Turbulent Times – Market Update Q1 2025

We hope this blog finds you doing well, looking forward to the spring season and some warmer days ahead. It has been a bit longer than usual since our last blog so we will cover quite a bit of ground in this one. This may seem long, but it will only take 10 minutes to read through and as your advisors we strongly encourage you to take the time to do so. Peace of mind comes through understanding and with so much going on we feel it’s very important for you to understand the moving pieces. We know the first few paragraphs might put some of you to sleep but please press on to the bullet points below as they are very relevant for today’s market and are much easier to digest.

Also, keep in mind that the stock market is made up of thousands of companies. Many of which are very attractive right now and are trading at attractive prices. We reference the S&P 500 quite a bit in the next few paragraphs as we are setting the stage for further discussion. But remember, the S&P 500 is only 500 companies, and the Dow Jones Industrial Average is only a basket of 30 companies. There are thousands of stocks that don’t fall into those categories and all of them combined represent the stock market as a whole.

The S&P 500 has now been in a bull market for a little over 2 years and we would like to highlight a few characteristics of this bull market that will provide a good lens for viewing the rest of the information we’ll cover below.

To recap, stocks entered a bear market in 2022 as inflation got out of control and the Federal Reserve raised interest rates from 0% up to 5.50% in an effort to cool inflation. Towards the end of 2022, and early 2023, generative AI (artificial intelligence) made its way onto the scene and hopes for this technology paired with a gradual cooling of inflation brought that bear market to an end as stocks began to move up again. Though not all stocks across the board. 2023 was a year of significant dispersion where just a handful of large cap technology stocks did remarkably well in contrast with the rest of the market moving sideways or down until the final 2-3 months of 2023 – when the Fed ended the rate hiking cycle, and a relief rally rippled across the market more broadly.

In 2023, the Market Cap Weighted S&P 500 was up roughly 24% whereas the Equal Weight S&P 500 index was up roughly 11%. In 2024, almost the exact same thing happened. Market Cap S&P 500 was up roughly 23% and Equal Weight S&P 500 was up right around 11%. So, what created such a marked difference between the average stock compared to the index as a whole? To put it simply, the biggest companies got bigger, much bigger. While the average company did okay. In case you aren’t familiar with Market Cap vs. Equal Weight – a market cap weighted index gives each company a proportionate weighting relative to the Market Capitalization (the size of the business). For example, a large company like Apple (AAPL) currently has a weighting of around 7% in the S&P 500. That means whatever AAPL does on any given day has a big impact on the S&P 500 because it’s a huge part of that index. Whereas an equal weight index gives each company the same allocation. In this case each company in the S&P 500 would have a roughly 1/500th weighting.

Two of the primary themes we believe played into this were artificial intelligence and high interest rates. Until recently it was believed that the large language models behind AI would cost in the hundreds of millions if not billions of dollars to develop due to the scale and computing power required. That meant you needed to have very deep pockets to play in that arena and there were only a handful of companies with the cash to do so. Enter the “Magnificent 7” companies – AAPL, AMZN, GOOG, MSFT, META, NVDA, and TSLA. Investors rewarded the spending on AI these companies were doing without knowing if there would be a proportionate or appropriate return on the hundreds of billions of dollars being spent. But that theme ruled both 2023 and 2024. To put this into perspective, these 7 stocks were responsible for more than 50% of the S&P 500’s gain in both 2023 and 2024. Link

The second factor we mentioned is interest rates. Although higher interest rates are generally a headwind for stock prices. They are less of a headwind if you are sitting on mounds of cash already and don’t have to borrow if you don’t want to – we think this concept is another factor that incrementally drove investors to favor the biggest companies that are less sensitive to rates, rather than smaller businesses that are impacted to a greater degree by higher interest rates.

The last item we wanted to highlight from the past couple of years before we get into some more specific topics is the PE (Price to Earnings) Ratio. It might be old fashioned to think that valuations matter in a world of momentum stocks, cryptocurrencies, meme coins, NFTs, and short squeezes. However, valuation is only irrelevant until it isn’t. Valuation isn’t a great market timing tool, however, when you are in the market it’s critically important to keep valuation in mind at all times.

At the market lows in October 2022. The PE ratio on the S&P 500 was around 16. By the end of 2023 that PE ratio had risen to around 23. And today it sits around 27 (or at least it was when we started writing this blog, now it’s closer to 26). Link To give you a sense of things – the average PE ratio on the S&P 500 over the last 20 years is 15.89. Today’s PE ratio is more than 4 standard deviations above the historical average. Link We’re using data from World PE Ratio – they remove the top 10% and bottom 10% outliers from the data. Other data has the current PE closer to 30 and the 20-year average closer to 19. Link Regardless of the specifics, what this means is that investors are willing to pay a significant premium relative to historical norms for each dollar of earnings being produced by US stocks. The point we are making with this data is that over the past couple of years, stock prices have gone up at a much faster clip than the underlying earnings. This is called multiple expansion and one way to think about it is that investors are giving markets the benefit of the doubt that future earnings will justify the higher multiple being paid today. Another way to think about it is that investors could be getting complacent and are not paying close enough attention to valuation – this could be a real issue at some point.

As we said, valuation isn’t a great market timing tool and our goal with discussing it above isn’t to create fear. However, it’s helpful to take note of the current landscape so that it can inform your thinking for the road ahead. There are a couple of ways to resolve a market that appears to be richly valued. Stock prices could come down OR earnings could climb and justify the lofty valuations. It’s also worth noting, there are many areas of the stock market that are trading at discounts to historical valuations – our discussion above has focused on the S&P 500. And with that all in mind, we’ll dig into some more specific topics.

Here’s what we’ll cover so you can fast forward if you’d like but we’d encourage you to at least skim through everything as they are all pieces of a much bigger puzzle with varying degrees of relevance for today’s market:

Fear Sells
Passive vs. Active Investing
Yen Carry Trade
Elections and their Impacts on Investment
Tariffs
New Administration’s Agenda
Quick Hitters:
- Inflation and Interest Rates
- DeepSeek and the AI outlook
- Labor Market
- Health of the Consumer
- Cash on the Sidelines
- OPEC Increasing Production
What does this all add up to?

Fear Sells – always keep this in mind when you see headlines. We live in a world with massive information overload and to attract eyeballs, hyperbole has become the rule and not the exception. We don’t mention this to downplay any real issues but to serve as a reminder for you as you sift through the never-ending headlines these days – they are designed to create a fear or greed response. As an investor it’s important to stay informed, however, each headline needs to be digested with a primary focus on the bigger picture. This perspective allows for prudent decision-making rather than knee jerk reactions.

Passive vs. Active investing:

2023 was a notable year because for the first time in history passively invested dollars became a greater percentage of the dollars in the market than actively invested dollars, at just over 50%. Link This has been nearly 50 years in the making, since John Bogle introduced the first passively invested fund at Vanguard in 1976. Link The reason we are bringing this up is because while there are merits to both styles of investing, there are some key concerns we have around the increasing market share of passive investing. First, is that the passive investing philosophy relies on efficient markets. Efficient markets, meaning that all available public information is immediately priced into markets, so in theory, no one person has an edge over anyone else. But an efficient market relies on discerning investors who are making informed buy and sell decisions based on what they believe each company is fundamentally worth – this process is called price discovery. The PE ratio we referenced earlier, is one of many metrics investors use to decide if a company is trading at an attractive price. It’s often called the PE multiple because stock prices trade at a “multiple” of today’s earnings and the company’s potential future earnings. The assumption is that a business won’t just earn a profit this year but for many years into the future. Since World War II the S&P 500 has averaged a PE multiple of around 16, this essentially means that investors have, on average, been paying for 16 years of future earnings. If a company’s growth potential is better than average, investors may be willing to pay a higher and, in some cases, much higher multiple than 16, as is the case in today’s market. This assumes not only that a company will be around 16 years from today, but that it will be producing greater earnings down the road than it is today. With all of this in mind you might already see where we are going – passively invested dollars are not giving any thought to valuations, they are just passively flowing into an index and in the majority of cases, a market cap weighted index like the S&P 500. To that end, as passive investing becomes a bigger piece of the pie, markets may become less efficient as price discovery becomes less prevalent. We don’t see this as an urgent problem, but it’s an important factor to keep in mind as we go along here, and it actually presents an interesting opportunity for active investors as price distortions occur.

This leads to our second concern, price distortions. This is something that John Bogle himself acknowledged in 2017 as an outcome if passive investing became too heavily adopted. At the time it accounted for roughly 25-30% of the market. Link As we said, even at over 50% today we don’t believe this isn’t an urgent problem, but there is a tipping point and for that reason, it’s important to keep in mind. Here’s how passive index investing can lead to price distortions, and we may have seen this play out over the last couple of years. Let’s say an investor decides to put $1,000 into the stock market and they choose to put it into an S&P 500 index fund. That decision means that roughly $70 goes into AAPL, $65 goes into NVDA, etc. to the point where roughly 30% of that deposit goes into the Magnificent Seven stocks. If you recall us mentioning that the big got much bigger in 2023 and 2024, it seems reasonable to think that passive flows could be a contributing factor to some degree. If this trend were to continue – you can see how the biggest companies will continue to passively receive the most investment dollars regardless of their fundamentals, and by default the biggest will continue to get bigger. Potentially leading to distortions in price, if not already causing distortions. As a side note, indexed investing was intended to be a diversified allocation, but having 30% of a portfolio allocated to only a handful of stocks, all of which are tied to a single theme of artificial intelligence to some degree, certainly isn’t as diversified as it was 40 years ago or even 5 years ago in the S&P 500. This is where the opportunity arises for active investors, and we are starting to see it play out in 2025 as money has begun flowing to other areas of the market.

Yen Carry Trade:

This is old news at this point, but the underlying risk remains, which is why we are mentioning it. The yen carry trade was a product of the US Federal Reserve raising the overnight lending rate from roughly 0-0.25% in March 2022 to 5.25-5.5% by July 2023. While in Japan, their central bank maintained near zero or even negative rates over that timeframe. This led to investors, in most cases hedge funds, to do the following: Borrow Japanese Yen at near zero interest rates, convert that to US dollars and buy US stocks. Essentially, they found the cheapest source of financing and leveraged up using it. That trade works out okay if the US dollar maintains or strengthens its value relative to the Yen. However, if the Yen starts appreciating relative to the dollar, which is what happened in July and August of last year, that trade can result in a margin call. This is where the lender in Japan says, hey, those dollars are losing value relative to the Yen we loaned you, you need to either give us more collateral or you need to return the Yen. When this happens on a small scale, it’s no big deal. But if it were to begin spreading it can have a major snowball effect because the investors doing this are forced to unwind the trade – they must sell the stocks, then convert those US dollars back to Yen and then return them to the lender and this process can then trigger margin calls for others that are in the same trade. This all came to a head on Monday, August 5th, 2024, a few days after the Bank of Japan increased their lending rates. Over the weekend prior, rumors of that trade getting unwound were circulating and the Nasdaq 100 opened down more than 5% at the start of trading on Monday the 5th. The volatility index (VIX) hit levels only seen in 2020 (Covid) and 2008 (Great Financial Crisis). That’s remarkable and normally coincides with more than a 5% selloff. But something strange happened that day, every major brokerage (Vanguard, Fidelity, Schwab, etc.) experienced technical issues that morning into the afternoon that kept retail traders from logging into their accounts until about 2pm. Link By the time the technical issues were resolved, the market had stabilized and begun climbing back up. We’re not going to speculate further on this, but it seems a rush to the exits by a much broader swath of investors was stopped. The reason we are bringing any of this up is because big cap tech stocks as a whole have generally moved sideways since July of 2024. It is our hope that the carry trade has been gradually unwinding over the last 9 months or so in a more orderly fashion, rather than resulting a more severe market downturn. However, as your portfolio managers, we continue to keep an eye on the USD/JPY exchange rate as well as many other factors, knowing there is potentially an underlying risk there with more wood to chop.

Elections and their Impacts on Investment:

Generally speaking, businesses and executives in the C suites, hold off on major capital investment decisions in the period leading into an election because there is uncertainty regarding the rules of the road under the next administration. Typically, you would see that investment begin rolling out once the outcome of the election is determined and that provides a nice tailwind for stocks. However, there continues to be a high degree of uncertainty and we believe that is delaying some of those investments for the time being. We’ll get into more of this as we go along, but we have been highlighting some of the broader risks in the investing environment so far, we’ll soon be highlighting more of the positives and potential positives. Capital investment should end up being a meaningful tailwind when the air eventually clears. Positioning for a new administration’s priorities is another opportunity for investors and we’ll discuss this further as well.

Tariffs:

This is the topic de jour and it seems to change daily if not hourly as things are rolled out with a potentially meaningful day approaching on April 2nd. There are many headlines around this topic and we will refer to our statement above, fear sells. One of the biggest fears circulating is that tariffs are going to usher in a new wave of inflation. Other fears are that the US is cutting ties with allies and ultimately fading its position as the leader of the free world. If you take some quotes and data in isolation, it’s easy to build these narratives. We’re going to zoom out a bit and hopefully give some perspective. We believe there are two goals behind the Trump Tariffs: First, bringing jobs and manufacturing back to the United States – Tariffs with this goal in mind could have an inflationary impulse and can put pressure on trading relationships, but it could also result in the opposite (eventual deal making). Second is to level the playing field of trade across the world. To give you a sense of things – one of the primary benefits of trade is that countries can specialize in what they are best at producing (or can produce the most cost effectively) and they can then export those goods and services to other countries. While at the same time, they can import goods and services that other countries are better at producing. On the surface it’s a win-win and this concept is a factor behind the globalization movement that accelerated once the Iron Curtain fell in 1989. Link Below the surface there is a lot of nuance and many unintended consequences. Protectionism is where a country will put restrictions or barriers of various kinds (tariffs are one example) on goods and services from other countries to protect their domestic production of those goods or services.

With this understanding, let’s dig deeper into what is going on today. The first goal of bringing jobs and manufacturing back to the US, as we said, could have an inflationary impulse if ultimately there are more tariffs across the board and things spiral into a trade war that lasts years. However, we don’t think this is the most likely outcome. We know from the first Trump administration that he uses tariffs as a bargaining chip and with the US being the largest importer of both goods and services in the world, it’s an effective tool. Link However, it can be a painful process and we’re in the midst of that process right now. If it ultimately results in lower trading barriers through deal making this can have a disinflationary impulse and can lead to greater productivity and lower prices. This is where the second goal comes into play – a level playing field. This is the concept behind the April 2nd reciprocal tariff plan. At a basic level, they plan to impose tariffs on other countries that match the tariffs those countries currently have on the United States. Taken at face value – this could be very disruptive to global supply chains and harmful to the consumer in the near term and this is generally what’s talked about in the news and subsequently is reflected in sentiment data. However, if this leads to deals where other countries end up lowering or dropping tariffs on the US, the result could be lower trade barriers, lower prices, and greater productivity. The reason we have some confidence in the latter being more likely in the end is because of the rest of the administration’s economic agenda – it relies on a strong and expanding economy. That being said, we do think there is more volatility to be had in the near term as these negotiations unfold. The market hates uncertainty and we are getting uncertainty by the truck load these days. However, as the air clears, we believe it will bring buyers into the market and will also begin to unlock the capital spending that is waiting for clarity.

New Administration’s Economic Agenda:

Regardless of your political leaning, as an investor you must consider and understand the objectives of each new administration in order to guide your decision making when emotions are elevated. The United States government has operated at roughly a $1.9 trillion budget deficit on average over the last four years – meaning it’s spending nearly $2 trillion more than it is bringing in through taxes. Link We have grown numb to numbers like these, but to give you a sense of these levels, if you spent $1 million every single day it would take you roughly 2,739 years to spend $1 trillion. The stated objective of the current administration is to balance the budget by finding $1 trillion of cost savings (this is what the department of government efficiency is working on) and increasing the revenue side by $1 trillion. Sounds easy enough, right? This sets up the dichotomy we are dealing with in markets and the economy more broadly. The tools they plan to use for increasing the revenue side of equation (deregulation, lower and more stable energy costs, lower and more predictable taxes) should have very positive impulses for the economy and stock market more broadly. However, cutting government spending in an economy and stock market that has grown accustomed to an ever-expanding debt load for someone else to deal with down the road has some potentially negative impulses in at least the short term. The dichotomy as an investor is to determine if the reduction in government spending or the increase in growth and efficiency will have the bigger impact. By our assessment, the reduction in spending will have a more immediate impact while the increases in growth and efficiency will have a greater long-term impact. Which is why Scott Bessent, the Treasury Secretary has said there needs to be a “detox period”. This is why we believe things may be choppy with lots of back and forth over the next few months, but we can build a case that’s very positive over the longer term. Eventually the market will focus on what’s ahead but for now it’s very tied to each tariff headline and all the uncertainty that comes with that. There are many analogies thrown around, but it’s like the administration is making the market and economy eat its veggies before it can have any dessert… this is a round about way to think about things right now. The biggest question is whether the vegetables are going to send the economy into a recession before dessert can make its way to the table.

How can you decrease government spending, lower taxes, AND increase tax revenue at the same time? This is the question you should be asking right now as it seems counterintuitive. In isolation, lowering taxes would lower the tax revenue, not increase it. However, there are many ripple effects to lower taxes. The concept being operated on right now is to drive investment and growth within the United States, leading to increases in GDP, which grows the tax base, which would increase the tax revenues. But how do you increase GDP without deficit spending? There needs to be an increase in private investment and spending. So essentially, as the government spending airplane is landing, the private spending and investment airplane needs to take off. This is where lower taxes, deregulation, lower interest rates, and lower energy costs come into play. I remember an anecdotal statistic from an internship I had in Toronto. I was in a tower on Bay Street working at a bank’s headquarters when someone mentioned that approximately 40% of the bank’s workforce were in a compliance-related role. It struck me that almost half of the people in that massive building, though fulfilling essential roles, were not producing anything of value to the customer or the business, they were merely ensuring that all the rules of the road were being followed. You can likely see where we’re going with this, any progress on deregulation in any industry, removes hurdles and roadblocks, allowing for greater investment. This also has a multiplier effect as dollars that were previously spent on compliance related tasks can be allocated more productively. We don’t need to go deeply into each one, but you can see how pieced together, deregulation, lower taxes, lower energy prices, and lower interest rates can all incrementally drive increased investment on US soil. Whether it drives enough investment to balance the budget remains to be seen, but all are tailwinds for stocks more broadly speaking. We believe much of this is behind the massive surge in small business confidence we’ve seen in the last 4 months or so. Link By the way, this surge in small business optimism isn’t usually what you see if a recession was imminent. But like we’ve said, the dessert eventually needs to come to the table or the optimism could fade quickly. This is what we meant when we said the bigger picture plan requires a strong and expanding economy – can’t grow the tax base if we’re in a recession. This gives us some confidence to see through the volatility of the day-to-day headlines.

At this point, you may be tired of reading so we’re going to condense the rest of the material we wanted to cover into quick hitter points:

Inflation and Interest Rates: the broader trend for inflation, though stalling, is still down. Even in the worst-case scenario of tariffs, we believe they would be one-time price adjustments that would roll off a year later so not a sustained inflationary impulse. Jerome Powell (Chair of the Fed) said as much in the last Federal Reserve press conference. In the best case we think there is no inflationary impulse to the current tariffs being thrown around. For a good read on the substitution effect and scenarios where tariffs are actually deflationary, check this article out: Link Remember – inflation is measured on a basket of goods, so even if some goods prices go up due to tariffs, others may go down as there is less money left over from spending on the higher priced goods, thus the impact on the whole basket of goods is somewhat muted. If inflation continues to trend lower, the Fed can resume lowering rates. Lower oil prices is a key component of this equation as well.

DeepSeek and the AI outlook: A Chinese company (DeepSeek) claimed it was able to produce an AI model for a fraction of the cost that its US counterparts are spending on AI models. This lobbed 17% off NVDA’s share price on January 27th and took the shine off the rest of the AI space for the time being. The question being, will there be a proportionate return on investment for all the spending that has gone on? The costs quoted by DeepSeek are almost certainly inaccurate, however, the efficiencies are real. Time will tell on all of this, but Jevons paradox says that as the costs of something come down, it drives increases in usage. On this thread, it makes the massive investments by the Magnificent 7 seem unnecessary while at the same time if the costs truly do come down, many more players could get into the game and the promises of increased productivity across the economy could be realized sooner than later.

Labor Market: the labor market is not yet sending any signals to be concerned about. This is one of the keys we are watching to assess the likelihood of a recession. Initial weekly unemployment claims have been very stable, but this is something we will be keeping an eye on as the year progresses. Link As the government work force is reduced, how quickly can those workers move into the private sector. This could be a variable that brings volatility to the jobs data as well and subsequently the market as it's digested so it’s a key piece to be aware of.

Health of the Consumer: the consumer is hanging in there. The labor market is the key to this as well. The last couple of months we’ve seen softer spending numbers, but at the same time the personal savings rate has moved up. Link This makes sense as sentiment has dropped since the first tariff announcement. If it translates to less spending in a more sustained fashion, that’s a concern. But it seems likely that consumers, like businesses, are sitting on their hands for now and once we get clarity on tariffs (which should come to some degree on April 2nd) then we would expect spending to improve on both fronts.

Cash on the Sidelines: Anecdotally, there are a lot of people sitting on piles of cash that are waiting for their chance to get into the market. More factually, we can see that money market funds are currently sitting with $7 Trillion in them. Link That’s quite a bit of dry powder and if rates trend lower – sitting in money market funds becomes less attractive. This can create a buying impulse for stocks as investors seek greater returns on those dollars.

OPEC is increasing production: OPEC is set to increase production in April. Link Any factors that lower the cost of oil are positive for almost everyone other than oil producers. This can change anytime as oil prices can be volatile, but incremental good news will find its way into stock prices and inflation data over time. Oil prices are a tricky tell for forecasting. Some would say lower oil prices point to lower demand associated with recessionary environments. This is valid, but the other side of the coin is that lower oil prices improve profit margins and leave more discretionary income left over that can be spent on other things, that would be expansionary. As a whole, we view lower oil prices as positive for the economy.

What does this all add up to?

We started the year with stock prices at very elevated levels relative to history. In that environment, the market needs things to continue going smoothly, so the outlook for future earnings can be supportive of the relatively high valuations. While there are many potential positives on the horizon, the market is laser focused on the uncertainty that tariffs and cuts in government spending have brought into the equation. As we have said, we expect volatility to remain elevated in both directions up and down through the negotiating phase of tariffs and trade. However, we believe the market will soon be able to look through the fog and with that visibility will come capital spending increases and some peace of mind for the consumer as well. We believe many market participants are focused on the question, what if it all goes wrong? This is expressed in bull/bear surveys and many other investor sentiment indicators. But a question that should be considered as well, what if some things start going right? We believe the market is clenching for bad news and a posture like that sets up an opportunity for significant upside surprises. The reason we have confidence in potential upside surprises is because much of the pain the market is feeling has been self-inflicted to some degree. As we’ve laid out above, longer-term pain in the markets would be counterproductive to the administration’s bigger picture objectives. To that end, the self-inflicted pain could easily give way to positive catalysts.

As for the market concentration risk we highlighted above. This recent pullback has already begun to resolve this issue on its own as the selling has been more pronounced in many of the Magnificent 7 names. This sets the market up to rally from a much healthier place and with participation from a much broader swath of the stock market. Deregulation and lower interest rates, though good for almost everyone, can have a higher proportionate benefit to smaller businesses than larger ones. We just need to get through this uncertainty so those benefits can start to be realized.

We sincerely appreciate the trust you’ve placed in us to help you navigate both the good times and the tougher times in markets over the years and we don’t take that responsibility lightly. We are very attentive to what is going on and if the data supports a different outlook, we won’t hesitate to make the needed adjustments to our portfolio. We encourage you to be patient over the coming days and weeks and as always, keep your eye on the bigger picture.

Authored by: Jeffrey Gardner, Financial Advisor and Michael McCracken CFP®, ChFC The information presented above has been prepared for informational purposes only and the commentary represent the opinions of the author and are subject to change at any time due to market or economic conditions or other factors.