I'm writing my year-end note a bit early.  The holidays are packed tight this year, and I'm afraid the year will go by in the blink of an eye once Thanksgiving is upon us.  Also, considering a change in my market outlook for the better, I thought I'd reach out to offer my perspective. 

I've started to recommend adding stock exposure to most of your portfolios.  This has been a long time coming, and a question arose about why we should make this move now at all-time highs.  I hope this note is a sufficient explanation. 

This is the second move I've recommended this year.  In July, I suggested that clients fill out their exposure to the riskier, more volatile part of the stock market: mid- and small-size company stock.  Let's look at why we didn't get a green light in 2022 and why we did this year.

Historically, new bull markets are led by the riskier parts of the market.  I'm using the Russell 2000 (green line) as a proxy for the riskier end of the spectrum, and the average large-cap stock is represented by the equally weighted S&P 500 (crimson line.)  

As you can see from the chart on the left, there was a clear preference for large stocks coming off the low in 2022.  Admittedly, the difference between the two on the chart on the left is not that drastic.  However, if you zoom out, the S&P 500 was within 5% of its all-time high 120 days from the low, while the Russell 2000 was still off 13%.  One conclusion you might draw is that investors were still nervous about investing in small-cap stocks in 2022.  That concern was likely due to how much of a toll high interest rates have on small companies relative to larger, more stable ones. 

Let's now look at the chart on the right.  This chart starts on July 11, 2024, when the monthly inflation report was released.  The stock market celebrated the release of this report, which showed that inflation grew at a lower rate than the previous month and came below expectations.  This lit a fire under small and mid-cap stocks, so the outlook changed.  The July inflation report seems to have answered the question hanging over small and mid-cap stocks: "Interest rates are elevated; when can we expect the Fed to lower them?" As you can see, the Russell 2000 jumped, took a breather, and then almost went vertical.  It remains to be seen if inflation has been tamed, but for now, investors seem convinced it has. 

Returning to the 2022 market low, we did not have sufficient evidence to move.  While a new bull market wasn't impossible to begin like it did, historically, the chance of success was not that great.  As such, I recommended a cautious allocation for most of you, knowing bonds provided a decent return through income. 

Let's answer, "Why are you getting in now at all-time highs?" Here are two more charts to explain.

The chart on the left shows the stock market peaking at the end of 2021.  Investors clearly preferred the larger, more stable company stocks of the S&P 500.  The riskier, interest rate sensitive small cap stocks were starting to get left in the dust, as you can see from the gap between the two lines.  When investor selectivity is apparent, it is a warning sign.  Sometimes, they correct themselves; others are the beginning of a bear market.  This time it was the beginning of a bear market.  We took action because of this and started to dial down stock exposure over the next several months into early 2022. 

Now, look at the chart on the right.  This is the stock market performance when the implications of the Pandemic took hold.  As you can see, the Pandemic caught investors off guard.  Up to the February 2020 market high, both small and large-cap stocks were rising in tandem.  Suddenly, one day, both fell off a cliff.  Drawdowns like these are just as scary, but the good news is that they tend not to last long, and the recovery usually has the same force as the loss.  Once whatever uncertainty spooked the market is resolved, the market takes a breath and starts to recover.  You can see the strong bounce of both indexes in March 2022. 

I recommend adding stock exposure now at all-time highs because the market's health is like early 2020. Investors' appetite for all parts of the market is expanding, not contracting, which is a good foundation for future gains. Should something catch investors off guard again, the market is in a good place to absorb any subsequent selling. 

In case of a nasty surprise, I suggest we split 12 months of your cash needs between cash and bonds.  From there, the allocation among stocks and bonds will depend on your risk tolerance.  I'll discuss this with each of you soon. 

My way of deciphering the best path forward in the market is not perfect.  After all these years, I realize I'm much more conservative than the average investor.  Anyone can squeeze out only so much uncertainty before deciding about the future.  I want to gather as much corroborating information as possible before advising you.  The downside is that sometimes, it takes time for the stars to align.  The 2022 recovery was one of those for me; I finally have enough evidence after all this time.  

I hope this helps you understand my thought process over the past few years.  I always welcome any questions you have for me, so please don't hesitate to ask why we're doing what we're doing.