2025—No Room for Error
Since the Fed started its latest rate-cutting cycle in mid-September, the results haven’t exactly fallen in line with the typical Fed easing-cycle playbook. Rather than easing, we’ve seen financial conditions begin to meaningfully tighten. The U.S. dollar index has surged from 99.86 to 108.92, and the U.S. 10-Year Treasury bond yield has jumped 100 basis points from 3.6% to 4.6%. In fact, the jump in yields since the Fed’s first rate cut is the largest seen following any initial cut since 1989.
That rise in yields has driven mortgage rates back up to nearly 7%. All told, this is certainly beginning to be a significant tightening of financial conditions. If the dollar, yields, and mortgage rates don’t start falling soon, it will likely trigger a resumption of the US-dollar-up, yields-up, everything-else-down (perhaps save gold) type of market last seen in 2022.
The Mag-7 and the S&P 500 (the benchmark index the Mag-7 have powered higher) aren’t ready for this, but the writing is on the wall. According to Bank of America’s latest global fund manager survey, market breadth reached a record monthly low in December. The survey recorded the lowest cash allocation in records kept since 2001. Confirming the BofA data and expanding upon it, the equity mutual fund cash-to-assets ratio has also set a record low within 67 years of data.
Everyone is all-in and levered-up in stocks, but outside of the Mag-7, the questionable foundations of stock values are already beginning to shake. The Russell 2000 small cap stock index peaked on November 25; value stocks fell for a record fourteen consecutive trading sessions during December; and home builders, energy, healthcare, materials, and financial stock sectors have all sold off sharply. Even the previously red-hot semiconductor stocks have started to cool off in a big way.
The last time we saw an extended period of falling stock prices and tightening financial conditions in 2022, we had two primary factors responsible for pulling the market up and out of its malaise. We had Reverse Repo (RRP) liquidity pulled into the stock market, and later the onset of the recent artificial intelligence (AI) mania.
Today, however, if Fed rate cuts fail to ease financial conditions, the old remedies for 2022’s market malaise may not come to the rescue this time. According to the Federal Reserve Bank of New York, RRP liquidity was a staggering $2.5 trillion at the end of 2022. In the throes of late 2022 market turmoil, however, it seems that actions taken by Janet Yellen’s Treasury Department began to pull that money out of the RRP facility. A meaningful portion of those funds found their way into the stock market over the last two years. Liquidity lifts all boats, and since the lows of 2022, we’ve certainly seen the tide rise to lift the equity boat.
Unfortunately for the raging party on Wall Street, the RRP account had been drawn down to $1 trillion by the end of 2023. As of last month, it had been drained to less than $200 billion. In other words, if financial conditions continue to tighten, Wall Street may need to find another major liquidity source.
As for the AI “miracle”? That narrative might not save the market this time, either. Two weeks ago, a Wall Street Journal article titled: “The Next Great Leap in AI Is Behind Schedule and 2 Crazy Expensive” poured some seriously cold water on all the AI hot air on Wall Street. As the Journal put it, “OpenAI isn’t the only company worrying that progress [on AI] has hit a wall. Across the industry, a debate is raging over whether improvement in AI is starting to plateau.”
Right now, the AI craze and the big tech mega behemoth Mag-7 beneficiaries are powering the S&P 500. If the AI narrative starts to crumble, these same Mag-7 names (companies that have thrown billions after the AI narrative) are in very big trouble. By extension, so is the S&P 500.
Again, most of the S&P 500’s 2024 stock gains (+23%) were driven by the Mag-7: Apple (+30%), Microsoft (+12%), Alphabet (+36%), Amazon (+44%), Nvidia (+171%), Meta (+65%) and Tesla (+63%). Much of this gain was not the product of booming fundamentals, but of rampant speculation in a future AI narrative chalk full of holes.
As famed market commentator Fred Hickey described the Mag-7 mania this week, “None of this idiocy shocks me, as I’ve seen it all before during the height of the 1999-2000 stock mania. The [stock and analyst] names change, but the actions are the same. The ending will be the identical too—a gigantic crash.”
As we enter 2025, tightening financial conditions, a potential illiquidity problem, and a very fragile AI narrative all need to be monitored closely. The Buffet valuation indicator is at a record high 200% and the stock market is priced for more than perfection. This stock market bubble is now incredibly vulnerable. Simply put, in 2025 the S&P 500 has no room for error. In light of the phenomenal risk, sufficient gold holdings as financial insurance are strongly advised.
Happy New Year to all readers!
Weekly performance: The S&P 500 was down 0.48%. Gold was up 0.87%, and silver was up 0.32%. Platinum was up 1.38%, and palladium was up 1.20%. The HUI gold miners index gained 2.20%. The IFRA iShares US Infrastructure ETF was up 0.50%. Energy commodities were volatile and mixed on the week. WTI crude oil was up 4.76%, while natural gas was down 0.86%. The CRB Commodity Index was up 1.80%. Copper was down 1.18%. The Dow Jones US Specialty Real Estate Investment Trust Index was up 0.87%. The Vanguard Utilities ETF was up 1.26%. The dollar index was 0.93%, to close the week at 108.80. The yield on the 10-yr U.S. Treasury was down 3 bps to close at 4.60%.
Have a wonderful weekend!
Best Regards,
Morgan Lewis
Investment Strategist & Co-Portfolio Manager
MWM LLC
