March 2025 Newsletter: Is Volatility Our Friend? Embrace the Volatility

I want to talk about two topics today.  Market valuations and political policy changes in Washington.  Boy, doesn’t this sound like fun!  The markets have never been fond of uncertainty.  And we have uncertainty in abundance.

Stock market valuations are historically high based on the series of charts we will be discussing shortly.  Multiple approaches to valuation all point to the same conclusion.  In addition, the policy changes that are occurring in Washington are adding significant uncertainty to the stock market.  Here are a few key points to consider.

Key Points:

• • Overvalued U.S. Equities: Whether you label it a bubble, a mania, or stretched valuations, the potential for a reversal in U.S. equities is now a serious macroeconomic risk.
  • U.S. economic policy: President Trump embodies a massive rise in policy risk. I’m not commenting on the policies, only on their possible economic impact. Some policies from Washington will stimulate the economy.   Other policies will be contractionary on the economy.  The real wildcard is that we don’t know how effectively a given policy will be implemented.
  • The distorted business cycle: Fiscal largesse (government spending) and the wealth effect have kept the economy afloat but papered up the cracks that are now starting to show through in the labor market and default rates.
  • Geopolitical risk: This had started to recede somewhat since early 2024 but seems to be increasing again lately.

Let’s start with the “Overvalued U.S. Equities.” I am including several charts at the end of my note about long-term market valuations of the U.S. stock market.  One valuation metric made popular by Warren Buffet and thus now called the “Buffett Indicator,” looks at the U.S. stock market value to GDP (chart 1). The next chart is called the “Shiller Cyclically Adjusted S&P Price to Earnings Ratio”, referred to as the “CAPE” ratio (chart 2).  The significance of both measurement tools is that the U.S. stock market is at a two standard deviation event on both charts.  Both tools agree that from a historical basis the market is highly priced.  Neither tool can be used as a timing device.  The market can continue to go up regardless of what these two charts are telling us. However, we do know that historically, once we hit these valuation levels, the stock market return has been low single digits over the next decade.  And of course, what that really means is that there has been a lot of volatility in the market over that decade.

In case the first two charts weren’t enough, I have five more charts from Gibbs Capital Management looking at the market from additional viewpoints.  Chart 3 is plotting the S&P500 Trailing 12-month Price to Earnings.  Chart 4 does the same as Chart 3 but adds inflation (CPI). Chart 5 is looking at Price to Sales.  Chart 6 is looking at S&P500 to cash flow.  And finally Chart 7 shows the S&P500 Equity Value to EBITDA (Earnings before interest, taxes, depreciation, and amortization).  All of the charts show that valuations are stretched regardless of which item you want to measure.

Let’s set the valuation issue aside for the moment.

Let’s talk about the policy changes that have been proposed by Washington.  The policy changes could include but not be limited to tax cuts, higher tariffs, reduced immigration, and government deregulation.   We need to stay focused on the economic and market effects of policy changes or how even just the expectation of policy changes could affect the economy and the stock market.

Some of the policy changes are expansionary and some are contractionary to the economy. For example, immigration (legal and illegal) is stimulating the U.S. economy.  Immigration added 1.6 trillion to the U.S. economy in 2022.  (“How Does Immigration Affect the U.S. Economy,” Council on Foreign Relations, October 30, 2024) U.S. GDP in 2022 was $26.01 trillion. (Google-World Bank) Reducing immigration will reduce GDP in the U.S.  How much GDP decreases will depend upon how effective policies are implemented and whether illegal immigration is replaced by legal immigration.

Do Tariffs raise inflation? Tariffs enacted only once actually cause a price level change as opposed to a sustained increase over time (inflation).  Tariffs continuously moving higher back and forth between countries would be inflationary. I was going to try to explain where the tariffs were heading. Since the plan keeps changing daily that has proven to be difficult. The continuous change probably just proves my point. Every time the plan for tariffs changes, the stock market changes direction with significant volatility.

How the policy changes will combine for a net effect on the economy adds to the volatility.  In addition, how effectively will the policies be implemented?  A fully implemented policy could have a big change, while if it is only partially implemented the change might have a minimal economic impact.

All of this leads back to unexpected actions compounding into volatility in the markets i.e. “Embrace the volatility” and “How do we make volatility our friend?”  There won’t be a single answer this year and different strategies will probably work at different times. Here are my thoughts on what we should be focusing on for this year.

Themes for investing in 2025:

1. Maintain your core positions.
2. Be selective and defensive in equities, focusing on areas with actual fundamental support – currently this means Communication Services, Utilities, Health Care and Financials.
3. Use alternative strategies that could take advantage of volatility. Market neutral investments would be one example.
4. International equity markets are a better value play than the U.S. equity markets. Emerging Asia countries are running at a 13% annualized earnings growth rate projected out to 2026 – beating out the U.S. (11%) but with valuations at just the 49^th percentile reading compared to 95th+ percentile for the S&P500.  Specifically, look at India, Indonesia, Malaysia, Philippines and Vietnam.
5. A little gold won’t hurt. Geopolitical turmoil can make gold a safe harbor.
6. Bonds are probably your friend.

On a Personal Note:

As many of you may know, Rachel and I have been pursuing our own financial dream of building our own home. We spent three years discussing, looking at ideas, and searching for the “perfect location”. We wanted a home in an area of Lawrence near downtown—that meant North Lawrence, East Lawrence, Old West Lawrence or the Pinkney Neighborhood. If you know Lawrence real estate (1) houses in those areas rarely go on the market and (2) finding an existing house to remodel or an empty lot is really difficult! We finally located two abandoned homes in the Pinkney area that just happened to be situated on lots right next to each other. Bingo!  We worked with a great local Architect and Builder and in January moved into our dream home. For any of you who have ever built a home, you know it’s not that simple, but Regina (our Architect) and Kiley (our Builder) made the process seem easy and without many hiccups. As we settle in, we are enjoying (maybe?) going through ALL of our belongings to cull them down to a smaller amount and making the place our home. It’s been quite the process and our decades of working together as business partners helped as we worked together on this project!

Catch you next time,

Phill