Since the last few strategy notes have been laser-focused on the post-election alternative strategy landscape—and its borderline ebullience in terms of capital market activity, private credit and private equity deal flow, growth at a reasonable price (GARP) in middle market private equity, etc.—we’re going to “strive in ’25” by focusing back on broader markets and asset allocation as succinctly as we are able to (I promise to be short and sweet).
Putting cash to work: A major theme for ’25
As you recall, one of our major themes coming into last year was putting cash to work.
Today, as long as you overcame inertia and put cash to work (and didn’t get sucked into the highly flawed duration/fixed income permabull thesis to buy bonds at lower yields than cash—and then got smoked when the yield curve steepened as expected), you probably have a big smile on your face.
Virtually every major alternative strategy outperformed cash (including private credit, middle market private equity, senior secured real estate lending, etc.) and only in certain cases like commercial real estate equity REITs and low beta liquid multi-strategy funds did you slightly underperform cash. Furthermore, if you said, “Troy, you know I love you, but I’m full up on alts and I just want to invest in leveraged loans, high yield bonds and/or equities,” you did modestly to substantially better than cash as well.
Well, here we are again with putting cash to work continuing to be one of our major themes in 2025.
We’re back to negative returns in cash after taxes and inflation (that 5.25% Fed funds/money market/T-bill interest rate was fun while it lasted). So, since investors have many democratized alternative options to increase yield and total return potential without taking uncomfortable levels of risk, whether it is private credit, middle market private equity, liquid multi-strategy funds, etc.—as long as you can tolerate the illiquidity and don’t need the cash in short term, what are you waiting for?
Equities are likely to see a solid year, but risks remain
This is more than likely going to be another solid year for U.S. market cap weighted indexes (S&P/Nasdaq), powered by a continuation of, at worst, gradually receding economic growth rates, and at best, continued north of 5% nominal gross domestic product (GDP) growth rates. They say “the trend is your friend” for a reason, after all!
However, it is difficult to imagine the same degree of multiple expansion reoccurring. That means we’re likely to see more muted gains with periodic bouts of volatility.
That being said, there is still the possibility of more multiple expansion, primarily driven by:
- Money supply
- Assets in money markets
- Flow to supply ratios of U.S. equities
In terms of money supply, we still have approximately 4.7% more money supply relative to nominal GDP than pre-pandemic.
Still more money supply relative to nominal GDP than prepandemic
Source: Macrobond, as of September 30, 2024.
In terms of assets in money markets, there are $3 trillion more in money markets ($7 trillion vs. $4 trillion), which is a whopping 31% more relative to nominal GDP.
Because of continued high levels of stock buybacks, debt-financed mergers and acquisitions, the secular trend of companies going from public to private and anemic purchase order (PO) volume in comparison to the existing market cap of U.S. equities—the flow (net new supply of U.S. equities) to supply ratios (inverse of stock to flow) of U.S. equities are the best of any major asset class on the planet at roughly -1% per annum.
Flow to stock remains negative for U.S. equities
Source: Macrobond, U.S. Equities as of Q2 2024, Treasuries—CBO estimate for 2025, Bitcoin as of April 2024 halving, Gold as of full year 2023.
However, there are challenges and risks to this positive outlook for equities.
Risks for equities
Valuations are clearly stretched, particularly in the S&P 500 and the Russell 2000 (the former is slightly more expensive than 2021 and the latter is 6% more expensive). Fortunately—or unfortunately for mega cap tech haters—the Nasdaq is actually 12.5% cheaper.
There will more than likely be multiple mini corrections driven by a steepening yield curve and higher back end yields (like we saw in the first full trading week of the year), but what else is new? Other than the correction driven by the horrific Russian invasion of Ukraine, every minor or major market correction since the end of 2021 has been driven at least partially by higher yields in Treasuries creating multiple compression in equities.
However, once continued strong nominal GDP growth, market cap weighted index revenue and earnings strength, and the technical factors mentioned above reassert themselves, we generally go on to higher highs. Going forward, the Fed will be your friend with slow, modest cuts and will probably wind down tapered quantitative tightening (QT)1 this year.
I totally get how the Magnificent 7 and Nasdaq could grow earnings at the market consensus forecast level of 20%+ given the secular growth present and the somewhat circular massive levels of investment. However, the broader S&P 500 earnings growth rate of 14.8% looks tough because it depends on an over 8% margin expansion (12% to 13% to a new record level) and non-Magnificent 7 earnings growing at rates of 13% vs. 4.2% in 2024.
Since the Magnificent 7 have already told everyone their margins aren’t expanding again anytime soon because of the scale of their AI investments (approximately 70bps–80bps of U.S. nominal GDP growth, or north of $200 billion), health care, industrials and materials would need to show up big time for this degree of margin expansion and earnings growth to be achieved. Conversely, consumer staples (very low profit margins) could completely disappear from the S&P and all of that market cap could rotate to IT-focused companies with much higher profit margins (and that’s unlikely to happen in just one year).
So for equities, the key risks include:
- Concentration risk: The Magnificent 7 make up 34% of S&P and, including Tesla, trade at 39X forward earnings (and clearly there will be political headwinds). However, excluding Tesla, valuations are a much more reasonable 29X. Or if you sub out Tesla and include Broadcom, you are at 31.5X. Thus, you have to be cognizant of this level of valuation relative to gradually slowing growth rates and the potential for future multiple compression.
- Exogenous risk: The China’s-about-to-invade-Taiwan permabear risk is making its rounds again (and once again is likely to be wrong), but in general, exogenous risk can always strike when you least expect it.
- Endogenous risk: AI could turn out to be a dud, but that is looking less and less likely, given the returns on invested capital (ROICs) that are already showing up.
- U.S. small cap risk: This sector looks particularly dangerous, with over 40% of the companies unprofitable and the richest valuations relative to history of any U.S. index. An expected earnings growth rate of 35% for this sector in 2025 looks like wishful thinking.
What could this mean for investors seeking growth from publicly listed equities?
In the S&P 500 and Nasdaq, you’re likely to see growth at highly elevated and potentially unreasonable prices. But you should expect continued more muted gains, nonetheless, for the reasons mentioned above (and at least you have growth).
In the Russell 2000, you have little if any growth (less than 2% trailing 12 months (TTM) revenue growth) at clearly unreasonable prices compared to anything public or private with an “E” standing for equity. So good luck with that.
And as I always joke around with our investors, if anybody can ever identify the reason to invest internationally (other than “cheapness”), please let me know. Unsurprisingly, I’ve been waiting a long time for a cogent rebuttal or compelling argument. One of the few things I am fairly certain about in capital markets is that you need nominal GDP growth to drive corporate revenue growth—and revenue growth to drive higher levels of earnings or EBITDA growth through corporate operating and/or financial leverage. Good luck finding that overseas!
As you can see from the chart below, the MSCI All World Index, excluding the mighty U.S., has even worse historical revenue growth than the Russell 2000.
Greater opportunity for growth in middle market
Source: National Center for the Middle Market, Bloomberg Financial L.P., as of June 30, 2024.
How can you successfully complement U.S. equities? Middle market private equity
If you have U.S. equities covered with the positive selection bias market cap weighted indexes through the S&P and/or the NASDAQ, the question then is, what do you complement it with?
- Russell 2000: As discussed, the Russell 2000 is outrageously priced for an index where 40%+ of the companies can’t make money (adverse selection bias) in a 5%+ nominal GDP growth environment, and where revenue has hovered between 0% and 2% for the past two years.
- International: Well, it’s cheap, but revenue growth has been negative over the past two years. And who is expecting material improvement in Europe, Japan, the U.K. or China anytime soon? C’mon man!
- Emerging markets: Double c’mon man…Cheaper still, but other than India, where are the bright spots for growth in emerging markets? China? Russia? Brazil? And that continued dollar strength is kind of problem.
Instead, investors may want to consider allocating to middle market private equity. We consider it to be the definition of GARP, with much better revenue growth, and 35% cheaper than the Russell 2000 on an enterprise value to EBITDA basis. Or put another way, the Russell 2000 is over 50% more expensive than middle market private equity, and with 12.6% as much revenue growth.
Challenges in the Russell 2000
Source: Bloomberg Finance, L.P. Russell 2000 Index. Data as of January 8, 2025. Shaded areas indicate National Bureau of Economic Research (NBER)-declared U.S. recessions.
Revenue growth has been negative in international markets
Source: Bloomberg Finance, L.P. Data for U.S. middle market as of June 30, 2024, latest data available. S&P 500 and Russell 2000 constituent index data as of September 30, 2024. Russell 2000 constituent index excludes financials and companies with less than $25mm EBITDA. The constituent population totals 792 companies.
Public market valuations continue to rise
Source: Pitchbook as of September 30, 2024, Bloomberg Finance L.P. as of December 31, 2024. Middle market private equity consists of multiples on deals between $500 million and $1 billion. Large cap private equity consists of multiples on deals between $1 billion and $5 billion. Mega cap private equity consists of multiples on deals of $5 billion or more.
What about bonds? The trend is your enemy
A combination of stronger-for-longer economic growth, higher-for-longer inflation and interest rates, a yield curve destined to steepen, relentless supply and questionable demand all add up to a challenging 2025 for bonds (and so far, not so good).
In diametric contrast to U.S. equities, Treasuries have the worst flow to stock of any major asset class: 7.1% new supply as far as the eye can see before factoring in the Tax Cuts and Jobs Act (TCJA) extension—that’s north of $20 trillion the next 10 years…wow). And if you factor in the TCJA extension, the flow to stock climbs to somewhere between 8% and 8.5% per annum, 10 years in a row!
Please wait until the 10-year yield minus Fed funds is at least 200bps before allocating to longer duration2 fixed income (and we have a long way to go before we get there).
Historical yield curve slope
Source: Bloomberg Finance L.P., as of January 5, 2025.
To be fair, with bonds, at least you have some degree of hedge protection, and the risk/reward is not nearly as disastrous as it was coming into 2022 (more yield, less duration). But you may be better off continuing to reallocate fixed income to private credit, senior secured commercial real estate lending, liquid multi-strategy funds, or just about anything else and call it a day.
Conclusion: Strive in ’25
This year presents a number of challenges and potential opportunities across key strategies. A combination of understanding the trends that have been at play and taking advantage of potential tailwinds from new policy will be essential to help achieve investor goals.
So, here is how we’re going to Strive in ’25:
- Putting cash to work, preferably in alternatives that can potentially increase income and total return without taking uncomfortable levels of risk
- Complementing U.S. market cap weighted index exposure with middle market private equity (and not other suboptimal listed equity exposures)
- Replacing or complementing fixed income with private credit, senior commercial real estate lending, and/or liquid multi-strategy solutions
Or put even more simply: The Time for the Right Alts is Still Now!
Investing in alternatives is different than investing in traditional investments such as stocks and bonds. Alternatives tend to be illiquid and highly specialized. In the context of alternative investments, higher returns may be accompanied by increased risk and, like any investment, the possibility of an investment loss. Investments made in alternatives may be less liquid and harder to value than investments made in large, publicly traded corporations. When building a portfolio that includes alternative investments, financial professionals and their investors should first consider an individual’s financial objectives. Investment constraints such as risk tolerance, liquidity needs and investment time horizon should be determined.
