Table of Contents
Macro Insights
Soft Finish to a Strong Year
The S&P 500 Index surged by 25% in 2024, marking consecutive annual gains of over 20% for the first time since 1998–1999. However, December finished lower, reflecting a more hawkish Fed forecast for 2025. The Fed’s new forecast of only two 25-basis-point cuts in 2025 led to a 35-basis-point rise in 10-year Treasury yields on the month, weighing on stocks. While higher long-term rates are typically worse for growth stocks, growth outperformed value by 6.5% during the month as cyclicals and small caps underperformed.
Technology and related industries continued to dominate market performance in 2024. The “Magnificent 7” mega-cap stocks rose 50% for the year, while the communication services sector gained 40%, and technology advanced 37%. Growth stocks outpaced the broader market by 9% and outperformed value stocks by 19% (see nearby table). With mega-cap tech driving much of the rally, U.S. equities significantly outperformed non-U.S. developed markets.
Long-term interest rates rose substantially in 2024, with 10-year U.S. Treasury yields climbing by 69 basis points to close the year at 4.57%—with half of that increase occurring in December. The rise reflected a shift away from economic pessimism early in the year and more persistent inflation, which altered expectations for the Fed’s policy path. Higher rates weighed on fixed income returns, though investment-grade bonds managed a modest 1.25% gain for the year.
After an 11% gain in November, small caps fell 8% in December and underperformed for the year. A shallower decline in Fed Funds is negative for small caps, though the setup for small caps looks promising entering 2025 (see this month’s Spotlight below).
The 25% rise in the S&P 500 in 2024 was roughly split between earnings growth and valuation expansion. Forward earnings expectations increased by 12%, while the forward price-to-earnings ratio climbed from 19.7x to 21.7x. While elevated valuations should temper future returns, the sentiment toward the artificial intelligence theme in the U.S. remains justifiably positive and will no doubt act as a material determinant of returns in 2025.
2024 Russell Index Returns
Investors significantly favored growth over value and large-cap over small-cap in 2024.
Source: Fort Washington and Bloomberg.
What to Watch
After a few months of focusing on employment, investors have reverted their focus back to inflation. Short-term inflation has risen, and markets will monitor incoming inflation figures for implications on Fed policy. Although expectations are positive, investors will pay close attention to new data for any signs of labor market weakness.
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Monthly Spotlight
The Case for Small Caps
Small-cap stocks have received increased attention since the U.S. election but might be less noticeable in many investor portfolios, especially relative to large caps. This is because small caps are currently less than 5% of the total U.S. stock market capitalization, compared to roughly 10% historically. We believe increasing small-cap exposure could prove timely, given the macroeconomic backdrop and current valuations.
Recent political and economic developments have created a potentially more profitable landscape for smaller companies. The incoming administration's "America First" agenda encourages domestic sourcing and manufacturing, creating an environment likely to benefit smaller companies that generate a larger proportion of their revenue within the U.S. compared to larger firms. Deregulation, another agenda item, should provide a tailwind for smaller firms that are often more laden by compliance costs. In addition, deregulation could lead to increased M&A activity, for which small caps are more often acquisition targets. Tax reform, specifically a lower corporate tax rate, could also disproportionately benefit smaller companies, which often have higher effective tax rates than their large-cap counterparts. Meanwhile, a more accommodative Federal Reserve, which has cut rates by 1% in recent months, is lowering financing costs for smaller companies which tend to have more leverage and higher amounts of floating-rate debt.
| In addition to the potentially improving earnings growth outlook, small caps appear to offer better relative value than large caps. While many large, global corporations have seen their multiples expand, making them look expensive compared to historical levels, small-cap P/E ratios remain closer to historical medians. In Figure 1, we can see that small caps historically trade at a premium P/E multiple relative to large caps, but since the pandemic, they have been trading at a substantial discount. The potential improvement in earnings growth, coupled with a convergence in the P/E ratios between large- and small-cap stocks, presents a compelling case for adding small-cap exposure or rebalancing from large to small caps. |
Figure 1. PE Ratio of S&P 600 Relative to S&P 500
Source: Fort Washington, Bloomberg, and Macrobond. |
Furthermore, small-cap stocks offer highly diversified exposure to the U.S. economy relative to the concentrated large-cap universe. The 10 largest names in the S&P 500 make up about 40% of the index’s total market value, exhibiting a meaningful bias toward mega-cap technology. We believe the benefits of diversification, potential earnings growth, and relative value offered by small caps warrant additional consideration in today’s environment. However, passive index exposure may not be an ideal vehicle to obtain exposure since about 25% of companies in the Russell 2000 have negative earnings. These negative-earning companies have underperformed positive earners by 9% over the past decade with 50% more volatility. As a result, we believe active managers are better suited to navigate the small-cap asset class, evidenced by 83%1 of active managers outperforming the Russell 2000 over the past 10 years (93%1 over the past 20 years).
Current Outlook
Market Data & Performance
As of 12/31/2024
Source: Fort Washington and Bloomberg. *Returns longer than 1 year are annualized. Past performance is not indicative of future results.
