Some new years glide in gently, blurring the line between the old and the new. But not 2025 - financial markets have been volatile, and the 10-year Treasury yield has rallied recently. This volatility reflects investor recalibration to evolving economic conditions. Scratching the surface, we see three underlying factors causing this investors' angst.
The December employment data exceeded expectations, suggesting fewer interest rate cuts by the Federal Reserve than previously anticipated. That changed the current market sentiment to expect just one-two additional rate cut in 2025, potentially marking the cycle's conclusion. But the markets are heaving a sigh of relief and rallying today on the latest inflation data. Two numbers, two extreme responses, but both are part of the same underlying volatility plaguing the markets.
The second factor causing apprehension is the meteoric rise of the shares of technology leaders known as Magnificent 7. The sustainability of the technology and artificial intelligence sector rally has become a focal point for market participants. The market-cap weighted structure of the S&P 500 means that outperforming stocks can become disproportionately represented in portfolios. This may result in unexpected concentration risk and heightened sensitivity to individual stock movements.
And the third factor impacting the current market environment is elevated valuations. The S&P 500's price-to-earnings ratio stands at 21.5x, approaching historic highs and nearing the 24.5x peak of the dot-com era. This has prompted discussions about potential market or AI sector bubbles. Higher price-to-earnings ratios indicate investors are paying premium prices for corporate earnings, potentially constraining future returns.
In addition to the above three factors, there is also the specter of policy risk. Tariffs, immigration policy changes, multiple geopolitical situations - all are making investors nervous. And when the markets are nervous, every news comes with heightened magnitude and reaction.
So, what do we, individual investors, need to do in these circumstances? Context is crucial when interpreting market movements. While current volatility may create unease, it's worth noting that the new year has just started. A similar pattern emerged at the start of 2024, but the year ended in sustained market appreciation. Past performance is definitely no guarantee for future results. This comparison is just to note that short-term market fluctuations should not derail long-term investment strategies.
Multiple market pullbacks occur in nearly every calendar year, but markets typically demonstrate resilience in recovering from these temporary setbacks. Attempting to time these movements often prove counterproductive. Investors who maintained their positions through various challenges - including the pandemic, inflation surge, monetary tightening, and global conflicts - have generally been rewarded. The critical consideration is the current fundamental economic and corporate conditions. Unlike the speculative environments of 2000 or 2008, current indicators show continued economic growth, robust employment, and strong earnings from market leaders. For long term investors, market volatility is not a trigger to ditch equity markets. Instead, it can provide us opportunities to participate in the market at better valuations. In additon, market volatility underscore the importance of diversification across market segments that can outperform in different environments. Rather than speculating on the market's future trajectory, we should focus on building diversified portfolios aligned with our long-term objectives and risk profiles.
And last but not least, it is also helpful to remind ourselves that our wealth is more than our portfolios and assets. Our health, our relationships, our community, and our passions are all fundamental parts of true wealth. It is as important to invest in ourselves as it is to invest in the markets, and both investments need care, attention, and discipline. Whatever the short-term distractions be, let us continue to invest in markets and in ourselves, smartly and sensibly.
Lavina Nagar, CFP(R) is the president and founder of Maya Advisors, Inc., a financial planning and investment firm in Palo Alto, California.
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