2025 State of the Stock Market | Brian Feroldi | Ep 531

January 27, 202500:40:03

Explore the latest insights on the stock market performance and investment strategies with friend of the show and frequent guest Brian Feroldi. This episode dives deep into the trends that shaped 2024 and what to expect in 2025, discussing everything...

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[00:00]
A
Hello and welcome to choose a 5. Today on the show we have our good friend Brian Feraldi back on to talk about the 2025 State of the stock market. Ryan is our most frequent guest in the history of Choose A Phi. And he's the one I go to whenever I have questions about the stock market, about investing, especially with individual stock investing. It goes back to the very early days of Choose a Phi. And Brian has opened our eyes in so many ways. He's so intelligent, he's so, he's so well researched, and he's just a wonderful guest. I think you're really going to enjoy this. And with that, welcome to Choose Fi. Brian, always good to see you, my friend. How's it going, Brad?
[00:43]
B
Great to be back. Thank you for having me, my friend.
[00:45]
A
Yeah, you bet, you bet. So, okay, I think we should kick off. Obviously this is going to be the 2025 State of the stock market, but let's do a little, little look back. So let's talk about a review of 2024.
[00:58]
B
Yeah. Well, for all the financial nerds that are listening to this, I'm sure that everybody just updated their financial net worth statement in early January. And if those people had money in the stock market, it's likely that they had a big smile on their face because 2024 was another great year for investors. The large cap index funds, namely the S&P 500, finished the year up 25% and in 2023 it was up 26%. So two 20% plus return years in a row, that can do wonderful things for your net worth.
[01:34]
A
Yeah, ever so slightly. Right, that's, that's not a bad thing at all. Can you give us a sense historically of how anomalous is a 25% increase? Is that something we see fairly often, like just for people who have no sense of this, how regular is that?
[01:51]
B
So if you look back at the long term history of, let's say the S&P 500, the term that get always gets quoted is a 10% annualized return. That's about what people can expect if they invest in the US Stock market for long periods of time. However, that number is a little bit misleading because it's actually quite rare that the market actually returns about 10% in any given year. It tends to overshoot that number and then undershoot that number year by year. So 20% returns are not something that happened frequently, but they're not all that uncommon either. In fact, in the last 10 years, the S&P 500 has returned 20% let's see. 1, 2, 3, 4. This is the fifth time in the last 10 years that the S&P 500 has returned more than 20% in the calendar period. Wow.
[02:39]
A
Yeah, that is, that is remarkable. And, and yeah, it's interesting. I think in the FI community we generally use the back of the envelope, 8% number as an expected annual return. You said 10% is kind of the back of the envelope for S and P over a long term. So that's kind of more what we use for our calculations. But as you said, it's very fleetingly rare. The return is 8 to 10%. There are some years where it'll be down. There are some years obviously where It'll be up 20, 25%. And I think that's hard for people to wrap their minds around, Brian. I think especially when they're used to things like a high yield savings account that just spits off a certain amount of income every month. How do you counsel people to think about stock market returns and volatility versus risk?
[03:27]
B
Well, this always gets back to what you and Jonathan been preaching forever, which is the investor policy statement. And really, when anybody is going to make an investment in the market, the very first question to ask yourself is, when do I need this investment to pay off? This is such a critical question that so many people overlook when they're making an investment. If the answer is any time period less than five years, I don't think the stock market is the place that you should put that capital. Even if the market is looking quite enticing or you're very excited about the market, because simply put in over periods that are less than five years, the returns that you earn from the market are not predictable enough. So if you know that you have like a down payment you want to make on a house or you have kids that are going off to college. So if you know that you need to spend that money in, in the next five years. I don't tell people to put it in the market. However, if you're putting money into the market to pay for things like a FI lifestyle or a long term retirement, or if you're agnostic as to when the returns come, like if you have enough flexibility in your life that the returns could come in year two or year seven or year 13 and you can handle that kind of variability, then you can put money into the market.
[04:35]
A
Yeah, I like that. So five years is your kind of line of demarcation. In essence, if it's sub five years, like you said, maybe the stock market isn't exactly for you. And obviously we're not giving advice to anybody, let's be clear. But we can't give blanket advice to hundreds of thousands of people on a podcast and with any type of specificity. So that's just Brian's back of the envelope. But I think that's probably a good thing for you to consider. And it's funny, Brian, because we were actually talking about buying versus renting houses before we hit record. And I think that's actually kind of the time period that I consider for that as well. It's interesting, like what we all consider short versus medium versus long term. I know I would not buy a house if I was certain or nearly certain I was going to live there for fewer than five years. And it's interesting that you think the same for the stock market because as we know, there's volatility and if people are expecting that 8 to 10% return every year, it's just not the way of the world. It doesn't work that way.
[05:31]
B
Simply, yeah, you're setting yourself up for disappointment. I mean, investing is always an expectations game. It's what the asset is going to return in comparison to what you expect it to return. And investors can get in trouble when those two things are way out of whack.
[05:44]
A
So just one last piece on the look back at 2024. So we talked about S&P 500 being up 25%. I'm curious if we dove into that number or if we dove into different sectors or such. Is this a question of a handful of companies or a couple dozen companies that drove most of the return? Is this a broad economy wide increase? How do you think about that?
[06:09]
B
So as a general statement, the market returns are almost always driven by the largest components. Most people understand that the major indices such as the The S&P 500 are market cap weighed, meaning the larger a business is, the more influence that it has on the returns of the stock market and vice versa. So while there might be 500 stocks in the S&P 500, a minority of those companies, the top 10 drive the majority of the return. And that's one thing that's actually really interesting about today's market. I think most people have heard of the Magnificent Seven, those so called seven major massive tech companies with multi trillion dollar valuations. Those companies are Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia and Tesla. Well, all seven of those companies had stellar 2024 performances. The worst performer of of that group was Microsoft at 12% and the best performer was Nvidia at plus 171% in 2024. So actually what's interesting about that huge outperformance by the largest of the large companies is that if you look at the top 10 stocks in the S&P 500 at the end of 2024, just those top 10 stocks represent 39% of the total value of the index. And that is actually an all time high.
[07:35]
A
Wow. Is there any type of takeaway here for a FI investor who's thinking about investing in individual stocks? I know you, you famously were the one who brought that concept to us because we've long talked about, and it sounds so obvious and self explanatory now, but we've long talked about mutual funds and ETFs and obviously you do as well, let's be clear. But is there some takeaway for someone, both either positive or negative of hey, this is something you should do, or maybe it speaks to hey, this might be too difficult for the average investor. Like, I'm curious, I know this is a very broad, nebulous question, but any kind of takeaways from someone who's looking to invest in individual stocks?
[08:16]
B
Well, if you look back historically at say like the last 30 years, again, it's normal for the largest companies in an index to make up a very large component of the index. But today's concentration in those top names is something that we've almost never seen before. And that by definition means that the returns of the market moving forward are gonna be disproportionately impacted by the returns of essentially those top 10 biggest companies. Now, those top 10 biggest companies, many of which I just mentioned before, are just stellar businesses, perhaps the greatest businesses that have ever been created. And if you look at the fundamentals of those companies, they're all growing strongly, they're all buying back stock or paying dividends. They all have huge opportunities ahead. Almost all of them are benefiting from the buzzword of the day, which is artificial intelligence. So there is reason to be optimistic about the long term potential or the 10 year potential of those companies. However, if you've studied markets for long periods of time, you know that there is always a number of companies that are leading the index and, and capitalism is quite brutal and quite unforgiving. So if you rewind the clock to the biggest, Most dominant companies 20 years ago, only a handful of them would actually still be around and relevant today.
[09:38]
A
Huh? Yeah. That's incredible. That was my next question. Cause I'm certain I always try to put myself in the mind of the Listener. Okay, Brian's sitting here saying the top 10 or 15 companies drive most of the return. So shouldn't I just invest in the top 10 or 15 companies? But how you just ended that clearly suggests, hey, that's not the slam dunk you might be thinking just by hearing this as like a blink kind of reflex response.
[10:02]
B
Right. Well, let's rewind the clock to the year 2000. I'm going to list off some of the largest companies that existed in 2000. And just like today, these companies effectively looked invincible. They just look like dominant, massive winners. So the top companies in the year 2000 were Microsoft. Hey, they're still around doing their thing. But then there's General Electric, Cisco Systems, ExxonMobil, Intel, Citigroup, IBM, Oracle, Merck, Coca Cola and AIG. Now if you know anything about the last 25 years of returns for those particular stocks, many of them have an absolute train wrecks for investors. General Electric has been awful. AIG was effectively wiped out in 2008. ExxonMobil has been a go nowhere stock. Intel is in turnaround mode and they have drastically missed out on the uptick in AI chips. Citigroup was also effectively wiped out in the 2008 financial crisis. Cisco Systems is a shell of its former self. So again, these were the strongest businesses in the world, nearly invincible 25 years ago. And today many of them have provided investors with long term returns that have been horrific.
[11:13]
A
Yeah, it's sobering to see that and I think this speaks to me personally. And again, everyone has their own judgment in terms of how they invest, let's be entirely clear. But I think this is why mutual fund and ETF investing, broad based index funds really appeal to me so greatly that the beautiful part is I don't need to think about it. It's self cleansing. You have a little piece of all of this, I think to me, and we can never know the future, Brian, obviously, but to me this gives me the highest likelihood of success over the only term that matters for me, which is the long term. That's where my mind is. Of course, just like anything, strong convictions loosely held. That is what I believe today. That doesn't preclude me from changing my mind on investing sometime in the future. But nothing has so far gotten to that level where it's made me second guess that. So I mean, for anyone out there listening who's curious what I invest in, the vast majority of my wealth is in VTI and vtsax essentially. And I'm not beholden to Vanguard. Let's be clear. But I think having broad based S&P 500 total stock market index funds, that's where I choose to invest essentially all of my net worth. I do have, as you know Brian, a decent bit of Berkshire Hathaway stock and a little bit of Markel. So I don't want to say here that I have no individual stocks, but really the vast majority is in VTI at this point.
[12:37]
B
Yeah, and I think that is the correct thing for the vast majority of investors to do. However, I do think it's important that if that is your strategy, you just have to be aware that markets move in cycles. And generally speaking, when large cap stocks perform very well for long periods of time, which they have for essentially the last 16 years, it is not uncommon from a market historic perspective for then those stocks to underperform or revert to their have a mean reversion feature of them over the next 15 years. In fact, if you look back at the year 2009, essentially from 2000 to 2009 was a period of net negative returns for large cap stocks. So While the last 15 years have been sensational and large cap stocks have been the place to be, there have been plenty of periods historically where where large cap stock delivered substandard returns for their investors. In fact, famed investor Howard Marks, who's one of my favorite market commentators to read, recently put out a memo where he noted that with the valuation of The S&P 500, where it is today in the S&P 500 has similar dynamics to it as a Vanguard Total Stock Market Index. He said that historically over the last 30 years when the S&P 500 had reached levels that it's at today from a valuation perspective, the Future returns, the 10 year returns of the market essentially net out to zero for a ten year period. So he wasn't predicting that that was going to happen. But he did point out that we've seen this before and the net 10 year returns for investors from these levels have not been good.
[14:19]
A
Yeah, I mean that is, it's certainly sobering and again I'm using that word twice in five minute span here. But this is important. I think this is the perfect launching off point for the 2025 State of the stock market. Right. Because it is interesting when you think about it Brian. I mean if you're Talking the last 15 years, the returns have been stellar in the stock market. You've got a 40 year old person who maybe started investing at 25 and they've known nothing but good years. And that's a significant. That's a generation or two maybe. Right. And you have a lot of people who have except for the tiny little obviously we had the COVID The very short lived Covid drop. There are always periods where the stock market goes down, but in totality, 15 years of essentially nothing but up that I think we go back to that investor policy statement you talked about a couple of minutes ago. I think we all need to get our heads right because you simply don't know what the future brings. But yeah, you listen to someone like Howard Marks and it's. You'd be a fool to ignore that.
[15:21]
B
Yeah, I think that that's right. And again, the takeaway for me when I read his memos and I like evaluations today isn't Chicken Little, isn't the sky is falling, isn't need to do I need to do a wholesale change. But perhaps a takeaway is to be even more conservative with your assumptions about returns that you can get from the stock market moving forward and even perhaps to consider putting a larger portion of your portfolio into fixed income. So bonds and I will once again reference people to that wonderful episode that you did a few years ago with Frank Vasquez on the bonds, which to me is something that I re listen to annually.
[15:58]
A
Yeah. And Brian, that's episode 194 with Frank Vasquez. It's the role of bonds in a portfolio. And yeah, I know a lot of people consider that one of our absolutely best episodes. So yeah, it's nice to hear that you go back and listen to that so often. Thanks for listening to Choose A Vi and for all your support of our mission here. The absolute best way to support Choose a Pie is when you sign up for your next rewards credit card to use our cards page at choose a buy.com cards. I keep this page constantly updated so it should always be the top resource for you. Thanks for being part of our community and for your support. So Brian, you talked about valuations and I know that's something you've done some study on. So I'm curious again, 2025 State of the stock market, where are we with valuations?
[16:45]
B
Yeah. So every 90 days JP Morgan Asset Management actually puts out this wonderful presentation that is an updated state of the stock market. So a lot of the charts that I'm going to be referencing or the data that I'm going to be referencing is actually pulled from that. So in there they have a wonderful visual which shows the S&P 500 forward price to earnings ratio. I think many people are Listening understand what the price to earnings ratio of is. But that word forward might give them a little bit of raise an eyebrow. So what this is is it's the current value of the S&P 500 divided by next year's estimated earnings per share. So The S&P 500, like all markets, are forward looking mechanisms, they're always looking to the future and specifically the near term future to figure out where valuations can be. So JP Morgan has this wonderful a 30 year chart that shows the forward price to earnings ratio of the S&P 500. And then they put some simple standard deviation bars on there. And these can be used as a very rough proxy for is the market expensive right now or is the market cheap right Now? So the 30 year average for the S&P 500's forward price to earnings ratio is right around 17. Now of course there's periods when it's significantly above that number and, and significantly below that number, but that's still the long term average as a benchmark. Well, as of the end of 2024, according to JP Morgan, this number was 21.5. So effectively more than one standard deviation above its long term average. And unfortunately, if you look at the last two times that this number was above one standard deviation above its long term average, well, the most recent one was 2020 and 2021. And I certainly have the scars of 2022 drilled into my head. And then the last time it was above that number or this high was 1998 through 2000, which again was the peak of the market. So again, looking back at recent history, 30 year history, valuations today are roughly in line with the last two market highs.
[18:59]
A
Okay, so Brian, I certainly get that and obviously the historical reference, but ultimately I think what we're all asking is what does this actually mean based on the only thing we care about, which is our own future returns, essentially.
[19:13]
B
Yeah. So again, JP Morgan has wonderful, they have a scatter plot chart on here which shows, okay, when valuations are at these levels, what are the returns that investors get moving forward basis? And they actually have it on a one year basis, five year basis and ten year basis. So on a forward one year basis, the returns are actually all over the map. And that would be exactly what you would expect. Just because markets have gone up recently or valuations are high, that's actually a pretty poor predictor about what they're going to do over the next 12 months. The next 12 month returns of the market are always effectively random. However, if you look at longer term Time periods. So five year and ten year periods, that's when they become a little bit more predictable. And if you look at the five year returns at valuation levels that are similar to where they are today, there is an inverse correlation between starting valuation and future returns. The lower the starting valuation, the higher the future returns are and the higher the starting valuation, the lower long term returns are. So based on JP Morgan's data, it looks like low to single digit 5 year returns are about what the markets have done historically. But if you zoom that out to a 10 year period, which is I would argue is even more accurate data, the return expectations goes effectively towards zero with a slight deviation up or down. So again, I think the takeaway for this is if you're going to be investing from today and you have a long term time horizon, it's reasonable to pull back on the expectations that you have for the market. You mentioned previously that investors tend to use an 8% return or as a rough guide, the prudent thing to do for long term projections of your net worth might be to pull that back even more.
[20:59]
A
Okay, so right, pull back on expectations is what we're saying here. And I guess Brian, I'm curious. So you mentioned AI before and obviously we can never know the future. Right? And I kind of hate the whole prognosticating game frankly of like the financial media porn of oh, is it going to go up, is it going to go down? I ultimately we have no idea. But for someone who's sitting there saying, okay look, I get what Brian's saying, I get the history, but it feels like we're at an inflection point with where humanity can go. Do you have any thoughts? I don't mean specifically on AI necessarily, but for somebody who's sitting there saying like, okay, do I just look at history and say, all right, there's a reasonably high likelihood that my returns are going to be sub what I might have expected a couple years ago versus oh wow, maybe this time is different. And I always hesitate to ask that question, but I'm curious nevertheless, your thoughts?
[21:54]
B
Yeah. So the data that we presented is by its nature backward looking, based on history. When this has happened in the market. Here is a set of things that have happened in the future that you can use to guide your expectations. But to your point, I don't want to come on here and pretend to be Mr. Doom and Gloom. Like for the record, 90% of my net worth is still in the stock market as of today and I expect it to be have a heavy dose of stock market exposure essentially indefinitely. But there are reasons, potential reasons to believe that returns in the future might be higher than they have been historically, based on what you just said, given all the disruptions that are going on in the world right now, from a artificial intelligence perspective, from a biotechnology perspective, from a robotics perspective, from a clean energy perspective, to say nothing of Elon and Doge coming into office and potentially getting rid of lots of regulations which could in theory open up, grow our economy faster. All those things are certainly possible. And markets are nothing but forward looking discounting instruments. So there are legitimate reasons to believe that, well, perhaps earnings growth or profit growth over the next couple years might be higher than they have been during more historic periods because of everything that we just mentioned. And if that is the case, then perhaps valuations today are justified, given that stronger growth might be coming.
[23:25]
A
Yeah, it's an interesting case and obviously we, we don't know, but I think we all just need to just think broadly, keep aware. I think that that's all we can do, Brian, at the end of the day, right? Like, we just have to try to stay on top of this. That's why we have amazing guests like you come on the podcast and talk through this stuff because anytime and, and I'm talking for the financial independence community here. I, I think we are the most adept thinkers and people who understand the world and understand that things change all the time. So I never want to be monolithic about anything. Like, we only invest in the total Stock Market index fund. Like, no, that's not how, that's not how the world works. You have to always update your thinking. I think that's a really important intellectual exercise. But I think also it helps you stay nimble for opportunities like that. Brian, that's a beautiful aspect of life, is things are constantly changing. I feel like the FI community specifically, like, we're always on top of, hey, how can we maximize this new rule or whatever it may be. Like, we find ways and I think it's really interesting. So I guess I'm curious, are you. So we're recording this in the beginning of January of 2025. I know you said 90% of your net worth is still in equities. Are you contemplating or are you taking action on changing anything in your portfolio? I know we've talked previously how you think through your own portfolio construction. Can you give a quick overview of that for someone who probably hasn't listened to that episode and maybe how you're thinking about it now?
[24:58]
B
Sure. So to give you a high level Overview. My personal portfolio, my equity portfolio is a combination of index funds, broad based index funds such as Vanguard Total Stock market index funds, emerging markets, stock market index funds, and effectively my retirement accounts are 100% index funds. Beyond that, my cash, my taxable account that is 100% individual stocks. And I am a by and large long term buy and hold quality investor. So I log into my brokerage account two to three times per year and add or subtract individual stocks from them. So I am quote, unquote active with that portion of my portfolio, or at least more active than I would be if I was just purely a passive investor. And I can say from my perspective, I do monitor the valuations of the companies that I hold. And actually what 2022 taught me is that I should monitor the valuations of the stocks that I hold more closely, especially when there are big macro changes going on in the world. So I can say for myself that I am at a record high cash balance in my individual stock portfolio. I'm currently about 15% cash, which for me is on the higher side. And I could actually see taking that number higher over the next month or two given where valuations are with the hope to be able to redeploy that capital, but more favorable valuations if some of my favorite investments went on sale. But again, that is what I choose to do with my money. And I'm more comfortable with being a little bit more active with valuations where they are. But if you're just a passive investor who just wants to essentially set it up once and, and buy and forget, that strategy is still valid today.
[26:36]
A
Yeah, and I would echo that. I personally am not changing. As of this moment, I have not thought about changing anything in my own equity portfolio, nor putting additional money in. I'm continuing to do that month after month, essentially year after year. But that said, again, strong convictions loosely held, right? You can never say that I'm not going to change that, but as of right now, that's where I am. And yeah, I mean, I think we all just have to educate ourselves. I don't want to sound like a broken record here on the episode, Brian, but I think it's important and I think anytime you stick your head in the sand and assume something's going to work forever, you have a rude awakening. You know, look back Those the top 10 companies in 2000 like you mentioned earlier, right? It's, it's easy to think things will go on forever. And just the fact of history is it doesn't seem to work that Way.
[27:25]
B
One thing, Brad, that you said earlier that I just want to echo and even reiterate is the choose fi community is probably the best positioned community out there for whatever is going to come our way. When you have a very high savings rate, when your expenses are quite low in comparison to your income, and when you can be importantly flexible with your investing strategy and with your spending strategy, I think that that sets up the financial independence community to essentially thrive no matter what the markets throw at us. So even if the markets on a broad base return a very low number over the Next, let's say, 10 years, that might be devastating to many people who are at or near retirement and they need strong returns to pay for their lifestyle moving forward. But if you're in the asset accumulation phase or if you can simply be flexible with your spending patterns, what the market does over that time period won't impact you nearly as much as it would if you had a high expense lifestyle.
[28:23]
A
Totally agreed. I think savings rate to a large degree cures all. I know this is what I counsel my daughters is essentially if you have a 50% savings rate and it's easy, it's easy obviously for kids who, who haven't made mistakes and are just getting into life, but if you have a 50% savings rate, it's pretty darn hard to screw up your financial life. So I know I can speak from experience and making terrible investments and speculation in real estate and all this stuff. And by any measure I've reached financial independence and that's, that's a really nice thing. So yeah, like Brian said, we are set up wonderfully. So Brian, I wanted to go back to the state of the stock market. So we talked before about these largest companies, right? Certainly the seven, but I expect it extends a little beyond that. Are people rightly concerned about market concentration if this is something that's flittered through their mind or they read it on a CNBC article or something like, hey, the top 15 companies make up X percent, 30, 40, whatever. You know, you said earlier, is this something that is just kind of par for the course in terms of stock market? Is this something that we are at a historical anomaly? Is this something that you're concerned about? I just love to hear your thoughts generally.
[29:36]
B
Well, again, it gets back to the fact that the companies that are the largest components of the stock market today, they are all effectively some of the best businesses that have ever been created. They effectively hold monopoly or monopoly like positions in their market. They're all unbelievably profitable. Many of Them are still led by their founder or at least a longtime executive. And all of them, nearly all of them, are taking advantage of AI, which is a huge investment today, but could turn into huge amounts of profit in the future. So the market is not stupid. The market recognizes and has awarded these companies huge market values because they're just excellent businesses. And it's also, you could also reason that given where we are with communication technology and how interconnected the world is, perhaps we can support multi trillion or even multi 10 trillion dollar companies today, given how easy it is for communication to to happen in between companies, whereas in previous generations that would have been just impossible to do. Moreover, these companies are also what's called asset light, meaning that they don't need a lot of physical infrastructure, big things to actually produce profits. Whereas again, companies of the past that have dominated did so. These businesses are excellent and if you analyze any of them on an individual basis, you can probably come up with a reason why the company is trading at the valuation that it is. So again, this is more of just something that I am aware of and I am thinking about and some of the smartest money managers out there are raising as a potential issue. I don't think you should take action on it yet, but I do think it's something you should be aware of.
[31:19]
A
Yeah, fair enough. I'm smiling because I always like to needle you on Tesla, but obviously the returns have proven you right to date. But we will see. I'm not the biggest Elon fan. Any decade now you'll be right, to put it mildly. And it reeks of meme stock, but we will say any decade. That's awesome. Brian. Market share. Market share. Most investors have home country bias, right? I think we are no exception, but I think a lot of people who invest in US equities can say with a straight face, okay, maybe our home country bias makes a little more sense than if you were in Finland or England or wherever. That said, I'm curious how you think at this point in time about the US versus the world when it comes to investing.
[32:07]
B
Yeah, this is another interesting tell sign. Again, dialing back to that JP Morgan asset market presentation. What they actually showed was that if you added up all of the value of all the publicly traded companies in the world and then categorized them by what country are they located in? The United states effectively has 2/3 of the value of the entire stock market across the world, 2/3 to despite the fact that effectively the US is 5% of the global population. Now, again, a big component of that is driven by these huge, massive, unbelievably successful companies that we've referenced many times. But on the flip side, because 2/3 of the market value is in the U.S. that means that the balance between market values in the United States versus internationally has shifted drastically towards the US and again, if you look back historically at the dynamics between these functions, international stocks and US Stocks tend to go in and out of fashion where there are periods when the US dominates like it has over the last 20 years now. And then there are other periods such as like the 1970s when international stocks really dominate. So there could be reason for investors to consider increasing their allocation to international markets. If you are in the US if you're seeking more diversification, okay, so seeking.
[33:30]
A
More diversification is ultimately is the point there. Because I think a lot of people, they might claim that, but they're just chasing returns or they're just saying just something unsophisticated like oh, the US has outperformed for X number of years, it has to revert to X. Right? Like how would you respond to somebody who says that just off the top of their head like, oh, the US has outperformed, it has to turn around eventually. Is that even a plausible thing thought or is it truly like a diversification play like you're saying? I know that's a very broad question, but I'm just curious, like your quick hit thought.
[34:04]
B
Well, my quick hit thought is that you can actually get a decent amount of international exposure through the United States stocks. For example, take a company like Apple or Nike or McDonald's. Yes, they might be US companies that are listed in the US but they actually get a pretty sizable portion of their revenue for from international markets. So US Companies by their very nature, while their market cap might be associated with the United States, the companies behind them actually are more diversified geographically than you might naturally assume. But again, I always think it's useful to use history as a guide. History doesn't repeat itself, but it does rhyme. And if you look back over the decades, there are periods when international stocks go in and out of favor, just like there are people periods when asset classes go in and out of favor. And as a general statement, things that outperform tend to go on to underperform and things that underperform tend to go on to outperform. So again, I don't think you have to take an action based on the fact, but there's no doubt that the United States has been the dominant market and the best performing asset class for 15 years now. And it is possible that, that over the next 15 years, international stocks will have this time in the sun.
[35:17]
A
Yeah, Brian, we spent most of the episode talking about large caps and really these seven stocks, et cetera. Brian, there are a lot of people who think about, okay, small cap or mid cap, like different options other than just, hey, these are the absolute largest companies. I'm curious how you think through that in terms of portfolio construction. I know again, we've spent most of the episode talking about, hey, most of the return has been driven from these top, top companies. But again, like we just talked about with us versus the world, okay, sometimes certain segments overperform and there is some mean reversion. Is there any leg to stand on for somebody who's like, hey, maybe it's time to start looking at small cap?
[36:01]
B
Absolutely. If you look at again, the last 10 years, the returns of large cap stocks S&P 500 have been about 13% annualized basis. But if you look at small cap stocks, they've only been about 9% annualized. So that's a 4% delta, which doesn't sound like that big of a deal. But hopefully people that understand compound growth understand that over a long period of time that can be a huge difference between the two. So again, there could be reasons for you to consider upping your allocation to parts of the market that have underperformed. So small caps are certainly in there. Mid caps are in there. We've already covered international stocks. Another component to perhaps consider would be real estate and real estate investment trusts, which are publicly traded companies that invest in real estate. REITs, as they're called, have only returned 5% on an annualized basis over the last 10 years. And they've had a rough go in the last couple of years, especially due to Covid, which just threw a major monkey wrench into big parts of the real estate markets, namely office space. So again, if your goal is diversification and to lower your risk that you have, or the lower the concentration that you have in your portfolio to these mega cap companies, perhaps you should consider increasing your exposure to other parts of the market. So we talked about mid caps, small caps, international stocks, REITs, or heck, even fixed income.
[37:17]
A
Yeah, Brian, obviously this has not been a doom and gloom episode by any means. But I'm curious, are there reasons for optimism moving forward?
[37:26]
B
There are always reasons for optimism. And if you have a pessimistic mindset, you can find endless information to support that. And thankfully, the inverse is always true. So again, I'll point to that wonderful Howard Marks memo that he recently came out with. And he basically says, yes, valuations are high today, but they're not insane. Yes, the valuation of the Magnificent Seven is high, but they're incredible companies with realistic growth expectations ahead of them. Yes, valuations are high, but he doesn't see true signs of excess like we saw in say, 1999, where people were saying there's no such thing as too high of a price for an exes and companies. And moreover, markets are highly priced today, but there are plenty of pockets in there that are not at extreme levels. Moreover, if you talk about the things that we talked about before, with potential deregulation coming with AI, with robotics, with biotechnology, with all the disruptive innovation that's out there, I could see plenty of reasons to believe that growth moving forward could actually justify valuation. So like anything, the there's always reasons to be optimistic, there's always reasons to be pessimistic. The investor's job is to keep both in their mind at the same time and not go crazy.
[38:39]
A
Yeah, isn't that amazing how confirmation bias works, right? Like if you are looking for reasons for anything in life, you pretty much can find it. But as Brian just described, it's about being intellectually open and curious. And there is obviously skepticism. Anytime you get locked into anything, you need to be skeptical, you need to bring in new information and you can hold competing ideas in your head at the same time. That's okay, right? It's often derisively called cognitive dissonance, as if it's always a bad thing. But frankly, we need to think about these things and we have to be aware and we have to look down the field of life, if you will, a 50 year field, and see, all right, what makes the most sense for us. And I think that really is a hallmark of the financial independence community. So, Brian, I'm curious, are there any closing thoughts, any other aspects of the market for 2025 you want to talk about?
[39:32]
B
My closing thought would be the same thing that it always is. No matter where you are as an investor, the first step is to educate yourself, understand any of the terms and go and look up any of the terms that we said on the show that you did not understand. And perhaps you could even link to that JP Morgan report in the show notes for the podcast. But over the long term, the stock market has been a great place for investors to park capital, so I see no reason to believe that that shouldn't be the case moving forward.
[40:01]
A
Brian, I always love having you on. It's greatly appreciated your expertise and your friendship to this whole community. So thank you as always. Where is the best place for people to find you or to reach out?
[40:12]
B
Yep. So as a general statement, if there's a social platform that you like, I'm on it. So just type in my name Brian Feroldi and you can find interact with my content.
[40:21]
A
Wonderful Brian. Thanks again.
[40:23]
B
Thank you for having me, Brad. Always awesome to be here.
[40:25]
C
Thank you for listening to today's show and for being part of the choose if I community. If you haven't already, the best ways to get involved are first subscribe to the podcast. So you're listening to this on a podcast player, just hit subscribe and then subscribe to my weekly newsletter. I actually sit down every Monday and write this by hand and I send it out Tuesday morning. So just head over to choosefi.com subscribe and it's really, really easy to get on the the newsletter list right there and I would greatly appreciate it. It's the best way to get in touch with me. You can actually just hit reply to any of those emails and it comes directly to my inbox. So that's the way that I keep a pulse of the community and how we keep this the ultimate crowdsourced personal finance show. And finally, if you're looking to join an in real life community, we have choose a vi local groups in 300 plus cities all around the world. So head to choose a vi.com local and you'll find a list of all of Those cities in 20 plus countries all across the world. And if you're just getting started with FI or you have a family member or friend who you think would be interested, two easy ways choose a VI episode 100 is kind of our welcome to the FI community and even though it's a couple years old at this point, it still stands up and it's a really great just starting point to get an understanding of what is financial independence. What are we doing here? Why are we looking to live a more intentional life where we save money and use it as a springboard to live a better life and then choose a VI created a Financial Independence 101 course that's entirely free. Just head to choose a vi.comfi101 and again, thanks for listening.

2025 State of the Stock Market | Brian Feroldi | Ep 531

January 27, 202500:40:03

Summary5 min read

ChooseFI Podcast Episode Summary: "2025 State of the Stock Market | Brian Feroldi | Ep 531"

Release Date: January 27, 2025

Introduction

In Episode 531 of the ChooseFI podcast titled "2025 State of the Stock Market," hosts Brad and Jonathan welcome back their frequent guest, Brian Feroldi. Brian, a seasoned investor and financial expert, delves into an in-depth analysis of the stock market's performance in 2024, historical trends, investment strategies, and future outlooks.

Review of 2024 Stock Market Performance

Brian begins by highlighting the stellar performance of the stock market in 2024.

[00:57] Brian Feroldi: "2024 was another great year for investors. The S&P 500 finished the year up 25%, and in 2023 it was up 26%. So two 20% plus return years in a row, that can do wonderful things for your net worth."

He emphasizes the significant returns achieved through large-cap index funds, particularly the S&P 500, which saw substantial growth two years in a row.

Historical Context of Market Returns

Brad prompts Brian to contextualize the 25% increase by comparing it to historical data.

[01:50] Brian Feroldi: "The long-term history of the S&P 500's annualized return is about 10%. However, 20% returns have occurred multiple times in the last decade, marking the fifth occurrence in the past ten years."

Brian explains that while a 10% annualized return is often cited, the market frequently experiences significant deviations, with years surpassing 20% not being exceedingly rare in recent history.

Investor Mindset: Expectations and Volatility

The conversation shifts to managing expectations amidst market volatility. Brian underscores the importance of an Investor Policy Statement, advising on investment horizons.

[03:26] Brian Feroldi: "If the investment period is less than five years, the stock market might not be the appropriate place for that capital due to unpredictability in short-term returns."

He advises investors to align their investment choices with their financial goals, cautioning against short-term market investments for near-term needs.

Market Concentration and Top Performers

A significant portion of the discussion focuses on market concentration, specifically the dominance of the "Magnificent Seven" tech giants.

[06:08] Brian Feroldi: "The top 10 stocks in the S&P 500 represent 39% of the total value of the index, an all-time high. Companies like Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia, and Tesla led the charge, with Nvidia soaring by 171% in 2024."

Brian highlights the disproportionate influence of a handful of large-cap companies on the overall market performance, noting both their impressive growth and the inherent risks of such concentration.

Investment Strategies: Index Funds vs. Individual Stocks

Brad inquires about the implications of market concentration for individual investors and the merits of index funds versus picking individual stocks.

[08:15] Brian Feroldi: "While the largest companies are currently driving most of the returns, history shows that relying solely on top performers can be risky. Many once-dominant companies from the past have faltered, underscoring the unpredictability of individual stock investments."

Brian advocates for broad-based index fund investing, emphasizing diversification as a safeguard against the volatility and unpredictability associated with individual stocks.

Valuations and Future Return Expectations

The discussion delves into current market valuations and their implications for future returns, referencing insights from Howard Marks and JP Morgan Asset Management.

[16:44] Brian Feroldi: "The S&P 500's forward price-to-earnings ratio stands at 21.5, over one standard deviation above its 30-year average of 17. Historically, such high valuations have corresponded with subdued long-term returns."

Brian cautions investors to temper their return expectations, suggesting that historical patterns indicate lower future returns when current valuations are elevated.

Global Diversification: US vs. International Markets

Brad brings up the topic of home country bias, prompting a discussion on the importance of international diversification.

[32:07] Brian Feroldi: "The US comprises two-thirds of the global stock market's value, a disproportionate figure given its 5% share of the global population. Diversifying into international markets can mitigate risks associated with market concentration in the US."

Brian recommends considering international exposure to enhance portfolio diversification, noting that global markets periodically outperform US markets.

Portfolio Construction: Small Caps and Other Segments

Exploring further diversification, Brian discusses the role of small-cap and mid-cap stocks, as well as other asset classes like REITs.

[36:00] Brian Feroldi: "Small-cap stocks have underperformed large caps over the past decade, offering a potential avenue for higher future returns. Additionally, REITs and fixed income can provide diversification benefits and reduce portfolio concentration risk."

He suggests that investors evaluate underrepresented market segments to balance their portfolios and capitalize on areas with growth potential.

Optimism and Closing Thoughts

Despite acknowledging market challenges, Brian shares reasons for optimism, citing advancements in technology and potential economic growth drivers.

[37:26] Brian Feroldi: "There are legitimate reasons to believe that innovations in AI, biotechnology, and clean energy could drive stronger future earnings, potentially justifying current valuations."

Brian encourages a balanced perspective, advocating for both cautious optimism and prudent investment strategies.

Final Takeaways

Educate Yourself: Understanding market terms and trends is crucial for informed investing.
Diversify: Spread investments across various sectors and geographies to mitigate risks.
Align Investments with Goals: Ensure that your investment choices match your financial timelines and objectives.
Stay Informed and Flexible: Continuously update your investment strategies based on evolving market conditions and personal financial situations.

Brian Feroldi concludes by reinforcing the importance of education and long-term investment strategies, maintaining confidence in the stock market as a viable avenue for capital growth.

Notable Quotes

Brian Feroldi [00:57]: "2024 was another great year for investors. The S&P 500 finished the year up 25%, and in 2023 it was up 26%."
Brian Feroldi [03:26]: "If the investment period is less than five years, the stock market might not be the appropriate place for that capital due to unpredictability in short-term returns."
Brian Feroldi [06:08]: "The top 10 stocks in the S&P 500 represent 39% of the total value of the index, an all-time high."
Brian Feroldi [08:15]: "While the largest companies are currently driving most of the returns, history shows that relying solely on top performers can be risky."
Brian Feroldi [16:44]: "The S&P 500's forward price-to-earnings ratio stands at 21.5, over one standard deviation above its 30-year average of 17."
Brian Feroldi [32:07]: "The US comprises two-thirds of the global stock market's value, a disproportionate figure given its 5% share of the global population."
Brian Feroldi [36:00]: "Small-cap stocks have underperformed large caps over the past decade, offering a potential avenue for higher future returns."
Brian Feroldi [37:26]: "There are legitimate reasons to believe that innovations in AI, biotechnology, and clean energy could drive stronger future earnings."

Conclusion

This episode of ChooseFI provides valuable insights into the current state and future prospects of the stock market. Brian Feroldi's expertise offers listeners a comprehensive understanding of market dynamics, investment strategies, and the importance of diversification and informed decision-making in achieving financial independence.

For those interested in further discussions and actionable tips, subscribing to the ChooseFI podcast and exploring their resources is highly recommended.

Loading summary

Transcript47 lines

[00:00]
A
Hello and welcome to choose a 5. Today on the show we have our good friend Brian Feraldi back on to talk about the 2025 State of the stock market. Ryan is our most frequent guest in the history of Choose A Phi. And he's the one I go to whenever I have questions about the stock market, about investing, especially with individual stock investing. It goes back to the very early days of Choose a Phi. And Brian has opened our eyes in so many ways. He's so intelligent, he's so, he's so well researched, and he's just a wonderful guest. I think you're really going to enjoy this. And with that, welcome to Choose Fi. Brian, always good to see you, my friend. How's it going, Brad?
[00:43]
B
Great to be back. Thank you for having me, my friend.
[00:45]
A
Yeah, you bet, you bet. So, okay, I think we should kick off. Obviously this is going to be the 2025 State of the stock market, but let's do a little, little look back. So let's talk about a review of 2024.
[00:58]
B
Yeah. Well, for all the financial nerds that are listening to this, I'm sure that everybody just updated their financial net worth statement in early January. And if those people had money in the stock market, it's likely that they had a big smile on their face because 2024 was another great year for investors. The large cap index funds, namely the S&P 500, finished the year up 25% and in 2023 it was up 26%. So two 20% plus return years in a row, that can do wonderful things for your net worth.
[01:34]
A
Yeah, ever so slightly. Right, that's, that's not a bad thing at all. Can you give us a sense historically of how anomalous is a 25% increase? Is that something we see fairly often, like just for people who have no sense of this, how regular is that?
[01:51]
B
So if you look back at the long term history of, let's say the S&P 500, the term that get always gets quoted is a 10% annualized return. That's about what people can expect if they invest in the US Stock market for long periods of time. However, that number is a little bit misleading because it's actually quite rare that the market actually returns about 10% in any given year. It tends to overshoot that number and then undershoot that number year by year. So 20% returns are not something that happened frequently, but they're not all that uncommon either. In fact, in the last 10 years, the S&P 500 has returned 20% let's see. 1, 2, 3, 4. This is the fifth time in the last 10 years that the S&P 500 has returned more than 20% in the calendar period. Wow.
[02:39]
A
Yeah, that is, that is remarkable. And, and yeah, it's interesting. I think in the FI community we generally use the back of the envelope, 8% number as an expected annual return. You said 10% is kind of the back of the envelope for S and P over a long term. So that's kind of more what we use for our calculations. But as you said, it's very fleetingly rare. The return is 8 to 10%. There are some years where it'll be down. There are some years obviously where It'll be up 20, 25%. And I think that's hard for people to wrap their minds around, Brian. I think especially when they're used to things like a high yield savings account that just spits off a certain amount of income every month. How do you counsel people to think about stock market returns and volatility versus risk?
[03:27]
B
Well, this always gets back to what you and Jonathan been preaching forever, which is the investor policy statement. And really, when anybody is going to make an investment in the market, the very first question to ask yourself is, when do I need this investment to pay off? This is such a critical question that so many people overlook when they're making an investment. If the answer is any time period less than five years, I don't think the stock market is the place that you should put that capital. Even if the market is looking quite enticing or you're very excited about the market, because simply put in over periods that are less than five years, the returns that you earn from the market are not predictable enough. So if you know that you have like a down payment you want to make on a house or you have kids that are going off to college. So if you know that you need to spend that money in, in the next five years. I don't tell people to put it in the market. However, if you're putting money into the market to pay for things like a FI lifestyle or a long term retirement, or if you're agnostic as to when the returns come, like if you have enough flexibility in your life that the returns could come in year two or year seven or year 13 and you can handle that kind of variability, then you can put money into the market.
[04:35]
A
Yeah, I like that. So five years is your kind of line of demarcation. In essence, if it's sub five years, like you said, maybe the stock market isn't exactly for you. And obviously we're not giving advice to anybody, let's be clear. But we can't give blanket advice to hundreds of thousands of people on a podcast and with any type of specificity. So that's just Brian's back of the envelope. But I think that's probably a good thing for you to consider. And it's funny, Brian, because we were actually talking about buying versus renting houses before we hit record. And I think that's actually kind of the time period that I consider for that as well. It's interesting, like what we all consider short versus medium versus long term. I know I would not buy a house if I was certain or nearly certain I was going to live there for fewer than five years. And it's interesting that you think the same for the stock market because as we know, there's volatility and if people are expecting that 8 to 10% return every year, it's just not the way of the world. It doesn't work that way.
[05:31]
B
Simply, yeah, you're setting yourself up for disappointment. I mean, investing is always an expectations game. It's what the asset is going to return in comparison to what you expect it to return. And investors can get in trouble when those two things are way out of whack.
[05:44]
A
So just one last piece on the look back at 2024. So we talked about S&P 500 being up 25%. I'm curious if we dove into that number or if we dove into different sectors or such. Is this a question of a handful of companies or a couple dozen companies that drove most of the return? Is this a broad economy wide increase? How do you think about that?
[06:09]
B
So as a general statement, the market returns are almost always driven by the largest components. Most people understand that the major indices such as the The S&P 500 are market cap weighed, meaning the larger a business is, the more influence that it has on the returns of the stock market and vice versa. So while there might be 500 stocks in the S&P 500, a minority of those companies, the top 10 drive the majority of the return. And that's one thing that's actually really interesting about today's market. I think most people have heard of the Magnificent Seven, those so called seven major massive tech companies with multi trillion dollar valuations. Those companies are Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia and Tesla. Well, all seven of those companies had stellar 2024 performances. The worst performer of of that group was Microsoft at 12% and the best performer was Nvidia at plus 171% in 2024. So actually what's interesting about that huge outperformance by the largest of the large companies is that if you look at the top 10 stocks in the S&P 500 at the end of 2024, just those top 10 stocks represent 39% of the total value of the index. And that is actually an all time high.
[07:35]
A
Wow. Is there any type of takeaway here for a FI investor who's thinking about investing in individual stocks? I know you, you famously were the one who brought that concept to us because we've long talked about, and it sounds so obvious and self explanatory now, but we've long talked about mutual funds and ETFs and obviously you do as well, let's be clear. But is there some takeaway for someone, both either positive or negative of hey, this is something you should do, or maybe it speaks to hey, this might be too difficult for the average investor. Like, I'm curious, I know this is a very broad, nebulous question, but any kind of takeaways from someone who's looking to invest in individual stocks?
[08:16]
B
Well, if you look back historically at say like the last 30 years, again, it's normal for the largest companies in an index to make up a very large component of the index. But today's concentration in those top names is something that we've almost never seen before. And that by definition means that the returns of the market moving forward are gonna be disproportionately impacted by the returns of essentially those top 10 biggest companies. Now, those top 10 biggest companies, many of which I just mentioned before, are just stellar businesses, perhaps the greatest businesses that have ever been created. And if you look at the fundamentals of those companies, they're all growing strongly, they're all buying back stock or paying dividends. They all have huge opportunities ahead. Almost all of them are benefiting from the buzzword of the day, which is artificial intelligence. So there is reason to be optimistic about the long term potential or the 10 year potential of those companies. However, if you've studied markets for long periods of time, you know that there is always a number of companies that are leading the index and, and capitalism is quite brutal and quite unforgiving. So if you rewind the clock to the biggest, Most dominant companies 20 years ago, only a handful of them would actually still be around and relevant today.
[09:38]
A
Huh? Yeah. That's incredible. That was my next question. Cause I'm certain I always try to put myself in the mind of the Listener. Okay, Brian's sitting here saying the top 10 or 15 companies drive most of the return. So shouldn't I just invest in the top 10 or 15 companies? But how you just ended that clearly suggests, hey, that's not the slam dunk you might be thinking just by hearing this as like a blink kind of reflex response.
[10:02]
B
Right. Well, let's rewind the clock to the year 2000. I'm going to list off some of the largest companies that existed in 2000. And just like today, these companies effectively looked invincible. They just look like dominant, massive winners. So the top companies in the year 2000 were Microsoft. Hey, they're still around doing their thing. But then there's General Electric, Cisco Systems, ExxonMobil, Intel, Citigroup, IBM, Oracle, Merck, Coca Cola and AIG. Now if you know anything about the last 25 years of returns for those particular stocks, many of them have an absolute train wrecks for investors. General Electric has been awful. AIG was effectively wiped out in 2008. ExxonMobil has been a go nowhere stock. Intel is in turnaround mode and they have drastically missed out on the uptick in AI chips. Citigroup was also effectively wiped out in the 2008 financial crisis. Cisco Systems is a shell of its former self. So again, these were the strongest businesses in the world, nearly invincible 25 years ago. And today many of them have provided investors with long term returns that have been horrific.
[11:13]
A
Yeah, it's sobering to see that and I think this speaks to me personally. And again, everyone has their own judgment in terms of how they invest, let's be entirely clear. But I think this is why mutual fund and ETF investing, broad based index funds really appeal to me so greatly that the beautiful part is I don't need to think about it. It's self cleansing. You have a little piece of all of this, I think to me, and we can never know the future, Brian, obviously, but to me this gives me the highest likelihood of success over the only term that matters for me, which is the long term. That's where my mind is. Of course, just like anything, strong convictions loosely held. That is what I believe today. That doesn't preclude me from changing my mind on investing sometime in the future. But nothing has so far gotten to that level where it's made me second guess that. So I mean, for anyone out there listening who's curious what I invest in, the vast majority of my wealth is in VTI and vtsax essentially. And I'm not beholden to Vanguard. Let's be clear. But I think having broad based S&P 500 total stock market index funds, that's where I choose to invest essentially all of my net worth. I do have, as you know Brian, a decent bit of Berkshire Hathaway stock and a little bit of Markel. So I don't want to say here that I have no individual stocks, but really the vast majority is in VTI at this point.
[12:37]
B
Yeah, and I think that is the correct thing for the vast majority of investors to do. However, I do think it's important that if that is your strategy, you just have to be aware that markets move in cycles. And generally speaking, when large cap stocks perform very well for long periods of time, which they have for essentially the last 16 years, it is not uncommon from a market historic perspective for then those stocks to underperform or revert to their have a mean reversion feature of them over the next 15 years. In fact, if you look back at the year 2009, essentially from 2000 to 2009 was a period of net negative returns for large cap stocks. So While the last 15 years have been sensational and large cap stocks have been the place to be, there have been plenty of periods historically where where large cap stock delivered substandard returns for their investors. In fact, famed investor Howard Marks, who's one of my favorite market commentators to read, recently put out a memo where he noted that with the valuation of The S&P 500, where it is today in the S&P 500 has similar dynamics to it as a Vanguard Total Stock Market Index. He said that historically over the last 30 years when the S&P 500 had reached levels that it's at today from a valuation perspective, the Future returns, the 10 year returns of the market essentially net out to zero for a ten year period. So he wasn't predicting that that was going to happen. But he did point out that we've seen this before and the net 10 year returns for investors from these levels have not been good.
[14:19]
A
Yeah, I mean that is, it's certainly sobering and again I'm using that word twice in five minute span here. But this is important. I think this is the perfect launching off point for the 2025 State of the stock market. Right. Because it is interesting when you think about it Brian. I mean if you're Talking the last 15 years, the returns have been stellar in the stock market. You've got a 40 year old person who maybe started investing at 25 and they've known nothing but good years. And that's a significant. That's a generation or two maybe. Right. And you have a lot of people who have except for the tiny little obviously we had the COVID The very short lived Covid drop. There are always periods where the stock market goes down, but in totality, 15 years of essentially nothing but up that I think we go back to that investor policy statement you talked about a couple of minutes ago. I think we all need to get our heads right because you simply don't know what the future brings. But yeah, you listen to someone like Howard Marks and it's. You'd be a fool to ignore that.
[15:21]
B
Yeah, I think that that's right. And again, the takeaway for me when I read his memos and I like evaluations today isn't Chicken Little, isn't the sky is falling, isn't need to do I need to do a wholesale change. But perhaps a takeaway is to be even more conservative with your assumptions about returns that you can get from the stock market moving forward and even perhaps to consider putting a larger portion of your portfolio into fixed income. So bonds and I will once again reference people to that wonderful episode that you did a few years ago with Frank Vasquez on the bonds, which to me is something that I re listen to annually.
[15:58]
A
Yeah. And Brian, that's episode 194 with Frank Vasquez. It's the role of bonds in a portfolio. And yeah, I know a lot of people consider that one of our absolutely best episodes. So yeah, it's nice to hear that you go back and listen to that so often. Thanks for listening to Choose A Vi and for all your support of our mission here. The absolute best way to support Choose a Pie is when you sign up for your next rewards credit card to use our cards page at choose a buy.com cards. I keep this page constantly updated so it should always be the top resource for you. Thanks for being part of our community and for your support. So Brian, you talked about valuations and I know that's something you've done some study on. So I'm curious again, 2025 State of the stock market, where are we with valuations?
[16:45]
B
Yeah. So every 90 days JP Morgan Asset Management actually puts out this wonderful presentation that is an updated state of the stock market. So a lot of the charts that I'm going to be referencing or the data that I'm going to be referencing is actually pulled from that. So in there they have a wonderful visual which shows the S&P 500 forward price to earnings ratio. I think many people are Listening understand what the price to earnings ratio of is. But that word forward might give them a little bit of raise an eyebrow. So what this is is it's the current value of the S&P 500 divided by next year's estimated earnings per share. So The S&P 500, like all markets, are forward looking mechanisms, they're always looking to the future and specifically the near term future to figure out where valuations can be. So JP Morgan has this wonderful a 30 year chart that shows the forward price to earnings ratio of the S&P 500. And then they put some simple standard deviation bars on there. And these can be used as a very rough proxy for is the market expensive right now or is the market cheap right Now? So the 30 year average for the S&P 500's forward price to earnings ratio is right around 17. Now of course there's periods when it's significantly above that number and, and significantly below that number, but that's still the long term average as a benchmark. Well, as of the end of 2024, according to JP Morgan, this number was 21.5. So effectively more than one standard deviation above its long term average. And unfortunately, if you look at the last two times that this number was above one standard deviation above its long term average, well, the most recent one was 2020 and 2021. And I certainly have the scars of 2022 drilled into my head. And then the last time it was above that number or this high was 1998 through 2000, which again was the peak of the market. So again, looking back at recent history, 30 year history, valuations today are roughly in line with the last two market highs.
[18:59]
A
Okay, so Brian, I certainly get that and obviously the historical reference, but ultimately I think what we're all asking is what does this actually mean based on the only thing we care about, which is our own future returns, essentially.
[19:13]
B
Yeah. So again, JP Morgan has wonderful, they have a scatter plot chart on here which shows, okay, when valuations are at these levels, what are the returns that investors get moving forward basis? And they actually have it on a one year basis, five year basis and ten year basis. So on a forward one year basis, the returns are actually all over the map. And that would be exactly what you would expect. Just because markets have gone up recently or valuations are high, that's actually a pretty poor predictor about what they're going to do over the next 12 months. The next 12 month returns of the market are always effectively random. However, if you look at longer term Time periods. So five year and ten year periods, that's when they become a little bit more predictable. And if you look at the five year returns at valuation levels that are similar to where they are today, there is an inverse correlation between starting valuation and future returns. The lower the starting valuation, the higher the future returns are and the higher the starting valuation, the lower long term returns are. So based on JP Morgan's data, it looks like low to single digit 5 year returns are about what the markets have done historically. But if you zoom that out to a 10 year period, which is I would argue is even more accurate data, the return expectations goes effectively towards zero with a slight deviation up or down. So again, I think the takeaway for this is if you're going to be investing from today and you have a long term time horizon, it's reasonable to pull back on the expectations that you have for the market. You mentioned previously that investors tend to use an 8% return or as a rough guide, the prudent thing to do for long term projections of your net worth might be to pull that back even more.
[20:59]
A
Okay, so right, pull back on expectations is what we're saying here. And I guess Brian, I'm curious. So you mentioned AI before and obviously we can never know the future. Right? And I kind of hate the whole prognosticating game frankly of like the financial media porn of oh, is it going to go up, is it going to go down? I ultimately we have no idea. But for someone who's sitting there saying, okay look, I get what Brian's saying, I get the history, but it feels like we're at an inflection point with where humanity can go. Do you have any thoughts? I don't mean specifically on AI necessarily, but for somebody who's sitting there saying like, okay, do I just look at history and say, all right, there's a reasonably high likelihood that my returns are going to be sub what I might have expected a couple years ago versus oh wow, maybe this time is different. And I always hesitate to ask that question, but I'm curious nevertheless, your thoughts?
[21:54]
B
Yeah. So the data that we presented is by its nature backward looking, based on history. When this has happened in the market. Here is a set of things that have happened in the future that you can use to guide your expectations. But to your point, I don't want to come on here and pretend to be Mr. Doom and Gloom. Like for the record, 90% of my net worth is still in the stock market as of today and I expect it to be have a heavy dose of stock market exposure essentially indefinitely. But there are reasons, potential reasons to believe that returns in the future might be higher than they have been historically, based on what you just said, given all the disruptions that are going on in the world right now, from a artificial intelligence perspective, from a biotechnology perspective, from a robotics perspective, from a clean energy perspective, to say nothing of Elon and Doge coming into office and potentially getting rid of lots of regulations which could in theory open up, grow our economy faster. All those things are certainly possible. And markets are nothing but forward looking discounting instruments. So there are legitimate reasons to believe that, well, perhaps earnings growth or profit growth over the next couple years might be higher than they have been during more historic periods because of everything that we just mentioned. And if that is the case, then perhaps valuations today are justified, given that stronger growth might be coming.
[23:25]
A
Yeah, it's an interesting case and obviously we, we don't know, but I think we all just need to just think broadly, keep aware. I think that that's all we can do, Brian, at the end of the day, right? Like, we just have to try to stay on top of this. That's why we have amazing guests like you come on the podcast and talk through this stuff because anytime and, and I'm talking for the financial independence community here. I, I think we are the most adept thinkers and people who understand the world and understand that things change all the time. So I never want to be monolithic about anything. Like, we only invest in the total Stock Market index fund. Like, no, that's not how, that's not how the world works. You have to always update your thinking. I think that's a really important intellectual exercise. But I think also it helps you stay nimble for opportunities like that. Brian, that's a beautiful aspect of life, is things are constantly changing. I feel like the FI community specifically, like, we're always on top of, hey, how can we maximize this new rule or whatever it may be. Like, we find ways and I think it's really interesting. So I guess I'm curious, are you. So we're recording this in the beginning of January of 2025. I know you said 90% of your net worth is still in equities. Are you contemplating or are you taking action on changing anything in your portfolio? I know we've talked previously how you think through your own portfolio construction. Can you give a quick overview of that for someone who probably hasn't listened to that episode and maybe how you're thinking about it now?
[24:58]
B
Sure. So to give you a high level Overview. My personal portfolio, my equity portfolio is a combination of index funds, broad based index funds such as Vanguard Total Stock market index funds, emerging markets, stock market index funds, and effectively my retirement accounts are 100% index funds. Beyond that, my cash, my taxable account that is 100% individual stocks. And I am a by and large long term buy and hold quality investor. So I log into my brokerage account two to three times per year and add or subtract individual stocks from them. So I am quote, unquote active with that portion of my portfolio, or at least more active than I would be if I was just purely a passive investor. And I can say from my perspective, I do monitor the valuations of the companies that I hold. And actually what 2022 taught me is that I should monitor the valuations of the stocks that I hold more closely, especially when there are big macro changes going on in the world. So I can say for myself that I am at a record high cash balance in my individual stock portfolio. I'm currently about 15% cash, which for me is on the higher side. And I could actually see taking that number higher over the next month or two given where valuations are with the hope to be able to redeploy that capital, but more favorable valuations if some of my favorite investments went on sale. But again, that is what I choose to do with my money. And I'm more comfortable with being a little bit more active with valuations where they are. But if you're just a passive investor who just wants to essentially set it up once and, and buy and forget, that strategy is still valid today.
[26:36]
A
Yeah, and I would echo that. I personally am not changing. As of this moment, I have not thought about changing anything in my own equity portfolio, nor putting additional money in. I'm continuing to do that month after month, essentially year after year. But that said, again, strong convictions loosely held, right? You can never say that I'm not going to change that, but as of right now, that's where I am. And yeah, I mean, I think we all just have to educate ourselves. I don't want to sound like a broken record here on the episode, Brian, but I think it's important and I think anytime you stick your head in the sand and assume something's going to work forever, you have a rude awakening. You know, look back Those the top 10 companies in 2000 like you mentioned earlier, right? It's, it's easy to think things will go on forever. And just the fact of history is it doesn't seem to work that Way.
[27:25]
B
One thing, Brad, that you said earlier that I just want to echo and even reiterate is the choose fi community is probably the best positioned community out there for whatever is going to come our way. When you have a very high savings rate, when your expenses are quite low in comparison to your income, and when you can be importantly flexible with your investing strategy and with your spending strategy, I think that that sets up the financial independence community to essentially thrive no matter what the markets throw at us. So even if the markets on a broad base return a very low number over the Next, let's say, 10 years, that might be devastating to many people who are at or near retirement and they need strong returns to pay for their lifestyle moving forward. But if you're in the asset accumulation phase or if you can simply be flexible with your spending patterns, what the market does over that time period won't impact you nearly as much as it would if you had a high expense lifestyle.
[28:23]
A
Totally agreed. I think savings rate to a large degree cures all. I know this is what I counsel my daughters is essentially if you have a 50% savings rate and it's easy, it's easy obviously for kids who, who haven't made mistakes and are just getting into life, but if you have a 50% savings rate, it's pretty darn hard to screw up your financial life. So I know I can speak from experience and making terrible investments and speculation in real estate and all this stuff. And by any measure I've reached financial independence and that's, that's a really nice thing. So yeah, like Brian said, we are set up wonderfully. So Brian, I wanted to go back to the state of the stock market. So we talked before about these largest companies, right? Certainly the seven, but I expect it extends a little beyond that. Are people rightly concerned about market concentration if this is something that's flittered through their mind or they read it on a CNBC article or something like, hey, the top 15 companies make up X percent, 30, 40, whatever. You know, you said earlier, is this something that is just kind of par for the course in terms of stock market? Is this something that we are at a historical anomaly? Is this something that you're concerned about? I just love to hear your thoughts generally.
[29:36]
B
Well, again, it gets back to the fact that the companies that are the largest components of the stock market today, they are all effectively some of the best businesses that have ever been created. They effectively hold monopoly or monopoly like positions in their market. They're all unbelievably profitable. Many of Them are still led by their founder or at least a longtime executive. And all of them, nearly all of them, are taking advantage of AI, which is a huge investment today, but could turn into huge amounts of profit in the future. So the market is not stupid. The market recognizes and has awarded these companies huge market values because they're just excellent businesses. And it's also, you could also reason that given where we are with communication technology and how interconnected the world is, perhaps we can support multi trillion or even multi 10 trillion dollar companies today, given how easy it is for communication to to happen in between companies, whereas in previous generations that would have been just impossible to do. Moreover, these companies are also what's called asset light, meaning that they don't need a lot of physical infrastructure, big things to actually produce profits. Whereas again, companies of the past that have dominated did so. These businesses are excellent and if you analyze any of them on an individual basis, you can probably come up with a reason why the company is trading at the valuation that it is. So again, this is more of just something that I am aware of and I am thinking about and some of the smartest money managers out there are raising as a potential issue. I don't think you should take action on it yet, but I do think it's something you should be aware of.
[31:19]
A
Yeah, fair enough. I'm smiling because I always like to needle you on Tesla, but obviously the returns have proven you right to date. But we will see. I'm not the biggest Elon fan. Any decade now you'll be right, to put it mildly. And it reeks of meme stock, but we will say any decade. That's awesome. Brian. Market share. Market share. Most investors have home country bias, right? I think we are no exception, but I think a lot of people who invest in US equities can say with a straight face, okay, maybe our home country bias makes a little more sense than if you were in Finland or England or wherever. That said, I'm curious how you think at this point in time about the US versus the world when it comes to investing.
[32:07]
B
Yeah, this is another interesting tell sign. Again, dialing back to that JP Morgan asset market presentation. What they actually showed was that if you added up all of the value of all the publicly traded companies in the world and then categorized them by what country are they located in? The United states effectively has 2/3 of the value of the entire stock market across the world, 2/3 to despite the fact that effectively the US is 5% of the global population. Now, again, a big component of that is driven by these huge, massive, unbelievably successful companies that we've referenced many times. But on the flip side, because 2/3 of the market value is in the U.S. that means that the balance between market values in the United States versus internationally has shifted drastically towards the US and again, if you look back historically at the dynamics between these functions, international stocks and US Stocks tend to go in and out of fashion where there are periods when the US dominates like it has over the last 20 years now. And then there are other periods such as like the 1970s when international stocks really dominate. So there could be reason for investors to consider increasing their allocation to international markets. If you are in the US if you're seeking more diversification, okay, so seeking.
[33:30]
A
More diversification is ultimately is the point there. Because I think a lot of people, they might claim that, but they're just chasing returns or they're just saying just something unsophisticated like oh, the US has outperformed for X number of years, it has to revert to X. Right? Like how would you respond to somebody who says that just off the top of their head like, oh, the US has outperformed, it has to turn around eventually. Is that even a plausible thing thought or is it truly like a diversification play like you're saying? I know that's a very broad question, but I'm just curious, like your quick hit thought.
[34:04]
B
Well, my quick hit thought is that you can actually get a decent amount of international exposure through the United States stocks. For example, take a company like Apple or Nike or McDonald's. Yes, they might be US companies that are listed in the US but they actually get a pretty sizable portion of their revenue for from international markets. So US Companies by their very nature, while their market cap might be associated with the United States, the companies behind them actually are more diversified geographically than you might naturally assume. But again, I always think it's useful to use history as a guide. History doesn't repeat itself, but it does rhyme. And if you look back over the decades, there are periods when international stocks go in and out of favor, just like there are people periods when asset classes go in and out of favor. And as a general statement, things that outperform tend to go on to underperform and things that underperform tend to go on to outperform. So again, I don't think you have to take an action based on the fact, but there's no doubt that the United States has been the dominant market and the best performing asset class for 15 years now. And it is possible that, that over the next 15 years, international stocks will have this time in the sun.
[35:17]
A
Yeah, Brian, we spent most of the episode talking about large caps and really these seven stocks, et cetera. Brian, there are a lot of people who think about, okay, small cap or mid cap, like different options other than just, hey, these are the absolute largest companies. I'm curious how you think through that in terms of portfolio construction. I know again, we've spent most of the episode talking about, hey, most of the return has been driven from these top, top companies. But again, like we just talked about with us versus the world, okay, sometimes certain segments overperform and there is some mean reversion. Is there any leg to stand on for somebody who's like, hey, maybe it's time to start looking at small cap?
[36:01]
B
Absolutely. If you look at again, the last 10 years, the returns of large cap stocks S&P 500 have been about 13% annualized basis. But if you look at small cap stocks, they've only been about 9% annualized. So that's a 4% delta, which doesn't sound like that big of a deal. But hopefully people that understand compound growth understand that over a long period of time that can be a huge difference between the two. So again, there could be reasons for you to consider upping your allocation to parts of the market that have underperformed. So small caps are certainly in there. Mid caps are in there. We've already covered international stocks. Another component to perhaps consider would be real estate and real estate investment trusts, which are publicly traded companies that invest in real estate. REITs, as they're called, have only returned 5% on an annualized basis over the last 10 years. And they've had a rough go in the last couple of years, especially due to Covid, which just threw a major monkey wrench into big parts of the real estate markets, namely office space. So again, if your goal is diversification and to lower your risk that you have, or the lower the concentration that you have in your portfolio to these mega cap companies, perhaps you should consider increasing your exposure to other parts of the market. So we talked about mid caps, small caps, international stocks, REITs, or heck, even fixed income.
[37:17]
A
Yeah, Brian, obviously this has not been a doom and gloom episode by any means. But I'm curious, are there reasons for optimism moving forward?
[37:26]
B
There are always reasons for optimism. And if you have a pessimistic mindset, you can find endless information to support that. And thankfully, the inverse is always true. So again, I'll point to that wonderful Howard Marks memo that he recently came out with. And he basically says, yes, valuations are high today, but they're not insane. Yes, the valuation of the Magnificent Seven is high, but they're incredible companies with realistic growth expectations ahead of them. Yes, valuations are high, but he doesn't see true signs of excess like we saw in say, 1999, where people were saying there's no such thing as too high of a price for an exes and companies. And moreover, markets are highly priced today, but there are plenty of pockets in there that are not at extreme levels. Moreover, if you talk about the things that we talked about before, with potential deregulation coming with AI, with robotics, with biotechnology, with all the disruptive innovation that's out there, I could see plenty of reasons to believe that growth moving forward could actually justify valuation. So like anything, the there's always reasons to be optimistic, there's always reasons to be pessimistic. The investor's job is to keep both in their mind at the same time and not go crazy.
[38:39]
A
Yeah, isn't that amazing how confirmation bias works, right? Like if you are looking for reasons for anything in life, you pretty much can find it. But as Brian just described, it's about being intellectually open and curious. And there is obviously skepticism. Anytime you get locked into anything, you need to be skeptical, you need to bring in new information and you can hold competing ideas in your head at the same time. That's okay, right? It's often derisively called cognitive dissonance, as if it's always a bad thing. But frankly, we need to think about these things and we have to be aware and we have to look down the field of life, if you will, a 50 year field, and see, all right, what makes the most sense for us. And I think that really is a hallmark of the financial independence community. So, Brian, I'm curious, are there any closing thoughts, any other aspects of the market for 2025 you want to talk about?
[39:32]
B
My closing thought would be the same thing that it always is. No matter where you are as an investor, the first step is to educate yourself, understand any of the terms and go and look up any of the terms that we said on the show that you did not understand. And perhaps you could even link to that JP Morgan report in the show notes for the podcast. But over the long term, the stock market has been a great place for investors to park capital, so I see no reason to believe that that shouldn't be the case moving forward.
[40:01]
A
Brian, I always love having you on. It's greatly appreciated your expertise and your friendship to this whole community. So thank you as always. Where is the best place for people to find you or to reach out?
[40:12]
B
Yep. So as a general statement, if there's a social platform that you like, I'm on it. So just type in my name Brian Feroldi and you can find interact with my content.
[40:21]
A
Wonderful Brian. Thanks again.
[40:23]
B
Thank you for having me, Brad. Always awesome to be here.
[40:25]
C
Thank you for listening to today's show and for being part of the choose if I community. If you haven't already, the best ways to get involved are first subscribe to the podcast. So you're listening to this on a podcast player, just hit subscribe and then subscribe to my weekly newsletter. I actually sit down every Monday and write this by hand and I send it out Tuesday morning. So just head over to choosefi.com subscribe and it's really, really easy to get on the the newsletter list right there and I would greatly appreciate it. It's the best way to get in touch with me. You can actually just hit reply to any of those emails and it comes directly to my inbox. So that's the way that I keep a pulse of the community and how we keep this the ultimate crowdsourced personal finance show. And finally, if you're looking to join an in real life community, we have choose a vi local groups in 300 plus cities all around the world. So head to choose a vi.com local and you'll find a list of all of Those cities in 20 plus countries all across the world. And if you're just getting started with FI or you have a family member or friend who you think would be interested, two easy ways choose a VI episode 100 is kind of our welcome to the FI community and even though it's a couple years old at this point, it still stands up and it's a really great just starting point to get an understanding of what is financial independence. What are we doing here? Why are we looking to live a more intentional life where we save money and use it as a springboard to live a better life and then choose a VI created a Financial Independence 101 course that's entirely free. Just head to choose a vi.comfi101 and again, thanks for listening.