Q1 2025 Review
The first quarter has been a challenging one for many investors. The S&P 500 ended the first quarter down 4.3%, as the market experienced a significant rotation out of recently favored growth stocks into more defensive sectors and foreign markets. The NASDAQ Composite finished the quarter down 10.3% and was the worst-performing of the major indices. The biggest surprise to investors was the outperformance of foreign markets. The MSCI Developed Markets Index finished the quarter up 6.9%, while the MSCI Emerging Markets Index finished the quarter up 2.9%. There was also a significant shift in preferred style by investors. The style box from Morningstar to the right shows market cap and style returns for the quarter[1]. In a major shift, Large Cap Value outperformed its growth peers by 13.48%. This follows a multi-year period of concentration in the market, during which the Magnificent 7 tech stocks dominated the headlines and performance charts.
Investor sentiment turned bearish throughout the quarter. The American Association of individual Investors (AAII) survey showed bearish sentiment above 55% for three consecutive weeks. The only other time this occurred was in March of 2009, and the current decline pales in comparison. The technology sector rallied through the end of 2024 led to the most highly concentrated market since the 1929 peak[2]. The outperformance of technology caused S&P 500 investors to become less diversified, which we believe led to a swift fall in investor sentiment despite the market having only fallen 8.3% from its all-time high of 6,147 in February of this year.
Entering the new year, we had a cautious view of the market and expected volatility to increase, along with a higher probability of a pullback. The three key factors that we cited were:
- Seasonality
- Market Technicals
- Valuations
While the above factors may not have been the sole driving force behind volatility, tariffs and softening economic data also made significant contributions. The Morningstar Style Box above highlights why we believe investors should develop a strategic allocation that is diversified, in line with their desired level of risk, while staying committed to it. These market rotations often happen without warning and come as a surprise to most market participants.
For the first time in multiple years, investors did not look at their bond portfolio performance with disappointment. The aggregate bond index ended the quarter positive by a modest 2.8%. The negative correlation from high quality fixed income was a welcome reprieve from the spike in equity market volatility. The chart on the following page from Morningstar shows the reversal in various categories from bonds quarter over quarter[3].
The fixed-income market saw a significant drop in yields (prices going up) despite the Fed holding policy rate unchanged for the quarter. The 10-Year Treasury Yield started the year off at 4.57% and closed the quarter yielding 4.16%. This was in large part due to softening economic data and growth concerns. The Atlanta Fed’s GDPNow, is forecasting growth to decline by 1.8% in the first quarter. Much of this decline can be contributed to the trade deficit which was brought on by pre-purchasing inventory/materials in preparation for the potential tariffs ahead.
The headlines for the quarter were dominated by tariffs. When the new administration took over there was immediate rhetoric towards a new tariff policy. Economists have debated over the implications, short and long-term, but much of it is unknown until rhetoric turns into action. The end goal of the tariffs is to make domestically produced goods more attractive to US consumers. The increase in consumption and the increased government revenue from foreign produced goods would reduce our trade deficit and would lead to an increase in relative value of the US Dollar[4].
Market participants have reacted to these potential policies quite negatively as we have witnessed an uptick in long-term inflation expectations and worries regarding future economic growth. The actual impacts are yet to be seen and as long-term investors we believe it is prudent to evaluate your portfolio’s current risk exposures to ensure they align with your long-term objectives and to remain diversified across asset class, market capitalization, style, and geography. The actual impacts of these policies, negative or positive, are yet to be seen so investors should be prepared for either outcome.
Q1 2025 Outlook
Equity Market
In the first quarter outlook we noted that the pattern of the S&P 500 rally from the October 2023 low formed a wedge pattern and that the pattern implied slowing momentum in the market which could be an indication of being in the latter stages of a bull market. The chart can be seen below[5]:
This “wedge” indicates each leg of a rally is weaker than its last. The S&P 500 broke its wedge pattern in late February, signaling an end to the bull leg from the 2023 low and suggesting that a corrective period is underway. Despite sentiment turning bearish, actual positioning has yet to turn bearish. Investors still have a relatively high allocation to the equity market despite saying they are uncertain about future market performance. The chart to the right shows that investors still have a 50.5% allocation to equities[6]. For comparison, that figure was just above 35% at the 2022 low and just above 25% at the 2020 COVID low. We believe this figure will need to decline to see a market low and an ultimate sustainable move higher.
From a fundamental point of view, we believed valuations were elevated throughout the quarter. The forward four quarter price to earnings multiple was in the 21-22.5 level for the majority of the quarter. While we these multiples are not at historical extremes, we do believe they are elevated and warrants some caution heading into the second quarter. We believe earnings and the price you pay for the earnings are the most significant determinant of future stock prices. Earnings growth was strong in the last quarter, but earnings estimates have been revised down and continue to put upward pressure on market multiples. Despite the lackluster performance last quarter, the S&P 500 is still trading at 20.5x forward earnings[7]. If you couple this with a 25% reduction in expected earnings growth it leads us to believe volatility will remain elevated and deeper pullback could be in store. The chart below shows Q1 2025 earnings estimates over time7:
Earnings growth expectations have returned back to historical averages, but we believe average earnings growth does not warrant a 20x multiple. Even if we see earnings growth we could see equity market returns less robust than in recent memory due to valuations coming down to historical levels. The 10-year average forward P/E for the S&P 500 is 18.3x[8].
Equity market weakness does not imply a significant drop from current levels. Since 1929, the average drawdown during a market correction (widely defined as a 10% decline) is 13.8%[9]. This drop would imply the S&P 500 reaching 5,299. This also happens to be the average intra-year decline for the S&P 500. Well-defined support for the index resides in the 5119-5265 zone, which is the April 2024 high, August 2024 ‘growth scare’ low, and trendline that extends off of the October 2022 and October 2023 lows. A decline into this range would represent a drawdown of between 14.37% and 16.73% and still be classified as a correction.
Fixed Income Market
Inflation risks remain relevant but are not a major concern in our opinion. From the onset, we believed the final stretch to reach the Fed’s target of 2% would likely be choppy and would take time. Policymakers have made significant progress bringing inflation down and we believe the current policy rate is restrictive enough to ultimately reach the desired level of inflation. but it may not come as quickly as the market would like. The Fed Fund’s future market has priced in two rate cuts for the year, which aligns with recent statements made by the Federal Reserve[10]. If more rate cuts occur, we believe that would be a negative for the equity markets and would likely mean a material breakdown in the economy. Again, that is not our base case, but it remains a possible outcome.
Our long-term view on the fixed-income market remains unchanged from previous quarters. We believe starting yields are attractive opportunities for investors and real returns will increase as the inflation continues to moderate. We also like the risk/return trade off in the bond market. The following chart from PIMCO is a good visual to highlight this:
As you can see, the risk/return profile is skewed in the current environment. Higher starting yields provide downside protection and offer significant upside if we see a decline in rates (this is due to price appreciation in rate cutting environment). We see rates remaining range bound throughout the year with the 10-year yield in the 4-4.75% range. If we do see economic deterioration, and the negative correlation like we have historically witnessed, the upside potential for high quality bonds is significant.
Conclusion
Currently the market is moving not because of market and/or economic factors but more so from factors outside of the market’s purview. We acknowledge the difficulty in blocking out headline noise and the ever-changing political environment. As long-term investors, we believe it easier for investors to do this if they work with their advisor to thoughtfully develop a strategic asset allocation that not only matches their desired risk level but to also meets their long-term investment objectives. We believe going through this process helps investors navigate volatile markets. Headlines can move markets in the short-term, but we believe multi-year returns are little affected by them. We also believe utilizing a systematic rebalancing program can take the emotion out of portfolio repositioning during these times of volatility.
At Krilogy®, we are committed to helping you effectively navigate the ever-changing market environment. As long-term investors, we believe it is critical to remain patient and stick to the plan that was developed for your unique situation to arrive at a personal allocation target. Our entire team remains dedicated to helping you achieve your financial goals.
Sources
[1] MorningstarResearch, Inc. https://www.morningstar.com/markets/13-charts-q1s-dramatic-rotation-stocks
[2] GoldmanSachs https://www.goldmansachs.com/pdfs/insights/pages/top-of-mind/market-concentration-how-big-a-worry/report.pdf
[3] Morningstar Research, Inc https://www.morningstar.com/markets/13-charts-q1s-dramatic-rotation-stocks
[4] Morningstar https://www.morningstar.com/news/marketwatch/20250302182/wall-street-cant-stop-talking-about-the-mar-a-lago-accord-heres-how-the-currency-deal-would-work
[5] KPS Research, Trading View
[6] Paulsens Perspective, https://paulsenperspectives.substack.com/
[7] LSEG I/B/E/S https://lipperalpha.refinitiv.com/wp-content/uploads/2025/03/TRPR_82221_793.pdf
[8] FactSet Research, Inchttps://advantage.factset.com/hubfs/Website/Resources%20Section/Research%20Desk/Earnings%20Insight/EarningsInsight_032825.pdf
[9] Fidelity Investments, https://www.fidelity.com/news/article/top-news/202503131621RTRSNEWSCOMBINED_KBN3FQ1W4-OUSBS_1#:~:text=Since%201929%2C%20corrections%20on%20average,115%20days%2C%20Yardeni%20Research%20showed.
[10] CME Group https://www.cmegroup.com/markets/interest-rates/cme-fedwatch-tool.html
[11] PIMCO, “Advisor Playbook Ahead of The Curve”. Q1 2025
Important Disclosures
Investment Advisory Services offered through Krilogy®, an SEC Registered Investment Advisor. Please review all prospectuses and Krilogy’s Form ADV 2A carefully prior to investing. This is neither an offer to sell nor a solicitation of an offer to buy the securities described herein. An offering is made only by a prospectus to individuals who meet minimum suitability requirements. All expressions of opinion are subject to change. This information is distributed for educational purposes only, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products, or services. Diversification does not eliminate the risk of market loss. Investments involve risk and unless otherwise stated, are not guaranteed. Investors should understand the risks involved of owning investments, including interest rate risk, credit risk and market risk. Investment risks include loss of principal and fluctuating value. There is no guarantee an investing strategy will be successful. Past performance is not a guarantee of future results. Indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio. The S&P data is provided by Standard & Poor’s Index Services Group. Services and products offered through Krilogy® are not insured and may lose value. Be sure to first consult with a qualified financial advisor and/or tax professional before implementing any strategy discussed herein.
