2025 is going to be a year of many changes. From the perspective of the markets we have major changes in Fed monetary policy alongside a new President with different tax and spending priorities. While President-elect Trump is considered pro-business, it is unlikely he will spend wildly on Ukraine or immigration as President Biden has done. This will create winners and losers as government stimulus has been a big support for consumer and defense spending.

• With the post-election glow wearing off, markets sold off in December as interest rates continued to drift higher and fears of higher inflation affected the outlook for Federal Reserve interest rate policy.

• Despite lower inflation and signs of labor market weakness, bond markets weakened as investors fear President-elect Trump will not solve the Federal spending crisis.

Table 1: Market performance estimates as of 12/31/2024 (LIMW)

The current narratives on the markets

Day-to-day activity in the markets remains a tug-of-war between two camps.

Here is what the market optimists are focused on:

1. The economy continues to grow.
2. Unemployment is at historically low levels.
3. Inflation has fallen from the 2022 highs.
4. Technology innovations will be revolutionary.
5. President-elect Trump is expected to implement pro-growth policies.
6. Any financial or bank problems are likely to be bailed out.

Here is what the market pessimists are looking at:

1. The yield curve has uninverted with interest rates at cycle highs.
2. Most post-pandemic new jobs have been given to immigrants.
3. Leading indicators are improving, but still indicate recession.
4. Labor market conditions are weakening.
5. Stock market valuations and expectations are at record highs.
6. Government over-spending is hiding a weak private economy.

Let's review some of the raw data and draw our own conclusions.

Purchasing manager surveys continue to be weak

Purchasing manager surveys (PMIs) continue to be generally weak. In particular, the service economy PMIs unexpectedly fell in November 2024 after showing signs of recovery for most of the year.

This is important because the United States is a service economy, and while the manufacturing economy has been poor for several years now, the service economies of the West have continued to show strength up until now.

If you remember, the way these survey results work is that readings above 50 indicate growth; those below 50 indicate contraction.

Figure 1: Manufacturing and Service Economy PMIs (LIWM)

The labor market data is difficult to interpret

It is difficult to understand the current labor market. Corporations report that they are maintaining their payrolls, while household surveys of workers show weakness. We can see this down below in a comparison of the unemployment rate and initial jobless claims. While unemployment is rising, it doesn't seem like many out-of-work people are filing for unemployment.

Figure 2: US Unemployment Rate versus Initial Jobless Claims (LIWM)

Additionally, there continues to be anecdotal reports of jobs becoming very difficult to find, in particular for recent college graduates. Here is an analysis that compares S&P 500 returns with the JOLTS Job Openings data.

Note that the tight relationship between the JOLTS data and the S&P 500 performance seems to have broken during the pandemic. It is too early to tell if this is permanent or temporary.

Figure 3: Job openings versus the S&P 500 (yty) (Jeff Weniger)

The Kansas City Federal Reserve calculates a Labor Market Conditions Index based on 24 variables that is designed to tell us whether the labor market is good or bad. Here are some of the factors they capture in this index:

1. Unemployment rate (U3)
2. Broad unemployment rate (U6)
3. Unemployment forecast (Blue chip)
4. Quits rate
5. Average hourly earnings
6. Initial Claims
7. Non-farm Payrolls

These are some of the raw data points we talk about from time to time. If you want to see the whole component list of the KC Labor Market Indicator it is HERE.

In the chart below, you can see that during the last 3 economic cycles, the labor market was in sync with the stock markets both up and down. In this cycle, however, the labor market has deteriorated during a very strong market rally. This is another potential warning sign for the market bulls and a puzzle: why has the stock market disconnected from the labor market?

Figure 4: Kansas City Fed Labor Conditions Index (Jeff Weniger)

Finally, there have been big downward revisions to government labor data in the last few weeks. For example, the popular Payrolls data was revised down by 800,000 jobs indicating that the labor market is much weaker than originally expected.

Interest rates, Fed policy, and our abnormal economic cycle

The pandemic of 2020 and the government's response have made this a very difficult cycle to forecast. Historically, the relationship between the interest rates, inflation, economic growth and the bond market has been pretty clear: rising rates slow economic growth, inflation falls with the lower growth, and the Fed cuts rates as the economy falls into recession. Then the growth cycle begins again.

This pattern has played out many times since the 1970s, yet this particular cycle has been propped up by massive government stimulus in 2021 and bank bailouts in 2023. This resulted in 9% inflation in 2022, Federal Funds rates of 5.5% earlier this year, and an economy that can't seem to slow down.

Inflation has fallen dramatically from its 9% peak. The Federal Reserve, for its part, has cut rates by 1.00% since the first rate cut in September 2024. Normally, the bond market would react with lower rates, but in this cycle long-term interest rates have risen as the Fed cut their policy interest rate.

Even with lower inflation readings, we don't expect the Fed to cut interest rates further because of the risk that the bond market will allow longer-term yields to rise. In this new environment, the return of "bond vigilantes" strike fear into the hearts of presidents, legislators, and central bankers when their policy plans promote inflation.

Figure 5: Consumer Price Index, Federal Funds Rate, and 10-year Treasury yields (LIWM)

Remember that the Fed only controls the overnight lending rate between banks and their balance sheet. The bond market drives the yield on longer duration bonds such as 5-year, 10-year and 30-year debt.

Here is a chart that looks at the yield curve changes over time. The yield curve is drawn by looking at Treasury interest rates for bonds maturing in 3-months, 1-year, 2-years, 5-years, 10-years and 30-years. The shape of the yield curve is important as an economic signal to lenders and investors. When short-term yields are higher than long-term yields, we call that a "yield curve inversion." The yield curve inversion we just experienced was the steepest since the 1970s and the longest in duration ever since the creation of the Fed in 1917.

The key point here is that when short-term interest rates are higher than long-term interest rates, this has historically been a signal for lending to slow down. When the Fed cuts interest rates, this signal reverses normally. However, in this cycle, as the Fed cut short term interest rates by 1%, long-term interest rates rose by 1%!

Figure 6: Recent Yield Curve shapes (WolfStreet.com)

The connection to the real world is through mortgage rates and the interest rates on auto loans, student debt and credit card debt. In the next chart you can see the very painful rise in mortgage rates which will eventually slow down housing activity.

Figure 7: 30-year fixed mortgage rates since May 2024 (Mortgage News Daily, Wolfstreet.com)

In past economic cycles, the changing shape of the yield curve has been an excellent tool for recognizing the transition from expansion to recession. By cutting interest rates, the Fed is essentially saying "...the economy is weak, inflation is falling, so we better do something to mitigate a potential recession..."

The tool many analysts use is a measurement of the difference in yields between 10-year Treasury bonds and 2-year Treasury bonds. Normally, this change is caused by a collapse in the yields of short-term bonds while long-term yields fall more gradually. So far in this cycle, we've seen a combination of short-term yields falling and long-term yields rising. It is not clear how this will affect the broad economy.

Here is the 10-year/2-year spread over time compared with historical recessions and the S&P 500. When the purple line rises, the Fed is raising interest rates; when the indicator is above the dotted line, the yield curve is inverted. When the purple line falls, the Fed is cutting rates.

Figure 8: 10-year/2-year yield spread over time versus the S&P 500 (LIWM)

Of course, there is a penalty for imposing inflation on a nation's economy. Here in the United States, both the Federal Reserve and Congress are to blame for the current inflation problems that led to bond market losses and a loss of consumer spending power.

Let's look at a chart of the broad bond benchmark. You can see how it fell after the pandemic as stimulus and inflation ripped through the economy. Over the last 2 years, the bond market has tried to put a bottom in as inflation fell and restrictive Fed policy slowed economic growth.

In Washington, however, there is no fear of inflation from the White House or Congress. While they bemoan interest expenses of $1+ Trillion per year, they do not pass policies to lower the budget deficit of $2+ Trillion per year.

If the deficit is not cut and inflation allowed to run hot, we expect a repeat of the 1970s inflation experience which will be a problem for investors and consumers.

Figure 9: Broad bond market price activity 2018-2024 (LIWM)

Market expectations are extraordinarily high

Boy, I hope they are right. Because articles like this have been hallmarks of major market tops in the past. For example, in 1929 famous Yale economist Irving Fisher was quoted as saying "Stocks have reached a permanently high plateau" as a justification for high valuations. He spent the rest of his life atoning for this comment because his advice caused many investors to lose money in the subsequent 1930-33 bear market. If you are interested, you can still find his book, The Debt-Deflation Theory of Great Depressions on Amazon.

Judging from the cost of his book, not many are interested in reading about slowdowns, recessions or depressions.

Economists aren't the only ones feeling bullet-proof. Surveys of investors indicate this is the most confident they have been in 40 years, even exceeding the optimism of 1999.

Figure 10: Consumer confidence in stock prices (Conference Board, Jeff Weniger)

Company valuations of popular growth stocks such as Apple, Microsoft, Tesla, Nvidia, Amazon, Google and Netflix reflect this optimism. The valuation levels here significantly exceed those of 2000. These growth forecasts better work out; it's a long way down to valuation support.

Figure 11: Price-to-sales ratio of popular tech stocks (Merrill Lynch)

The ultimate problem with high valuations is that they imply lower forward returns. While not a timing tool, this type of valuation research tells us generally when the risk-reward of a stock market investment is favorable.

The Cyclically Adjusted Price/Earnings ratio for November 2024 was 40, implying near-zero returns on stocks over the next 10 years.

Figure 12: Cyclically Adjusted Price/Earnings ratio versus the S&P 500 (Morgan Stanley, Robert Shiller)

We created a bear market indicator based on factors that historically were most helpful for predicting a significant pullback in stock prices. It is a composite of five key data points:

1. 10-year Treasury minus Federal Funds rate (yield curve inversion)
2. Institute of Supply Management Purchasing Manager Index (ISM PMI)
3. Consumer price inflation (CPI)
4. Cyclically Adjusted Price/Earnings ratio of the S&P 500 (CAPE ratio)
5. Unemployment

Our bear market indicator is not at a tippy-top as in 2000, 2007, 2018 and 2022. This reflects a recessionary indication for the ISM PMI and weakening metrics on the other four. Clearly, this indicator has not worked over the last year or so. However, in other economic cycles the combination of high valuations and weak economic growth has been problematic for stock prices.

Final thoughts

The labor market is weakening, the Fed has started cutting rates, the yield curve has uninverted and valuations are at all-time highs, leading us to believe that this is an unattractive time to be overweight stocks. Like a black hole, the rising market has pulled in many participants, unable to resist its powerful gravity. It feels good to buy up here and participate in the market.

However, we all know that the best time to buy is when people are unhappy, the economy is in recession or investors have been hit with losses. Other than energy stocks and bonds, there is not much evidence of this in the current markets.

As always, we welcome your feedback and are happy to discuss.

Happy New Year to you and your family!

Rob 281-402-8284

Chris 281-547-7542

Rob Lloyd, CFA^®

Lloyds Intrepid Wealth Management

1330 Lake Robbins Dr., Suite 560

The Woodlands, TX  77380

281-402-8284

Robert.Lloyd@lloydsintrepid.com

www.lloydsintrepid.com

Christopher Lloyd, CFP ^®

Vice President and Senior Wealth Planner

Lloyds Intrepid Wealth Management

1330 Lake Robbins Dr., Suite 560

The Woodlands, TX  77380

281-547-7542

Chris.Lloyd@lloydsintrepid.com

www.lloydsintrepid.com

Lloyds Intrepid LLC is an Investment Advisor registered with the State of Texas, where it is doing business as Lloyds Intrepid Wealth Management. All views, expressions, and opinions included in this communication are subject to change. This communication is not intended as an offer or solicitation to buy, hold or sell any financial instrument or investment advisory services. Any information provided has been obtained from sources considered reliable, but we do not guarantee the accuracy, or the completeness of, any description of securities, markets or developments mentioned. We may, from time to time, have a position in the securities mentioned and may execute transactions that may not be consistent with this communication's conclusions. Please contact us at 281.886.3039 if there is any change in your financial situation, needs, goals or objectives, or if you wish to initiate any restrictions on the management of the account or modify existing restrictions. Additionally, we recommend you compare any account reports from Lloyds Intrepid LLC with the account statements from your Custodian. Please notify us if you do not receive statements from your Custodian on at least a quarterly basis. Our current disclosure brochure, Form ADV Part 2, is available for your review upon request, and on our website, www.LloydsIntrepid.com. This disclosure brochure, or a summary of material changes made, is also provided to our clients on an annual basis.