Several investment themes have dominated markets in recent years, challenging a fundamental principle of finance: mean reversion, which suggests that what rises must eventually fall, and vice versa. As we head into 2025, the key question remains - will contrarians finally have their moment, or will trend-followers continue to outperform?
AI stocks and tech giants have delivered stunning outperformance over the past two years, leaving the broader market behind. Even within the Magnificent Seven, the gap between high-AI and low-AI exposure has led to noticeably different returns. While DeepSeek could introduce a disruptive shift in technological progress, the broader AI-driven rally is likely to persist -potentially expanding beyond hyperscalers to benefit AI adopters across industries.
The divergence between U.S. and international stocks took root after the Financial Crisis. Over the past decade, U.S. productivity and growth have consistently outperformed the rest of the world. This trend shows little sign of reversing and is expected to continue in the foreseeable future.
The 10-year yield seems to have pivoted, marking the end of a 40-year bond bull market. While it’s on an upward trajectory from the 2020 lows, this could simply signal a mean reversion to the "historical normal" of higher rates, in contrast to the ultra-low rate environment of the 2010s.
Since 2020, the correlation between stocks and bonds have turned positive, eroding bonds' diversification benefit. This shift is caused by higher inflation, which empirically increases bond volatility and leads to a positive correlation with equities.
If inflation expectations remain anchored, the Fed may not hike short-term rates again, and any increase in long-term rates will likely stem from a rise in the term premium. In this scenario, the relationship between stocks and bonds should normalize back to its historical negative correlation.
If earnings yield (E/P) fails below the Treasury bond yields, it suggests that the compensation for taking on the additional risk of equities over risk-free government bonds may no longer be worth it. After two decades of the equity risk premium beating the 10-year yield, we may be nearing an inflection point.
Not only did the momentum factor outperform all other factors in 2024, but it also had its best year since 2013. What many investors may not realize is that momentum was the strongest factor in the second half of the 20th century. While it's not impossible for momentum to continue to shine, it's important to stay cautious of potential shifts in tech/AI trends and macroeconomic regime changes.
Aside from a few bumps, value stocks and particularly small-caps have experienced a decade of weak relative strength. While an earnings bounce-back could clear a sentiment hurdle, rotating back into these underperforming groups may also require bucking the prevailing trends in AI stocks and the momentum factor.