Revenue sources in 2024

Good morning and happy new year. While we were gone, the stock market went down a bit. Are investors locking in profits for 2024? There may have been a few, but there was no rush to leave, and it was a relatively peaceful holiday season. Will 2025 remain calm? Submit your predictions to: robert.armstrong@ft.com and Aiden.reiter@ft.com.

Where will the stock market dollar return come from in 2024 (and where will it come from in 2025)?

The S&P 500’s total return last year was 24.5%. This has been a great year and the fourth time in the last six years that we have exceeded 20%. So what horrors await us in 2025? It’s natural to think so. Trees don’t grow towards the sky.

However, stocks are not trees. There is a sense that because you have had above-average returns in the past, you are predicting below-average returns in the future, but this is only true over the long term. During long bull markets, valuations become very high. Very high valuations are correlated with returns over the next 10 years or so. However, this tells us nothing about a single year.

Taking a look at exactly where 2024’s big gains are coming from might give us a little bit more of a sense of what to expect. About 1.2 percentage points of the S&P’s total return last year came from dividends. An additional 10 percentage points was due to an increase in stock valuations (the index’s forward price/earnings ratio went from 20.5 to 22.6). The last 13 percentage points or so is due to rising earnings expectations. This revenue growth outlook can be broken down into revenue growth (approximately 5 percentage points) and profit expansion (the remaining 8 percentage points).

What parts of that could be repeated or improved? It’s natural to think that valuations are reaching a point where they can’t go any further. We are nearing a historic peak in valuations. But again, valuations and returns are only relevant over many years. There’s no reason the P/E ratio won’t rise another 10% next year. What’s more, it’s shrinkage.

The higher hurdle is expanding margins. S&P’s net profit margin is expected to be 12% in 2024, according to FactSet. This would have been the highest in a decade if not for the unusual post-pandemic year of 2021 (12.6%). The consensus is that it will reach 13% in 2025, up from that year. That’s certainly possible, but what explains it? Yes, the U.S. economy is expanding at about 3%, but it’s not accelerating. And the rest of the world, which accounts for 40% of index revenue, is faring poorly. The question bulls need to answer for 2025 is why margins need to continue expanding.

I can’t think of any reason why they should (AI? Maybe in a few years, but probably not in 2025). So, as Unhedged discussed last year, the likely scenario is recent earnings growth in the range of 3% to 5%, an additional 1% in dividends, and only a small amount from margin expansion. It’s a thing. Moreover, no one knows what the valuation multiple will be.

marton stock

One of the best things I read over the Christmas break was an article in The Economist magazine about the benefits of dynamic asset allocation. Rather than rebalancing to maintain a fixed asset composition, the combination of risky and safe assets in a long-term portfolio is changed in response to changing circumstances. For example, 70/30. This article focuses on a formula developed half a century ago by Robert Merton for finding appropriate allocations over time.

The formula for calculating “Marton’s stock” is the excess return provided by a risky asset (such as stocks) over a risk-free asset (such as an inflation-linked government bond) divided by the product of the volatility of the risky asset and the square of the volatility of the risky asset. is. A measure of an investor’s risk appetite. This is a lot to remember in your head, but the idea is very intuitive. How much risk you need to take depends on the additional profit you get, the risk of that profit, and how much risk you want to take.

The Economist article was good, but it left me with two questions.

First question: How do investors who actually use dynamic allocation determine the number in the denominator of the formula?The numerator is very simple. When you look at a stock index, you get the earnings yield (earnings/price) and subtract the real Treasury yield. The current figure (using the S&P 500 index and 10-year chip yield) is 2.1 percent (4.3 minus 2.2). But how can we quantify risk aversion, and which measure of risk asset volatility should we use?

Second question: Does Merton’s approach tell us what our risk asset allocation should be at this point?

I put both questions to Victor Haghani, founder of Elm Wealth, an asset management company that implements Merton’s ideas.

If you know the math, you’ll find that quantifying risk aversion is relatively easy. I won’t go into details, but it can be derived from what trade-offs investors choose. Would you make a 50/50 bet that if you win your total assets will increase by 30%, but if you lose you will lose 20%? What about 40 and 20? and so on. What’s even more interesting is that there are many ways to calculate market volatility, from the Vix index to long-term options to price momentum, but it doesn’t really matter which one you use. Haghani argues that the basic distinction between low-risk, regular and high-risk markets is enough to help dynamic allocation generate better returns over time. The key is to have a good enough risk measurement system in place and follow the signals it sends.

As for what Merton’s approach says about current allocations, the answer is clear. If your core risk assets are large-cap U.S. stocks, your allocation should be much lower than normal. The excess expected return of US stocks is very low. That means valuations are extraordinarily high, and real yields on U.S. Treasuries are extremely high (about the same as they have been for the past 15 years). So no matter what your risk appetite and what your volatility estimates are, Merton’s formula will yield a below-average risk share.

It’s fine to build a long-term portfolio around US stocks. It’s been a good bet for a long time. But if you do, you should end up holding a much higher percentage of risk-free assets than you normally would. Yes, 2025 could be a good year too. Remove a few chips from the table as well.

GDP growth rate

After our forecast letter, one reader asked whether there was a “magical real GDP growth rate above which budget deficits actually start to shrink” relative to GDP. This is a timely question. The next few years will likely be characterized by battles over the budget and the impact on growth of regulatory, tax, immigration, and customs policies.

The Congressional Budget Office in June estimated that the U.S. budget deficit at the end of 2024 will be 6.7% of nominal GDP. Using CBO’s projections for the budget deficit from 2024 to 2034, we calculated the nominal and real GDP growth rates needed to maintain that ratio. At the end of the decade.

The actual “magic” number is 2.1 percent. This is significantly higher than the CBO’s current projection of 1.8% (which still implies a whopping $2.8 trillion annual deficit in 2034).

CBO’s budget deficit forecasts vary widely from year to year, and economic trends can be surprising. Since June, GDP growth has taken a surprising turn for the worse, and Donald Trump was elected on an expansionary fiscal basis that (to us) has the potential to have a short-term positive impact on growth. But the harsh reality is that without significant changes in demographics, productivity, and fiscal policy, the United States is not on track to overcome its budget deficit. That will impact the bond market, and all markets, for years to come.

(writer)

one good book

Poor management.

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