After a strong November, financial markets took a step back in the final month of the year.
For December, the S&P declined 2.4%, the DOW, S&P equal weight and foreign developed markets all shed around 5%. Small caps (IWM) got crushed with a 7% decline. Bonds declined by more than 1.5% as rates continued to move higher.
The declines primarily occurred during the second half of the month after the Fed’s December policy meeting.
TWG model portfolios lagged their respective benchmarks, as an increased allocation to large cap growth in its surge during the first half of the month dropped close to 5% in the final two weeks of the year.
WHAT MOVED MARKETS
The Fed and higher bond yields were the main drivers of market declines. During the FOMC’s final rate policy meeting of the year, Powell suggested further rate cuts may be on hold given uncertainty about the potential re-inflationary impact of the incoming administration (tariffs, immigration, tax cuts) against the backdrop of a strong economy and stable job market. While the Fed did cut rates by an expected .25%, the presser was ostensibly hawkish. The market declined by over 4% from before the announcement into the close, one of the largest two-hour declines we can recall in recent times. Twenty-year treasuries declined almost 7% in the month.
The market is now pricing in only two rate cuts in 2025, down from four prior to the meeting.
Such a dramatic change in Fed posture created uncertainty, which unsettles financial markets.
Higher rates are clearly putting pressure on stocks, particularly small caps which are more rate sensitive. The market could very well require signs of economic weakness to bring treasury rates back down, which, in isolation, should be supportive of higher stocks prices. However, economic weakness and a potential slowdown would likely negatively impact earnings, and thereby likely negatively affect stock prices given current elevated valuations…a conundrum that we are sure will play out in the months ahead.
As written in past notes, rates can also have a profound impact on the “broadening of the market” theme, as other areas beyond large cap tech are much more rate sensitive given their lending needs. And higher rates do not help grow earnings, all things equal. Furthermore, defensive sectors, such as utilities, REIT’s and other dividend payers are less attractive against a backdrop of higher rates. Thus, we may again see mega cap tech as holding both the sword and shield, which would be constructive for us given our current weight in large cap tech via QQQ.
PORTFOLIO ADJUSTMENTS
By the end of December, the portfolios have undergone significant changes. Notably, the allocation to QQQ has dramatically increased, demonstrating a transition toward technology and growth-oriented investments. This shift reflects a strategic move to capitalize on the innovation and recovery within the tech sector, which picked up notably in November and early December, as illustrated by the graphic below:
In contrast, the allocation to the S&P 500 has decreased, indicating a movement away from broader market representation in favor of higher growth potential. The introduction of IWF (Russell 1000 growth) and HYG (high yield bonds) alongside CWB (convertible bonds) indicates a focused venture into growth and high-yield corporate bonds, seeking higher return potential in a changing rate environment.
Despite the portfolios negative return in December, the adjustments made are proactive, align with market conditions and potentially capitalize on future tech sector rebounds. These reallocations reflect a responsive approach to market dynamics and highlight the value in enhancing growth prospects while navigating volatility.
LOOKING AHEAD
With the new administration taking office this month, we anticipate the immediate future of market returns to be positive, driven by the excitement of less regulation and lower taxes, to name a few. Of course, the earnings season is right around the corner, which is typically a fundamental driver of near-term market direction. As we’ve stated in prior notes, earnings drive stock prices, and the 3Q earnings beat rate was higher than average, leading stocks to move up and to the right, albeit with some interim volatility as other factors (rates, fed policy, etc.) influenced market participation.
We also are anticipating continued volatility in the face of ten-year treasury yields breaching 4.6% – the highest level since April 2024 when the Fed first started lowering rates. There will likely be a tug of war between rates and stocks around this critical 4.5%-4.6% level. Should rates breach 5%, then the market will likely roll over. Should rates decrease below 4%, then the market should be on more solid footing and continue to make fresh all-time highs.
Wherever rates trend to, know that we are keeping an eye on the dynamics at play, and our process will adjust accordingly, as we adjust based on pricing behavior, and have ample tools to manage whichever direction the market may head in the near term.
Stay warm, and Happy New Year!
