Fourth Quarter, 2024

Click here for a printable version of the Investment Update.

Chevy Chase Trust’s Quarterly Investment Update

Chevy Chase Trust’s unique approach to Thematic Investing weaves together multiple themes across sectors, geographies, and industries, each designed to capitalize on research-driven insights. Listen to our quarterly update of economic conditions and investment strategy.
Everything we do starts with a conversation. Understanding your unique story is key in the development of a plan with your best interests in mind. To connect with us to learn more and begin a conversation, visit chevychasetrust.com.

To read the Q4 2024 Investment Update, visit chevychasetrust.com/fourth-quarter-2024. For more information about Chevy Chase Trust, visit chevychasetrust.com.

Important Disclosures⁠ This commentary is for informational purposes only. The information set forth herein is of a general nature and does not address the circumstances of any particular individual or entity. You should not construe any information herein as legal, tax, investment, financial or other advice. Nothing contained herein constitutes a solicitation, recommendation, endorsement, or offer to buy or sell any securities or other financial instruments. This commentary includes forward-looking statements, and actual results could differ materially from the views expressed. Materials referenced that were published by outside sources are included for informational purposes only. These sources contain facts and statistics quoted that appear to be reliable, but they may be incomplete or condensed and we do not guarantee their accuracy. Fact and circumstances may be materially different between the time of publication and the present time. Clients with different investment objectives, allocation targets, tax considerations, brokers, account sizes, historical basis in the applicable securities or other considerations will typically be subject to differing investment allocation decisions, including the timing of purchases and sales of specific securities, all of which cause clients to achieve different investment returns. Past performance is not indicative of future results, and there can be no assurance that the future performance of any specific investment or investment strategy will be profitable, equal any historical performance level(s), be suitable for the portfolio or individual situation of any particular client, or otherwise prove successful. Investing involves risks, including the risk of loss of principal. The level of risk in a client’s portfolio will correspond to the risks of the underlying securities or other assets, which may decrease, sometimes rapidly or unpredictably, due to real or perceived adverse economic, political, or regulatory conditions, recessions, inflation, changes in interest or currency rates, lack of liquidity in the bond markets, the spread of infectious illness or other public health issues, armed conflict, trade disputes, sanctions or other government actions, or other general market conditions or factors. Actively managed portfolios are subject to management risk, which involves the chance that security selection or focus on securities in a particular style, market sector or group of companies will cause a portfolio to incur losses or underperform relative to benchmarks or other portfolios with similar investment objectives. Foreign investing involves special risks, including the potential for greater volatility and political, economic and currency risks. Please refer to Chevy Chase Trust’s Form ADV Part 2 Brochure, a copy of which is available upon request, for a more detailed description of the risks associated with Chevy Chase Trust’s investment strategy. The recipient assumes sole responsibility of evaluating the merits and risks associated with the use of any information herein before making any decisions based on such information.

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The S&P 500 delivered another year of exceptional returns in 2024. It’s been quite a run. Today, U.S. equity market valuations fully reflect both recent good news and expectations of more, increasing the risk of a correction if inflation picks up, the economy slows or anything else goes wrong. We see the broad markets as less attractive than 12 months ago, but we’re still finding opportunities in individual companies at home and abroad that we believe will better withstand – or even benefit from – the challenges and disruption that may lie ahead.

INVESTING IN FROTHY MARKETS

It was another very strong year for global equity markets, and the U.S. again performed better than most. While the MSCI All-Country World Index generated a total return of 18% in 2024, the S&P 500 Index returned 25%.

The S&P 500 delivered similarly strong returns in 2023, and double-digit returns in five of the past six years. Its price has more than doubled from 2,507 at the start of 2019 to 5,882 at 2024’s close. In contrast, U.S. Treasuries have delivered four consecutive years of negative returns.

SOLID FUNDAMENTALS AND FROTH

There were good reasons for equity market strength in recent years. U.S. economic growth has beaten low expectations, and there still isn’t a recession in sight. In addition, inflation has fallen sharply from its highs of two years ago, prompting the Federal Reserve to lower its benchmark discount rate repeatedly, from 5.25%-5.50% in early September to 4.25%-4.50% at year end. Most analysts expect the Fed to continue cutting interest rates. There is also widespread optimism that the incoming Trump Administration will slash regulations and corporate tax rates, and that artificial intelligence (AI) will improve productivity.

But this “good news” is already reflected in share prices, and there are clear signs of froth. Consider:

The sudden surge in cryptocurrency prices
Massive retail inflows into speculative corners of the market, such as leveraged ETFs and options with zero days to expiration
Stock valuations that imply that every company related to AI will capture a significant share of a massive and highly profitable new market

Not to mention a banana duct-taped to a wall selling for $6.2 million at Sotheby’s.

SEVEN (OF MANY) RISKS TO CONSIDER

For the reasons below, we have worked over the past year to reduce risk in clients’ equity portfolios, and we think it prudent to position more defensively for 2025.

1. High Expectations: At the beginning of 2024, Wall Street economists were bearish, expecting the S&P 500 to rise by just 2% for the year, well below its long-term average annual gain. Instead, the Index rose far more than average. In contrast, the same economists now expect 2025 to be a banner year for equities, projecting above average returns despite slowing revenue growth and margins already near record highs.

2. Very High Valuations: The S&P 500 was trading at more than 26 times earnings at year end, far above its average of 19 since 2008. P/E multiples for the index have only been higher twice: in the 1990s heading into the tech and telecom bubble and for brief periods during the pandemic.

3. U.S. Equity Dominance: U.S. stocks now make up over two-thirds of the MSCI All-Country World Index’s market capitalization, an even larger share than in the Nifty-50 era of the 1970s. At $63 trillion, the total value of U.S. stocks is now four times bigger than all of Europe’s stock exchanges combined. Ten years ago, the U.S. market wasn’t even twice the European markets’ size. The Stoxx Europe 600 Index is trading at a record 40% discount to the S&P 500. In our opinion, U.S. outperformance has gone too far, even given the well-known structural deficiencies of other developed markets.

4. Unprecedented Market Concentration: The top ten companies by market capitalization in the S&P 500 now represent 39% of the Index’s total capitalization, a record high. On average, these companies are trading at about 58 times earnings, more than double the Index P/E, and more than three times their average a decade ago.

Within the top ten lies the Magnificent Seven (“Mag 7”), which drove well over half of the S&P 500’s return over the past two years. These companies may continue to do well in 2025, but we believe their best returns are behind them. Their profit-growth advantage is narrowing, and their market dominance is becoming less assured. Further, much of the excitement about the Mag 7 is tied to AI, which has thus far delivered low returns on investment.

5. High Bond Yields: Yields on 10-year Treasuries are not high relative to history, but they are well above levels typically seen since 2008. Higher bond yields theoretically raise the opportunity cost of investing in equities—particularly growth equities, whose value is expected to be generated far into the future.

6. Policy Risks: November’s U.S. election results buoyed equity markets, and small-business optimism rose markedly. While it’s true that deregulation, a cornerstone of the new administration’s platform, often leads to productivity improvements, and lower corporate taxes should boost earnings, two other pillars of its platform may be less market friendly.

First, widespread tariffs would increase the cost of goods for both consumers and businesses and may depress spending by both. More than half of global trade consists of intermediate goods that will likely be subject to higher tariffs, increasing expenses for both foreign and domestic companies. And the U.S. stock market is not an island: S&P 500 companies derive over 40% of their earnings abroad. After decades of global economic and financial market integration, the fate of many U.S. companies is intricately tied to economic prospects overseas.

Second, tight restrictions on immigration and deportation of current U.S. residents could slow the economy or increase inflation. The recent surge in immigration allowed the labor force to grow rapidly to meet demand, while wage growth normalized. As a result, U.S. policymakers, unlike most peers abroad, were able to moderate inflation without depressing economic growth. If immigration falls substantially and labor demand remains strong, the downtrend in inflation might reverse or economic growth might slow.

According to the National Foundation for American Policy, immigration has accounted for 88% of the growth in the U.S. labor force since 2019. Historically, slower labor force growth has led to slower economic growth.

7. Extremely Broad and High Levels of Equity Ownership: Strong equity market performance over the past several years has enticed U.S. investors to hold more of their wealth in equities. Today, a record-high share of U.S. families across all income levels own stocks, and equities comprise a larger share of total household financial assets than at any time since the Federal Reserve started collecting the data in 1952. That means more people would be hurt by a market drop, which could set off a broad decline in consumer spending and a negative economic feedback loop.

This list is far from all-inclusive. We could also have highlighted risks associated with record-high deficit spending and government debt, which have increased Federal interest expense from $350 billion per year in 2020 to nearly $1 trillion today; or structural issues in residential and commercial real estate; or the slowdown in U.S. job creation.

PORTFOLIO POSITIONING

Our responsibility as portfolio managers is to maximize returns while mitigating risk. In fast-rising equity markets, the responsibility of mitigating risk is often overlooked. It is hard to contend that the balance between risk and reward has not shifted at least a little after the dramatic rise in U.S. equities.

Over the past year, we have been thinking about an old quote from Bob Farrell, who was at the time chief economist at Merrill Lynch: “Exponentially rising or falling markets usually go further than you think, but they don’t correct by moving sideways.”

Farrell wrote this in late 1998, when the tech and telecom bubble was expanding to an unsustainable extreme. Farrell was right, but early. The bubble continued to expand for more than a year, before bursting in March 2000. Leaving the party too early can be very costly for investors, as can leaving the party too late.

We recognize that we, like Farrell, might be too early in taking a more cautious stance. Equity markets rise more frequently than they fall. That’s why we trimmed, rather than eliminated, many holdings that have experienced outsized returns in recent years. In general, we redeployed the proceeds from these sales into areas that have done less well and that, in our view, offer greater return potential.

Assessing the macroeconomic landscape is an important part of our four-step investment process. We use this judgment to weight our investment themes and the holdings within them. Over the past year, we reduced the portfolio weight of our Dawn of Heterogeneous Computing theme. Many of its technology stocks – including several in the Mag 7 – enjoyed outsized returns over the past two years. We believe these stocks are more vulnerable than others if the economy slows or the AI journey stumbles.

After several years of underperformance, our Advent of Molecular Medicine and Next Generation Automation themes look particularly enticing to us. Significant technological advancements in the past few quarters have boosted the prospects for both themes, but this progress is not yet reflected in share prices.

We are now evaluating additions to our End of Disinflationary Tailwinds and Opportunities Abound Abroad themes. With inflation declining globally, countries outside the U.S. will likely stimulate their economies, by increasing government spending and lowering interest rates. Both actions would be likely to boost the relative performance of these two themes.

Energy, a key component of our End of Disinflationary Tailwinds theme, has been the worst-performing sector over the past two years, underperforming the S&P 500 by 54 percentage points. Investors seem to be expecting sharp declines in oil prices, despite all-time highs in global oil demand and very low inventories.

Investors may worry that the incoming President’s “Drill, Baby, Drill” rhetoric could drive up supply, depressing prices. We do not. Large U.S. energy producers have shown incredible discipline in managing their investments, balance sheets and uses of cash. They have reduced capital spending growth in recent years, and aggregate capex remains significantly below the levels of a decade ago, even in nominal terms. Many companies have told investors that they have no plans to increase production at current oil prices. Instead, they are returning cash to shareholders at record payout ratios. We view this as an opportunity.

In general, our portfolios are trading at lower valuations than their benchmark indices, while having similar-to- faster expected earnings growth. That is a setup we like and one we believe can deliver strong relative returns over time.

CONCLUSION

After more than doubling in price since the beginning of 2019, the S&P 500 was near record highs at year end. Therein lies the challenge: Defining an alternative to passive investing in a broad market that has continued to set new all-time highs and appears increasingly driven by flows and exuberance.

As active managers, we don’t invest in the market as a whole. We seek to invest in good companies with superior return potential, and avoid those with inferior potential, based on our research into broad themes that we see reshaping the economy and markets.

As 2025 begins, we are engaged in a delicate balancing act: carefully assessing risk versus reward, selling neither too early nor too late, pursuing opportunities while remaining clear eyed in the face of uncertainty. This is the mission that has energized us for decades.

Important Disclosures This commentary is for informational purposes only. The information set forth herein is of a general nature and does not address the circumstances of any particular individual or entity. You should not construe any information herein as legal, tax, investment, financial or other advice. Nothing contained herein constitutes a solicitation, recommendation, endorsement, or offer to buy or sell any securities or other financial instruments. This commentary includes forward-looking statements, and actual results could differ materially from the views expressed. Materials referenced that were published by outside sources are included for informational purposes only. These sources contain facts and statistics quoted that appear to be reliable, but they may be incomplete or condensed and we do not guarantee their accuracy. Fact and circumstances may be materially different between the time of publication and the present time. Clients with different investment objectives, allocation targets, tax considerations, brokers, account sizes, historical basis in the applicable securities or other considerations will typically be subject to differing investment allocation decisions, including the timing of purchases and sales of specific securities, all of which cause clients to achieve different investment returns. Past performance is not indicative of future results, and there can be no assurance that the future performance of any specific investment or investment strategy will be profitable, equal any historical performance level(s), be suitable for the portfolio or individual situation of any particular client, or otherwise prove successful. Investing involves risks, including the risk of loss of principal. The level of risk in a client’s portfolio will correspond to the risks of the underlying securities or other assets, which may decrease, sometimes rapidly or unpredictably, due to real or perceived adverse economic, political, or regulatory conditions, recessions, inflation, changes in interest or currency rates, lack of liquidity in the bond markets, the spread of infectious illness or other public health issues, armed conflict, trade disputes, sanctions or other government actions, or other general market conditions or factors. Actively managed portfolios are subject to management risk, which involves the chance that security selection or focus on securities in a particular style, market sector or group of companies will cause a portfolio to incur losses or underperform relative to benchmarks or other portfolios with similar investment objectives. Foreign investing involves special risks, including the potential for greater volatility and political, economic and currency risks. Please refer to Chevy Chase Trust’s Form ADV Part 2 Brochure, a copy of which is available upon request, for a more detailed description of the risks associated with Chevy Chase Trust’s investment strategy. The recipient assumes sole responsibility of evaluating the merits and risks associated with the use of any information herein before making any decisions based on such information.