Stocks are on pace for a second consecutive year of double digit gains and Treasury bond yields continue to hover around 4.50%. Overall, this has been a pretty good environment to invest in. Now, with the election behind us and year-end approaching, clients are naturally wondering what next year will look like. While we are not in the prediction business, this article will highlight various data points to help frame expectations for the year ahead.
What history says
We’re students of market history and believe expectations play a crucial role in successful investing. On a baseline level, we think it’s a fair expectation that next year’s stock market will be “less great” than the prior two years. That’s not a forecast for negative returns in 2025. Rather, we simply do not observe many instances where the S&P 500 gained more than 15% three years in a row, something it will try to accomplish next year.
Since 1926, the S&P 500 has risen 15% or more three years in a row six times. Three of those times occurred during the Dot Com bubble in the mid-late 1990s (1995-1997, 1996-1998, 1997-1999). One interesting note here is if you believe we’re in the midst of an AI bubble, or crypto bubble, (or any kind of bubble), then perhaps you’d say “history will rhyme,” and stocks are set to keep soaring into the back-half of the decade. Again, we’re not making predictions, we’re just looking at the data. And the data says three year streaks of 15%+ gains are not commonplace.
At any rate, stocks will go into 2025 on a two year winning streak, having risen in 2023 and 2024 after a down year in 2022. Since 1926, there have been 16 other instances of two year winning streaks following a down year. Year 3 has been positive 13 times and negative 3 times. In those 16, “Year 3” years, average and median returns were 9.65%, and 8.32%, respectively. This data fits with our “less great” theme for 2025.
The simple takeaway here is that two year winning streaks have often been followed by a third consecutive year of solid gains. But the average and median returns are less than what we’ve experienced the last two years. Personally, we think it would be a good thing if the market returned to average. As the late 1990s sample shows, when markets go up huge year after year, there can be a heavy price to pay later (stocks fell 45% from 2000-2002).
A “buy more” environment in bonds
We’ve been recommending treasury bonds as treasury yields have stabilized over 4%, and are even approaching 5% on longer maturities. A common question we’re hearing is, “What if bonds keep going down and yields keep going up?” Well, we’d say to buy more. The ability to lock in 5-6% on treasury bonds, if we get there, should be treated similarly to if stocks went down 20-30% next year: a buying opportunity.
In addition, various data points support the case for owning bonds. For example, the annual inflation rate (CPI) of 2.4% is now below the interest rate on 10 year treasury bonds (4.35%). Since 1976, when inflation is below long-term rates, bonds have performed well, averaging annual returns of 8% over the following 12 months.
Furthermore, since the Fed began cutting rates over the summer, the yield on cash is falling. This means the interest paid on high yield savings account and money market funds has started to decline. Bonds have historically done well when cash yields fall, perhaps as investors start looking for different, but still safer, ways to deploy their cash.
Trying to be market agnostic
In general, the data points to a good environment for investing heading into 2025. Stocks have shown that the momentum behind a two year winning streak often carries into the third year. Interest rates on bonds are at levels that often lead to positive returns for that asset class as well. But it’s only natural for investors to play through the “what if?” scenarios in their minds. What if stocks crash 30% next year? What if inflation soars again and crushes bonds? What if this? What if that? It’s a never ending game if you decide to play it.
The best way to approach these fears, if you have them, is with buckets. Certain buckets of money should be ear marked for certain things. A younger investor may view their 401(k) as a long-term bucket and should try to be agnostic to changes in the market environment. For example, if this person has $100,000-$200,000 in a 401(k) and has the means to max that contribution next year, that means they are adding 23%-11.5% in new money to the account (based on a $23,000 contribution amount). So, if the stock market falls, they are getting a chunk of new money in at lower prices, and that would bode well for their future returns.
A retiree who is living off of supplemental income from their portfolio shouldn’t be overly concerned with the market on a month-to-month basis… Rather, they just need to worry if their portfolio can provide the income they need for as long as they need it. With 4-5% interest rates on bonds, a $500,000-$1,000,000 allocation to treasuries can generate $20,000-$50,000 in interest income each year, without touching the principal. This amount, combined with social security or pension benefits, can provide stable cash flows in retirement.
If the thought of stocks even declining 10% sends shivers down your spine, then consider tools like Buffered ETFs, which can protect against market declines. But remember, since 1980, stocks have averaged an intra-year decline of 14% once per year but still finished higher the majority of the time. Markets go up and down, there is no magic bullet to avoid those gyrations completely. Expectations can play a key role in helping you stay calm and disciplined no matter what the market is doing. And in general, after two very good years for stocks, we believe expectations should be a little lower going into 2025.
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