After starting the year with equities down -20% near the end of the first quarter, 2025 turned out to be a solid year from a return standpoint.
Fast forward to today and the S&P 500 is up a little over 14% as we head into the fourth quarter. Once again, stocks find themselves in “expensive” territory.
While there has been plenty to be concerned about, there has also been plenty to be excited about. Market gyrations have perfectly embodied a euphoric sense to both the up and downside this year. The 2020s have turned out to be a tale of two halves so to speak.
As we head into year-end, a time when equities tend to perform well, we must still consider that while equities may grind higher, we are starting from the later stages of a bull market. High valuations and a bull market that stated in 2013 warrants some level of caution. From an investment perspective, it reminds us that we should be prudent in our picks and follow an old Warren Buffett adage:
"Be fearful when others are greedy and greedy when others are fearful".
The Highs and Lows of Investing
Source: JP Morgan Guide to the Markets
One slide that helps us keep our emotions in check is from JP Morgan. As you can see, over the last 45 years, we’ve had intra-year drops of at least -14.1% roughly annually (34 of 45). More importantly, this chart gives us some comfort in having a better idea when stocks may be expensive or cheap compared to the past.
To provide more clarity, we’ve marked areas where rebalancing tends to make sense. Taking chips off the table (red/gold) and zones where we should consider adding cash (gold/green).
For additional context, we’ve added a version of our own.
Looking at price movements of the S&P 500 going back to 1980, we can see a very similar pattern. Notice that in both cases, equities are entering into the expensive zone again. While we never know when prices may turn, this gives us a little more confidence and supports our Three Dials Valuation being negatively tilted. One or two data points doesn’t mean we’re exiting the markets. However, if you expect big expenses or have cash flow needs in the next year or so, then it would make sense to take those funds off the table and collect just under 4% in money markets. We don’t see a reason to risk the value of cash that has already been spoken for.
Innovation or Bubble???
One of the biggest topics in the markets today is the rise of AI. While it’s true that markets are extended, AI valuations have entered the stratosphere, and we’re seeing a daily deluge of IPOs in this space. It’s also true that patience, expectations, and time frame make a big difference over the long term.
Wall Street chatter is filled with feelings of the 2000 Tech bubble and rightfully so, it’s warranted. Having said that the chart below from JP Morgan underscores the importance of this paradigm shift. As we move to an era of AI, Bitcoin & Crypto, and technology integrations across the global economy, it will require upgrades to almost all our work habits, compute needs, and energy infrastructure required to support it all.
Source: JP Morgan Guide to the Markets
The above chart highlights the need to pay attention to the major companies driving growth and innovation within the economy. These names tend to shift about once a decade. The primary drivers of the 80s were industrial foundations: oil, chemicals and early tech. This combination laid the foundations for American consumer dominance and “globalization” that bled into the 1990s where most stock market leaders were the same.
In the 2000s we saw a shift towards banking, tech portals, and drug companies as financialization and living standards began their ascent.
By 2015 software had become a dominant force. Today, we’d be hard-pressed to find an S&P 500 company that isn't dominated by software or impacted by technology chips. As Mark Andressen noted, software has eaten the world.
While we’re currently witnessing another trifecta of hype: AI buzz, energy infrastructure contracts to support, and tech companies heavily investing in one another. We’re also in the midst of a paradigm shift culturally, monetarily, and technologically. This time is likely not different in a general sense, but we must also recognize that in some ways we are re-living the FOMO of the Roaring ‘20s or Tech Bubble mania of 2000s.
While bubbly dynamics are present, what’s more important, is that the fundamental foundations of our market leaders have materially shifted (see above chart). Software is no longer eating the world. It is the world. And this sector of the market is getting a makeover with AI.
This recent shift also highlights another common theme across financial history and that is, that market participants are obsessed with securitizing important commodities, infrastructure, and other critical assets so they can be used as liquidity within our ever-evolving financial ecosystem. While it does lead to boom-and-bust cycles, it also is how technological innovation has worked for a few hundred years.
Near term we may be extended. But long term, futures are built by the hype of the moment.
Just as industrialization was taking shape in the early 1900s, US railroad and oil companies entered boom-and-bust phases. As did many other sectors over the next 100 years.
Today, we’re seeing a similar pattern unfold with a rebirth in the underlying foundations of the internet. Chips are becoming the rails that re-industrialize America. So that we can compete in the 21st century on the AI front and in cyberspace.
As we move forward, investors’ patience will be tested again. It will be important to not get greedy with allocations, and to recognize when there might be better or worse entries into specific market themes. As is always the case, re-assessing our appetite for risk is likely warranted when major market forces are shifting. Reach out to your Arkos advisor if you’d like to take a quick risk assessment.
The Impact of Inflation on Asset Allocations
During inflationary periods maintaining purchasing power supersedes investment return.
We can simplify things on the investment front by focusing primarily on our core five choices: Stocks, Bonds, Commodities (Gold & Silver), Currency, and the new addition Digital Assets (Bitcoin).
The relationship between these assets can at times be confusing, but from a historical lens, they can tell us a lot about the underlying structure of markets as a whole.
Source: JP Morgan Guide to The Markets
In times like today, unlike during deflationary periods, bond interest does not cover the loss of purchasing power due to inflation. Investors seeking income are required to hold a different mix of bond instruments as the overarching goal shifts to maintaining purchasing power.
Commodities and sound money assets like gold, silver and Bitcoin become popular as investors seek store holds of wealth over income and protection. Stocks generally perform inline or slightly ahead of inflation but like in the 1960s and 1970s can swing wildly.
Mainstream and institutional investors are just beginning to take note.
In the modern era of Federal Reserve printing of money (M2), money supply has increased by roughly 8% annually from 2020 to 2024 and around 7% over the last 50 years.
That excess liquidity must go somewhere, and it has tended to move into stocks which have averaged around 8% since about 1957.
The relationship between stocks and money supply (inflation) sheds light on some of the adjustments made to CPI. CPI, most often quoted as inflation, is actually the rate of change of inflation. Not inflation itself. CPI is a function of change and is based on an ever-changing basket of goods. Our inflation rate is what we pay at the checkout counter to support our current living standards. In most cases, our inflation rate is drastically higher in recent years than what is quoted by CPI.
Source: JP Morgan
While the following may seem a bit deep and technical. It helps us gain a better understanding as to the importance of real interest rates.
What’s that you might ask? Real rates are (10-year Treasury rate – inflation). At the time of this writing, the 10 year is currently at 4.12% and the various measures of inflation are:
If we use the lowest and not actual inflation, CPI, then real rates are at 1.22% (4.12 – 2.9). Using M2, -0.65% and using the average of CPI, M2, typical monthly expenses, then real rates are -4.80% (4.12-8.92).
What real rates tell us is the ability of a bond to maintain purchasing power after accounting for inflation. Or said another way, when we should consider shifting allocations to bond alternatives and sound money assets in the presence of inflation. We have actively been doing this in our Three Dials Model.
When real rates are above 4-5%, bonds offer better returns than stocks as the income and protection are preferred over the volatility of potential return in stocks. With bonds having bounced around below this level we’ve needed to consider different parts of fixed income land such as high yield, floating rate preferreds, gold, bitcoin and alternatives like utilities.
For comparison, today’s markets mimic what we saw in the 1960s and 70s. Another period with bouts of deflation, inflation and supply chain disruptions were present.
Image Source: Capital Wars: The Rise of Global Liquidity by Michael Howell
As this chart explains, in deflationary environments bonds and stocks tend to be uncorrelated (2000-2015), trading largely in opposite directions. However, as inflation picks up (above 3-4%) stocks and bonds sync-up and tend to trade in the same direction. This is very much what we’ve seen since about 2018, a re-syncing of bonds and stocks. Something not seen since before 2000.
Additionally, above 4% inflation and specifically above 6-8%, real assets/sound money assets: land, gold, silver, commodities, and Bitcoin perform significantly better. This is what we’ve seen playout so far in the 2020s.
What’s worth pointing out is that valuations, as we’re seeing with stocks, can stay elevated during periods similar to now. So, while we may be overvalued in the stock market and with AI hype, the overvaluation can remain that way until inflation is high enough to impair stock returns. Much like we saw in 2022 and 2023.
Source: Capital Wars: The Rise of Global Liquidity by Michael Howell
One metric we monitor is Cyclically Adjusted Price-Earnings Ratio (CAPE). CAPEs have been at extreme levels for years. Greater than in 1929 and just short of levels seen in the euphoria of 2000. While valuations have remained high stocks have had some turbulent periods but have continued to trend higher. This is what the previous chart hinted at and proves that, “markets can remain irrational longer than participants can remain solvent.” A famous quote by John Maynard Keynes.
As the chart above shows, CAPE values at these levels tend to have poor rolling 5-year returns. That is, once inflation stays above the 5-10% range. While it’s hard to pinpoint where inflation actually is, we know that we pay more at the pump, at the restaurant, and for healthcare than the often quoted 2-3% CPI measures. From a consumption standpoint it is a reason to always be cognizant of one of the seven steps in our process, your monthly burn.
We’ll continue to keep an eye on valuations. Though they tell a story, they can be tricky to time.
Shifting Tides
Image Source: JP Morgan Guide to The Markets
While we’re not ready to throw in the towel on US stocks there is plenty more to consider than just your standard daily headline about how well international stocks have done in 2025.
Rather than chase the daily gainers we like to look at the larger trends. As you can see, we’ve been in a prolonged period of US dominance as it relates to international stocks (purple below the line) The US has outperformed for the longest period since 1975.
In recent years, with the decline of the dollar, it is not surprising to see international stocks begin to level the playing field relative to US stocks. Dollar weakness is what makes it easier for international companies to compete. We own international for diversification reasons and based on the above we’d expect the trend to continue. At least for a little while. We’ll keep our eyes on it and make adjustments as needed.
Shifting Tides
Looking ahead, as we enter the fourth quarter with markets extended, valuations high, and investor sentiment at a strong fever pitch. We’re not likely to step aside just yet, but rather, we’re more likely to double-down on staying disciplined.
We encourage you to check your balance sheet, look for opportunities to reduce debt, and consider pre-funding any large, expected cash needs that might be coming over the next 12 to 18 months. In short, we want to take advantage of these good markets by taking some profits and raising needed cash while stocks are high.
We’ll continue to stay diversified across stocks, commodities, and sound money assets as our main goal is to position portfolios for resilience for years to come. As always, we’re here to revisit your plan and risk profile anytime you’d like.
Disclaimer: Our intent in providing this material is purely for informational purposes, as of the date hereof, and may be subject to change without notice. This article does not intend to constitute accounting, legal, tax, or other professional advice. Visitors and readers should not act upon the content or information found here without first seeking appropriate advice from a trusted accountant, financial planner, lawyer or other professional.
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