Transcript
Host: Jeff, thank you for joining us this afternoon. I hope you had a great holiday week and a terrific New Year. Let’s start 2025 off with an update on the ClearBridge Recession Risk Dashboard. Last time we spoke, it was an overall green expansionary color, but progress had stalled with no indicator upgrades since August of 2024. Did anything notable happen in December?
Jeff Schulze: After a period of no indicator upgrades, you saw quite a bit of movement in December. The dashboard experienced four individual changes last month, all in a positive direction. Retail sales and building permits both improved from yellow to green. The yield curve and ISM New Orders both improved from red to yellow. And, given the progress other indicators made beneath the surface, it wouldn’t be a surprise to us to see further positive signal changes in the dashboard as we move through the first quarter. Specifically, job sentiment, truck shipments and money supply are on the cusp of an additional upgrade. So the overall signal right now is firmly in green expansionary territory. And we look at the 12 individual indicators—right now we have seven green, four yellow, and one red signal, but we’re expecting more upgrades as we move through the first half of 2025.
Host: Jeff, in the past you’ve mentioned that the indicators have different weightings in a dashboard. Can you remind us why that is and what was the most important indicator change last month from a weighting perspective?
Jeff Schulze: So, when we look at these indicators, the dashboard is dynamically weighted on three particular variables. First off, over the last eight recessions, how many did the variable get right? How many did it get wrong? Secondly, how many false positives did you give us? If you gave us a false positive every time you got it right, you’re not an indicator in the dashboard. And then lastly, what’s the consistency of that indicator turning red? Does it turn red every three months before recession or is it all over the place? And based on those three criteria, the dashboard has indicators ranked anywhere from 4% of the dashboard up to 12%. And retail sales is 12%. So it’s one of our top-rated variables, and we’re really excited to see this turn green. And when you look at the consumer section of the dashboard (five indicators) with this upgrade, four out of five of those are now green and it’s really reflective of a robust US consumer.
And retail sales is a great barometer of how Americans are doing. The US consumer has been a source of strength throughout the current cycle, a key contributor to why the economy has continued to defy consensus expectations for slower growth. And we really think it’s a combination of strong individual balance sheets (for example, household net worth is up over US$49 trillion since the beginning of 2020, so that’s before the pandemic even happened) and a strong labor market with sticky wage gains, which has helped boost spending power for many people. And when you look at inflation-adjusted retail sales or real retail sales like we do, it’s well above the pre-pandemic trend. So we’ve been waiting for this indicator to turn green and we’re really excited because it is a top-ranked variable in the ClearBridge Recession Risk Dashboard.
Host: Do you have a specific number or probability that you can give us for the odds of a recession this calendar year?
Jeff Schulze: Yeah, at the moment it’s 15%. It’s been 15% since October of last year. Actually last year in 2024, it was 25% or lower for majority of that year. So at 15% right now, this is about as good as it’s ever going to get from a probability standpoint. So from our vantage point, the US economy is firing on all cylinders.
Host: That’s terrific news for the US economy. It’s been outperforming for years at this point. Can the US continue to outperform the rest of the developed world this year?
Jeff Schulze: Yeah, we believe that US economic exceptionalism is going to continue in 2025, because a lot of the key drivers of superior US economic growth remain intact. We just talked about the consumer. The workhorse of this economy continues to be quite strong. You’ve had really robust productivity gains in the US, especially when you look at other areas of the developed world. And as a reminder to the listeners, when you think about economic growth or GDP, it’s a function of two things. The increase of labor force and the increase of productivity growth, or how many more widgets can a factory make this year compared to last year with the same inputs. And productivity growth is now back at levels that we saw prior to the global financial crisis. And with all this investment in AI [Artificial Intelligence], we think productivity growth is going to be pretty healthy over the next five to 10 years.
So this is a pretty big differentiator for the US economy. So the consumer productivity gains, AI investment boom that you’re seeing in the US and really supportive fiscal policy or government spending in monetary policy as well. And even though the Fed may not be cutting as much as what we anticipated this year, the Fed has still cut 100 basis points, which is more than what was needed to create that soft landing of 1995 and 1998. So if you put all these together, this is, you know, the components that you have for another year of US economic exceptionalism.
Jeff Schulze: So US economic exceptionalism is likely here for another year. Can we see more upside this year in US equities after the S&P 500 delivered approximately 25% total return in 2024?
Host: Well, history would say yes, and I think a good parallel here is when you think about a gambler, they often believe that after a long streak of a particular outcome, the probability of a different result has increased. For example, if someone were to flip a coin five times and in each of those instances the coin landed on heads, many would believe that the odds of tails on the sixth flip are greater than even (or 50/50) in order to bring the sample in line with long-term averages. But the coin has no memory, and the law of large numbers doesn’t strictly apply to smaller data sets like five or 10 flips. It applies when you have a thousand or 2000 flips. So the desire to seek balance can create a gambler’s fallacy where past results skew perceptions on what’s likely to occur in the future.
So when you think about this from a stock market perspective, I hope that this is a pretty strong lesson to be learned. So the S&P 500 delivered 25% total returns in 2024; you had 26.3% in 2023. So you had two back to back years of equity market returns of 20% or greater. So with the gambler’s fallacy, many may believe that the market is due for a bad year because the average long-term annual S&P 500 return is lower. When you look at history, a different story actually comes to fruition. So the market typically continues to deliver solid returns in the year that follows back-to-back 20% gains. This has happened eight times before going back to 1950. Average return in year three, which is this year, is 12.3% with a positive return happening 75% of the time. So yeah, I think that the S&P 500 is going to have positive returns this year, especially with the economic backdrop that we envision.
Host: So if memory serves me correctly, we didn’t have a 10% correction in US equities in the last two years. Does that mean we should expect one this calendar year?
Jeff Schulze: No. If you look at this bull market, it’s taken a lot of people by surprise. The S&P 500’s up 70% from a total return perspective since the lows back in October of 2022. But what’s even more notable is that we have not had a 10% or worse correction during the last two plus years. And although this may seem like an outlier destined for mean reversion and lower equity prices, history shows that this actually may not be the case. So if you go back again to 1950, the S&P 500 has experienced nine periods that went longer without a 10% or greater correction. Four of those periods lasted more than twice as long as we currently stand. And two of those periods went over eight years without a 10% plus correction, which happened in the 1970s and the 1990s. So the fact that we haven’t had a correction in over two years doesn’t mean that one’s a foregone conclusion this year.
But, that said, 2024 had a bit of a weaker tone to it. December was the second worst month of the year, and it’s a sign that maybe a period of digestion may be needed after seeing some strength over the last couple of years. And there’s a number of catalysts that are out there. But from my vantage point, I really think it may be policy sequencing from the new administration. It might be a little bit of a hurdle near term, because we’re going to get visibility on the tariffs front first—well before we get visibility on the green shoots that we’re going to get from deregulation and tax cuts. So put differently, the headwinds are going to come into greater focus than the tailwinds. But this is a progression that’s actually different from the first administration where you saw the benefits from deregulation and tax cuts in 2017 before giving way to 18 months of tariffs-induced choppiness in 2018 into 2019. But I think what’s different this time is that tariffs are not going to become as much of a surprise to market participants today versus six years ago. But also we’re likely going to get some fiscal support for the economy that’s going to overpower some of this tariff drag that we may see in the next couple of quarters. So, again, you may see some choppiness here for the next quarter or two, but a 10% correction is not a foregone conclusion.
Host: So Jeff, you highlighted tariffs. Outside of tariffs, are there any other things that could cause volatility in US equities?
Jeff Schulze: Well, market optimism right now is elevated. You can look at a number of different investor sentiment metrics, but they’re all pretty bullish. One that kind of stood out to me was the Conference Board’s Consumer Confidence Survey. The number of respondents expecting higher stock prices in the next 12 months is the highest in history, going back to the 1980s. So generally speaking, when you have pretty bullish sentiment, you may have a period of digestion. Another reason for maybe some bumpiness comes from the fact that the S&P 500 has elevated market concentration. Right now the top 10 largest companies in the index make up 38.7% of the benchmark, which is a record high. And while this has the potential to be problematic at the index level, it does present a pretty good opportunity for active managers who tend to do better when the average stock is outperforming. In fact, when you look at the top 10 weights of the S&P 500 and they’ve been elevated like today, the equally weighted S&P 500 has, generally speaking, outperformed its cap-weighted counterpart over the next five years. So again, this is a reason why we may see some choppiness. And if you look underneath the surface of the market, a lot of stocks may be doing well on a relative basis, but the index may not move materially higher near term from here.
Host: That sounds like a great opportunity for long-term investors, doesn’t it?
Jeff Schulze: This is a tremendous opportunity from a historic perspective. Now at these levels of market concentration (as I mentioned earlier, we’re at 38.7%), the equally weighted index has outperformed the cap-weighted index by 10% per year over the following five years. So at this level, there’s not a lot of observations. But even if you go all the way back to when the top 10 makes up 25% of the index or greater, you’ve had no negative observations of relative outperformance for the equally weighted index. In every single instance, the equally weighted index has outperformed over the next five years. So it’s a pretty crazy statistic and I think, you know, this represents a really good opportunity for the average stock to start to catch up to some of the larger stocks that have been dominating over the last couple of years.
Host: So Jeff, I mean, what do you see as a potential catalyst for such a move?
Jeff Schulze: There’s a couple catalysts that come to mind, and it doesn’t mean that the markets can’t get more concentrated in the quarters to come, right? In December, the Mag Seven[1] outperformed the equally weighted S&P 500 by 10%. But again, history shows that you typically see mean reversion around these levels of concentration. So from a catalyst perspective, historically it’s been a recession that has seen the equally-weighted index outperform. But I think with the economy being relatively strong right now, the catalyst is going to be broader earnings delivery for the average stock in the S&P 500 and smaller capitalization stocks after years of superior Magnificent Seven’s earnings growth. So when you have better earnings delivery, these stocks should catch up on a relative basis. So, you know, I think that the laggards of the cycle, small caps, mid-caps, value, again, the average stock, you know, have some upside in the environment that we’re anticipating. So earnings delivery is going to likely be better this year.
The second potential catalyst is that the Magnificent Seven stocks derive over half of their revenues from outside of the United States. The S&P 493, 35% of their revenues. Russell 2000, which are small caps, 23%. So at 53%, a substantially larger portion of the Magnificent Seven’s top line comes from outside the US versus other areas of the US equity markets, which makes them a little bit more susceptible to the risks of retaliation should we start to see trade wars escalate from here. So there’s a number of catalysts that that are out there, but all of these catalysts are really fundamental in nature on why you could see the average stock or some of these areas that haven’t done so well start to catch up.
Host: So Jeff, earlier you emphasized US economic exceptionalism. Do you think that US equity market exceptionalism will continue this year? Hasn’t the recent dominance been primarily a function of valuations?
Jeff Schulze: Well, many believe that a period of outperformance for international equities is, you know, quote unquote due after a lot of years of US leadership. And while I think this will eventually occur, global equity asset allocation decisions have been susceptible to the gambler’s fallacy I talked about before for over 15 years now. So if you go back to 2010, 15 years, if you look at the US, or specifically the S&P 500, it’s outpaced the MSCI ACWI ex US, or global equities, by 295% cumulatively. And US equities have led in 13 out of the last 15 years. But I think an important differential here is that this large performance differential has been primarily a function of superior earnings growth, which the US has out-earned the rest of the world by 143% over the same timeframe. So this means that US relative outperformance over the last decade and a half and in particular in the last couple of years have been driven in large part by better fundamentals. And it means that a mean reversion won’t likely occur until those fundamentals change. And I just don’t see those fundamentals changing over the next 12 months. So, I do think another year of US market exceptionalism will happen in 2025.
Host: How do you see positive returns for the S&P 500 with valuations being historically high?
Jeff Schulze: Well, valuations are historically high, but if you look at the average stock in the equally weighted S&P 500, forward P/Es [price/earnings ratios] right now are 16.3 times earnings versus a historic average of 15.4. So the average stock is actually in line with what we’ve seen over the last 30 years. So there’s a lot of opportunity there, but you don’t need multiple expansion to have a positive return this year. If we just hit earnings expectations for 2025 and 2026’s earnings expectations remain intact, the S&P 500’s probably going to deliver mid- to high single-digit returns before you take into the account the dividend that you’re going to get on the index. And the reason why I don’t think that you’re going to see multiple compression or P/Es moving lower is, historically, it’s been unusual to see meaningful multiple compression in periods where you’ve had above average earnings growth, (which is what we’re expecting next year, double-digit earnings growth) and a declining fed funds rate on a year-over-year basis. When you go back to 1996 when you’ve had this combination, multiples have expanded by 1.7 turns on average with a positive hit rate of 82%. So while I don’t think multiples will necessarily move higher from where we currently stand, strong expected earnings growth and a supportive Fed suggest that multiples remain lofty and that earnings growth is really going to drive forward the positive returns that we’re expecting for US equities here in 2025.
Host: We’re coming to the close of today’s conversation. Thank you so much for sharing your insight and perspective with our audience. Did you have a final thought?
Jeff Schulze: I do. I think the big takeaway from the podcast here is that US exceptionalism from an economic and market standpoint will likely continue here in 2025. The economy’s on solid footing with the foundational elements of relative outperformance still intact. The US consumer continues to be a workhorse. You have strong fiscal and monetary supports in place, and productivity gains continue to come through. And with this backdrop, it’s really helped set the stage for healthy corporate profits and outsized US market gains. And while it may be tempting to think that the US is due for mean reversion, investors are probably going to have to wait a little bit longer for the fundamental drivers of US exceptionalism to wane in favor of international equities. So in other words, we think that investors should remain cognizant of the gambler’s fallacy we talked about earlier, or the notion that the next coin flip will be influenced by the last. And if we do get a period of near-term digestion for equity markets, we think that long-term investors are going to be well-suited to take advantage and deploy capital. And we’re expecting the laggards—small caps, mid-caps and value stocks—they could become leaders as we look forward to broader earnings delivery here in 2025.
Host: To all of our listeners, a happy and healthy new year, and thank you for spending your valuable time with us for today’s update as we kick off 2025. If you’d like to hear more Talking Markets with Franklin Templeton, please visit our archive of previous episodes and subscribe on Apple Podcasts, Google Podcasts, Spotify, or any other major podcast provider.
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1. The “Magnificent Seven” are Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia and Tesla.
