another 57% from October 2007 to March 2009. For example, Low Volatility did quite well, as did Dividend Growers (as measured by the S&P 500 Dividend Aristocrats index) and Quality. The S&P 500 Equal-Weighted Index had positive rates of return.
To make money during the Lost Decade, it helped to be invested differently. It helped to not be passive. If Bank of America, Goldman Sachs, and Vanguard are all right going forward, and if history serves as a guide, it might make sense to again be invested with a willingness to be different from the index.
At Tandem, we strive to own companies that can consistently grow through different economic cycles. We want steady growers. Steady growers, in our opinion, can deliver steady returns. At least for this writer, steady returns lead to a more peaceful investment experience.
The opinions expressed are those of the Fund’s Sub-Adviser and are not a recommendation for the purchase or sale of any security.
The Standard & Poors 500 Index (S&P 500) is an index of 500 stocks weighted by their market cap. The S&P 500® Dividend Aristocrats® measure the performance of S&P 500 companies that have increased dividends every year for the last 25 consecutive years. The S&P 500® Equal Weight Index is the equal-weight version of the S&P 500. The index includes the same constituents as the capitalization weighted S&P 500, but each company in the S&P 500 Equal Weight Index is allocated a fixed weight – or 0.2% of the index total at each quarterly rebalance. The S&P 500® Low Volatility Index measures performance of the 100 least volatile stocks in the S&P 500. The S&P 500® Quality Index is designed to track high quality stocks in the S&P 500 by quality score, which is calculated based on return on equity, accruals ratio and financial leverage ratio. The Russell 2000® Index measures the performance of the small-cap segment of the US equity universe. The S&P 500® Value measures constituents from the S&P 500 that are classified as value stocks based on three factors: the ratios of book value, earnings and sales to price. The S&P 500® Growth measures constituents from the S&P 500 that are classified as growth stocks based on three factors: sales growth, the ratio of earnings change to price, and momentum.
As of December 31, 2024 the Castle Tandem Fund held the following positions mentioned in this report: Microsoft Corp. (MSFT, 2.50% of Fund total net assets), Johnson & Johnson (JNJ, 2.19% of Fund total net assets), Genpact (G, 2.77% of Fund total net assets), Jack Henry & Associates (JKHY, 3.12% of Fund total net assets), Steris (STE, 2.91% of Fund total net assets), Zoetis, Inc. (ZTS, 0.97% of Fund total net assets), Costco Wholesale Corp. (COST, 1.51% of Fund total net assets), BlackRock, Inc. (BLK, 2.20% of Fund total net assets).
The Fund does not have a position in Apple, Alphabet, NVIDIA, Meta, Tesla, Amazon, Broadcom, AT&T, GE, Exxon Mobil, Royal Dutch Petroleum, Wal-Mart, NationsBank, Phillip Morris, Cisco Systems, Intel, Lucent Technologies, IBM, American Online, Procter & Gamble, Brown-Forman Corp., or MarketAxess Holdings.
The investment objectives, risks, charges and expenses of Castle mutual funds must be considered carefully before investing. The prospectus for each Fund contains this and other important information about the investment company, and it may be obtained by calling 1-877-743-7820, or visiting www.castleim.com. Read it carefully before investing.
Important Risk Information
The risks associated with the Fund are detailed in the Fund’s Prospectus. Investments in the Fund are subject to common stock risk, sector risk, and investment management risk. The Fund’s focus on large-capitalization companies subjects the Fund to the risks that larger companies may not be able to attain the high growth rates of smaller companies. Because the Fund may invest in companies of any size, its share price could be more volatile than a fund that invests only in large-capitalization companies. Fund holdings and asset allocations are subject to change and are not recommendations to buy or sell any security.
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