Fourth Quarter Review - Higher Interest Rates, a Few Good Stocks
"No state of capitalism is ever permanent or stable. Each new moment in capitalism's history produces new instabilities, and even contradictions, prompting vast spatial, social and political rearrangements."
-- Sven Beckert, Empire of Cotton (2015)
Two important developments are worthy of exploration in this quarter's commentary. First, rising intermediate and long-term interest rates are creating a markedly different environment for bonds and the broader investment landscape. Second, the trends that have characterized stock market returns over the last few years continued to an even greater degree in the fourth quarter and full year 2024.
Bear Market in Bonds Continues, Setting Stage for Higher Future Returns
Most of our clients have balanced accounts, meaning they own a combination of stocks and bonds that aims to align the expected risk and return of the portfolio with a particular client's needs and goals. Stocks and bonds both are meant to contribute to the portfolio’s risk and return characteristics. Following a multi-decade bull run for bonds that ended in 2020, however, intermediate-term bonds have faced a persistent headwind of rising rates for the last four years and offered little to no return.
The Barclays Aggregate Bond index (a sort of S&P 500 for the bond market), lost 3.1% during the fourth quarter and now has a negative return over the trailing three- and five-year periods (-2.4% and -0.3% annualized, respectively).
To clarify, the Federal Reserve did lower short-term interest rates three times during 2024, cutting the Federal Funds rate by about 1%, from 5.25% to 4.25%. These cuts meant that rates for various cash and very short-term fixed income investments declined during the year, as shown on the left edge of the chart below.
At the same time, market-driven rates for longer maturities (3 - 30 years) shifted upward, as they have for each of the last four years.
Source: Morningstar
This chart is also useful in explaining the performance of the bond funds we own in your portfolios. We own a mix of short-term and intermediate-term bond funds. Coming into the year, we felt there was value in very short-term bonds and we emphasized those investments within our balanced portfolios. As the year progressed, short-term rates declined modestly while intermediate-term rates rose modestly, and we decided to shift somewhat toward more intermediate-term bonds. The emphasis on shorter-term bond investments allowed the bond portion of balanced portfolios to outperform the Barclays Aggregate Bond index over the quarter, the year, and longer periods.
A key reason that longer-term rates rose is that the US economy performed more strongly than expected in 2024. Real GDP growth (i.e., after stripping out the impact of inflation) was 2.5% in 2024, based on preliminary estimates. Although unemployment ticked up slightly (from 3.8% to 4.1%), this was due to many new workers entering the workforce. Job growth was very strong (employment grew by 2.2 million jobs). This economic strength, however, contributed to higher than expected inflation numbers. Inflation did decline during 2024, just not as much as the Federal Reserve and others hoped for.
We don't know where interest rates are headed going forward, but a longer-term look at interest rates gives us some context for where we are today. The chart below shows the 10-year US Treasury bond rate over the last fifty years. The multi-decade bull market we referenced is bracketed by the 15.8% peak rate in the early 1980s and the minuscule 0.5% in 2020. From there, rates have risen back up to about 4.6%, still below but much closer to the 50-year average.
Source: YCharts
The good news for bond investors is that the best predictor of expected returns for bonds is the starting interest rate. From where we are today, the probability of positive returns is higher than at any point in the recent past, giving bonds a better chance to fulfill not just their risk reduction role in the portfolio, but also to contribute more positively to returns going forward.
Concentration of Stock Market Value, Performance and Risk Increased Further in the Fourth Quarter
The table below summarizes recent returns for key segments of the markets.
After a brief reversal during the third quarter, the fourth quarter returned to the prevailing trends of the last several years: bigger outperforming smaller, growth outperforming value, and the U.S. outperforming the rest of the world. As you can see above, although the S&P 500 was up during the fourth quarter, it was the only one of the capital appreciation segments in positive territory.
One immediate reaction to the election results was that non-US stocks dropped significantly. On a superficial level, this might be understandable. The promise of reduced regulations and lower corporate taxes for domestic companies, alongside threats of tariffs for the rest of the world, could create a more favorable environment for U.S. based corporations. But this post-election reaction was just the latest leg in a decade and a half long trend over multiple political administrations. That superficial reasoning also doesn't explain the relatively lackluster performance of U.S. small caps over a similarly long time frame.
The key factor that explains much of recent stock returns is the dramatic outperformance of the very largest US companies that have come to be known as the Magnificent 7 (Apple, Amazon, Google, Meta, Microsoft, Nvidia and Tesla). These companies have no doubt delivered strong revenue and earnings growth and been richly rewarded by investors with ever higher valuations. As a market cap weighted index, the S&P 500 has become more and more concentrated in these few companies (as of the end of 2024, they comprised 33% of the index). The below table separates out the performance of the Magnificent 7 compared to the remaining 493 stocks in the S&P 500 over the last four years. 
We are not saying that this performance represents a bubble. On some traditional valuation measures, these companies trade at lofty, but not absurd, valuations, perhaps justified by their strong fundamental performance. What we can say, though, is that the hurdle for continued market success for these companies is becoming stratospheric.
Take Amazon, for example, the median company by market value among the seven. At the end of 2024, Amazon had a market capitalization of about $2.5 trillion after delivering a stellar compounded return of about 20% in the previous five years. For Amazon to deliver to investors a per/share return of just 10% over the next 5 years (still great, but closer to the long-term average for stock returns), it needs to add another $1.5 trillion in market value (assuming its share count holds steady). While possible, it reminds us of Warren Buffett's quote: "I don’t look to jump over 7-foot bars: I look around for 1-foot bars that I can step over." We agree.
To be clear, our stock portfolios do have exposure to the Magnificent 7, just in smaller, and we think more appropriate, proportion than the S&P 500. Our largest fund in the US large cap segment, the Schwab Fundamental U.S. Large Company ETF (FNDX), holds about 13% of the portfolio in these names. This has undoubtedly hurt our recent performance, but we believe our portfolio of holdings that are well-diversified across geography and size, and trade closer to historically average valuations, is mostly filled with lower bars rather than 7-foot bars.
Beyond facing ever higher hurdles, in our role thinking about investing for the future and the Magnificent 7, the most fundamental reason for our caution is that a future in which those same companies maintain and grow their current dominant positions in the economy and drive market outperformance goes against the very nature and history of capitalism. No state of capitalism is ever permanent or stable.
Large Cap Value (LCV) Review
(Not all Bristlecone clients are invested in our Large Cap Value Equity portfolio strategy, depending on the overall portfolio size and the client's objectives and constraints.)
In Bristlecone's Large Cap Value portfolio, we added one new name to the portfolio - Occidental Petroleum (OXY). Occidental is one of the world's largest independent oil and gas producers. Occidental made what turned out to be an ill-timed acquisition of Anadarko Petroleum in 2019, on the eve of the pandemic which brought with it an historic collapse in oil prices and put Occidental in some distress. Since then, oil prices have rebounded and allowed Occidental to generate strong profitability and repair its balance sheet. It has shown itself to be a disciplined capital allocator (combining further attractively priced acquisitions with dividends and share repurchases) and we expect it to generate strong fundamental performance at current commodity price levels going forward. We're happy to invest alongside Berkshire Hathaway, Occidental's largest shareholder.
We also exercised some rights we received from our ownership in Howard Hughes Holdings (a real estate holding company) that allowed us to purchase additional shares of Seaport Entertainment Group (a spinoff of Howard Hughes) at a discount to their prevailing market price. Later in the quarter, Howard Hughes itself received an acquisition offer from its largest shareholder. While we think the offer still undervalues the company, it highlights the attraction of the company's assets and we believe there may be more news to come on this front.
Appreciation
Our community has faced immense devastation this month due to multiple wildfires that ravaged nearby areas, deeply affecting places close to our homes and hearts. We so appreciate that many of you reached out to check on our well-being following these wildfires and we're happy to report that the three of us and our families, as well as our homes and office, are safe and sound with no direct impact from the fires. We have clients and friends whose property was severely impacted and we know the recovery and rebuilding process will be long and difficult. We are here to support and the strong community response to the fires is a hopeful sign for recovery.
We wish you and your families a prosperous and healthy 2025.
One of Bristlecone Value Partners’ principles is to communicate frequently, openly and honestly. We believe that our clients benefit from understanding our investment philosophy and process. Our views and opinions regarding investment prospects are "forward looking statements," which may or may not be accurate over the long term. While we believe we have a reasonable basis for our appraisals, and we have confidence in our opinions, actual results may differ materially from those we anticipate. Information provided in this blog should not be considered as a recommendation to purchase or sell any particular security. You can identify forward looking statements by words like "believe," "expect," "anticipate," or similar expressions when discussing particular portfolio holdings. We cannot assure future results and achievements. You should not place undue reliance on forward looking statements, which speak only as of the date of the blog entry. We disclaim any obligation to update or alter any forward-looking statements, whether as a result of new information, future events, or otherwise. Our comments are intended to reflect trading activity in a mature, unrestricted portfolio and might not be representative of actual activity in all portfolios. Portfolio holdings are subject to change without notice. Current and future performance may be lower or higher than the performance quoted in this blog.References to indexes and benchmarks are hypothetical illustrations of aggregate returns and do not reflect the performance of any actual investment. Investors cannot invest in an index and returns do not reflect the deduction of advisory fees or other trading expenses. There can be no assurance that current investments will be profitable. Actual realized returns will depend on, among other factors, the value of assets and market conditions at the time of disposition, any related transaction costs, and the timing of the purchase.Economic factors, market conditions, and investment strategies will affect the performance of any portfolio and there can be no assurance that a portfolio will match or outperform any particular index or benchmark. Past Performance is not indicative of future results. All investment strategies have the potential for profit or loss; changes in investment strategies, contributions or withdrawals may materially alter the performance and results of a portfolio. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will be suitable or profitable for a client's investment portfolio.This content is developed from sources believed to be providing accurate information, and it may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security.