As we reflect on 2024 and head into the new year, investors have a lot to be cheerful about. We’ve just potentially witnessed one of the best two-year returns for U.S. stocks in history—the last period the S&P 500 Index posted back-to-back 25%+ total annual gains was in the late 1990s.

Notably, outsize gains have been driven by rising valuations rather than earnings growing; in fact, the trailing 12-month  earnings per share for the S&P 500 Index now stands at $212, below the 2022 high of $215.¹

It’s certainly possible that equities could continue to rally on the back of multiple expansion—the highest forward price-to-earnings ratio of the last 30 years was 24.1x, meaning we’re about 9% from the 30-year high; however, we’ve already come a long way, leaving less valuation upside available in stocks. Adding to the challenge, the 2025 earnings growth estimate for the S&P 500 Index is, in our view, elevated at nearly 15%.¹

Against this backdrop, we suggest that investors resist turning up the volume in portfolios in 2025 by fading recent gains in speculative, lower-quality areas and instead emphasize higher-quality parts of the market that are trading at reasonable valuations.

Managing valuation risk with U.S. mid-cap equities

To mitigate valuation risk into next year, investors will likely need to have a more dedicated value tilt. Looking across the capitalization spectrum, we prefer a mid-cap equity bias to achieve this goal because it allows us to employ a quality-at-a-reasonable-price approach.

A key theme we’ve been focusing on is the build-out of significant manufacturing capabilities across the U.S. Midwest, which has been driven by onshoring activity (supply chains moving to the U.S. from China and other parts of the world).

We believe this manufacturing build-out is most beneficial to more U.S.-focused mid-cap companies, particularly those in the industrials sector. For context, this is a high-quality segment of the market that represents nearly 20% of mid-cap indexes. Crucially, this is a secular theme that investors aren’t overpaying for: Mid caps are trading at the steepest discount to their large-cap counterparts since the late 1990s.¹

Finding relative value in intermediate core-plus bonds

Like equity investors, bond investors have been rewarded over the past two years by taking the greater risk, with the lowest-quality bonds in the credit spectrum seeing the biggest gains. Not only has elevated income contributed to total return within the credit space, but spreads have also compressed notably; in fact, U.S. high-yield bond spreads are now near their lowest levels in history, at 2.66% (the lowest level recorded in the last 30 years was in 2007, at 2.38%).¹

The overall yield on high-yield bonds is 7.4%, which looks relatively attractive when compared with equities; however, relative to investment-grade corporate bonds yielding 5.0% and mortgage-backed securities (MBS) at nearly 5.0%, investors aren’t really getting compensated for the additional credit risk that they’re taking when they invest in lower-quality bonds.

To avoid unnecessarily turning up the volume in bond portfolios, we prefer intermediate core-plus-type mandates with greater exposure to investment-grade corporate bonds and MBS. Such an approach enables investors to target an attractive yield of roughly 5% while not being overexposed to high-yield bonds.

“With equity valuations near all-time highs and credit spreads near all-time tights, we enter 2025 at a challenging starting point.”

Tailwinds in infrastructure/utilities

Another way investors can participate in markets without turning up the volume excessively is by considering an allocation to infrastructure, which remains our favorite category within the alternatives universe. We view alternative investments in two main buckets: return-seeking strategies (e.g., real estate, private equity, private credit, commodities, equity long/short) and risk-mitigating strategies (e.g., global macro, infrastructure, absolute return, systematic trend following, opportunistic fixed income).

With risk assets likely not fully pricing in fundamental or macro risks, we believe that incorporating risk-mitigating options will become increasingly important going into 2025. One of our preferred areas in this category is infrastructure. Exposure to infrastructure allows investors to take advantage of positive structural trends in the utilities and industrials sectors as demand for power and significant investment in electric vehicle and semiconductor production in the United States has accelerated meaningfully amid the AI revolution. Notably, both sectors have seen earnings growth estimates outpace those of the S&P 500 Index.

Listen to the music

With equity valuations near all-time highs and credit spreads near all-time tights, we enter 2025 at a challenging starting point. While favorable earnings growth estimates and solid economic growth could enable risk assets to continue to rally, it’s important to acknowledge the significant amount of value that’s already been unlocked in these parts of the market.

It’s also notable that following the presidential election, markets have shifted gears and a speculative frenzy has taken hold in areas such as crypto and lower-quality/unprofitable growth stocks—a sign that investor sentiment is becoming increasingly positive, albeit one-sided. To help manage valuation risk into next year, we would look to higher-quality parts of the market that are still offering value, such as U.S. mid-cap stocks. We would also reduce credit risk and embrace the income—along with relatively lower risk—available in core and core-plus fixed-income strategies. While we want to keep the music playing by fully participating in the markets, it makes sense to resist the urge to turn up the volume in portfolios going into 2025.