Charts of the Week: Thankful for the Data

A lot happened in November, so this newsletter is broken into a few different sections. Let’s dive in.

Stocks vs. Bonds - A Volatility Flip

Over the long term – in my data, that’s back to 1926 – stocks have given twice the return of bonds but with twice the volatility. That math is behind the recommended shift from stocks to bonds as investors get older – the ability to weather a 2x volatility differential is dependent on time horizon, which decreases with age.

That said, historical relationships like this aren’t consistent through time (hello 2022!), and the data is currently in the exact opposite position: from a total return perspective, bonds are currently more volatile than stocks. We’ve been here before (here = bottom quartile levels) and it looks to be somewhat mean reverting. Does that mean there is more opportunity in bonds in 2025?

If history is a guide, the answer seems to be no. The more volatile bonds are versus stocks, the more likely stocks are to outperform them over the next year. Looking at data from the 1960s, stocks beat bonds by a whopping 800bps the year following this kind of vol differential. The risk adjusted returns (not shown) are even more significant. This doesn’t mean bonds are necessarily a sale – that 800bp performance gap happens when both asset classes are producing above average returns. Bonds themselves return almost 8%, on average. Bonds haven’t been bad, stocks have just been better.

If you are tempted to think it’s different this time because stocks are expensive (earnings yield vs. treasury yields), I wouldn’t be. As with most things, valuation doesn’t typically tell you what you need to know about future performance. Even when the starting point for stocks is expensive (top half of the distribution), they still have handily beat bonds. Sometimes markets know things are expensive (or cheap) for a reason. Maybe the term TINA (there is no alternative) is back.

Next, let’s jump to the subject that seems to be on everyone’s mind – tariffs & inflation.

Tariffs Aren't Inflationary

 A resurgence in inflation remains a concern as we head into 2025 given the potential for increased tariffs. But the glaring problem is that tariffs aren’t inflationary, at least not from a historical perspective. In fact, during Smoot Hawley, we saw the opposite – tariffs caused deflation, not inflation. John Cochrane (find him on Substack as the Grumpy Economist) talks about tariffs as a relative price shock that destroys demand elsewhere. Unless someone gives you more money to pay higher prices, it likely comes from another area of spending. Meaning: there are usually offsets in other prices.

And our most recent experience with tariffs in 2018 highlighted another offset: currency. A stronger dollar goes a long way to muting price increases. Tariffs will have impacts, especially idiosyncratic ones, but be open minded to the data that suggests it might not be via inflation.

Deficit spending, and the potential for more of it, is another inflationary concern… but with another data problem: even with outsized government spending this year, core inflation - outside the shelter component - remains at or below the 2% target. It’s a little hard to argue that deficits cause inflation in only one area. Moreover, large deficits have been correlated with lower odds of accelerations in inflation.

If you think that happens because larger deficits disproportionately happen in recessions (which are disinflationary by nature), you’d be right. But even outside that, deficits seem to have the opposite correlation to inflation than you might think. So, if your concern is that tariffs and deficits would set us up for another inflationary impulse in 2025 and that neither the Fed nor the markets are going to like that…. the historical data should give you some pause in feeling certain about that investment thesis. What is causing the recent uptick in long yields? Well, long rates don’t go down much when there is growth - and that’s exactly what we have. And growth is more important to the equity market than rates. As long as that’s the case, the bull market should remain intact.

So, if the bull market remains, what’s my sector outlook? I think Financials have the more room to grow in 2025.

Four Reasons to Chase Financials

It’s been quite a run for Financials. A nearly 10% outperformance over the last three months has taken the sector from an almost laggard to the top performing sector year-to-date, beating Technology. What to do after a move like this? Investors’ experience over the last decade has been pretty reliable – the sector goes on to underperform, so they sell it. Historically, the sector has “positive momentum” – meaning you typically want to buy strength, not sell it – but that hasn’t been the case in a long while. To me, the setup looks different, and those differences matter. But first, what’s similar: the stocks are cheap and relative earnings growth has turned up from bottom quartile levels with more room to go.

Both of those situations historically have been significant tailwinds for the sector. To be fair, it didn’t create much durable upside in 2016, which many investors are comparing the recent outperformance to.

But the drivers don’t look like they did in 2016. First, valuation spreads have been pinned near recessionary levels over the last two years. As a mathematical expression of fear, wide spreads are a cautionary flag that if you’re worried about more regulation, more capital requirements, higher (or lower?) interest rates (or insert your personal concern here) …. investors are as well as they have been for quite some time. It increases the probability that bad news is priced in, so the wider valuation spreads are, the more likely the sector has been to outperform. The second significant difference is the backdrop on rates and credit.

It’s easy to call Financials a ‘rate play’, but they aren’t really – the stocks have the proven ability to out or underperform in any rate environment. It’s the combination of rates and spreads that’s mattered. This is a critical difference from 2016: both rates and credit spreads have been declining. Historically, this has been the sweet spot for the sector. Different setups could lead to different outcomes. And based on the data, it looks to me like you could “chase” Financials into 2025.

Any other topics you think I should cover in an upcoming newsletter? Let me know in the comments!

This information is provided for educational purposes only and is not a recommendation or an offer or solicitation to buy or sell any security or for any investment advisory service. The views expressed are as of the date indicated, based on the information available at that time, and may change based on market or other conditions. Opinions discussed are those of the individual contributor, are subject to change, and do not necessarily represent the views of Fidelity. Fidelity does not assume any duty to update any of the information.