In 1859 Charles Dickens published his twelfth novel, A Tale of Two Cities, which opens with this famous line:
“It was the best of times, it was the worst of times . . . .”
We lift this quote from its literary and historical context and use it for reasons completely foreign to the meaning of the book. We use it as an introduction to our year-end letter and as a reference to what, for investors, are the best of times, while concurrently, one might also say, are the worst of times. We divide the letter into two parts: first, the economy, and second, the markets.
GROSS DOMESTIC PRODUCT (GDP), A NEW PARADIGM? This is the “best of times” section. GDP is the broadest and most basic measure of the health of the U.S. economy. It measures how much is produced and how much is consumed. The natural condition of the economy is to expand as more people join the workforce each year and as the total body of workers increases its productivity. It is this combination of a growing labor force and productivity advances that, in most years, results in GDP growth. The exceptions are the years in which growth contracts due to a recession.
For many years economists have almost universally agreed that the real, adjusted for inflation, sustainable growth rate of the economy is 1.8%. The Federal Reserve (Fed) agrees. However, the 1.8% number is now being called into question simply because GDP growth has continually surprised to the upside. Except for the 2020 Covid year, GDP growth has exceeded 1.8% for the last six years, usually by a substantial amount. Not only that, after a concerted effort by the Fed to reduce inflation by raising short-term interest rates by 500 basis points over a two-year period, there has been no noticeable slowdown in growth. Perhaps of most importance is the fact that GDP is now performing above its 25-year trend. Considering these factors, should it be concluded that U.S. economic growth is in a new paradigm?
What might account for the economy performing so much better than expected? The ultimate determinant of economic expansion is investment. Think of all the capital that exists. It must go somewhere: to savings or investment. That which flows into investment buys better machines, new plants, and technology that equips workers to be more productive. And these increases in investment are best fostered by an overall economic environment of stability and low inflation. On this point there is encouragement since corporate investment has surged of late, particularly in manufacturing facilities and in technology investments for Artificial Intelligence (AI) development.
Technological innovation is the most likely cause of a new paradigm of growth, if there is one. Since population and immigration trends are stagnant at best, a consistently higher growth rate in GDP will be dependent on greater productivity. Technological advances have always been the driver of productivity improvements. AI has captured the imagination of the corporate world and certainly of the investment community, but at this early point it is more of a promise of higher growth for the economy than a reality. While productivity growth has picked up recently, it is too soon to tell if the improvement is due to AI. Nor do we know just how pervasive AI use will become and whether the productivity enhancements will be significant enough to power substantially higher economic growth. We do know, however, that in addition to AI, technology is providing advances in automation, clean energy, and biotechnology. All these areas open exciting opportunities for creating new industries and driving economic expansion.
New paradigms require new secular forces. Technological advances certainly can fall into the secular category since the nature of technology is to continually push the frontiers. We suspend judgment on the question of a new paradigm simply because secular themes are so difficult to identify as they are occurring. Suffice it to say, the economy continues to perform very well, and we are reminded of the words of John Maynard Keynes: “When the facts change, I change my mind.” Indeed, we welcome the rapid economic growth we are experiencing now and agree that in this sense, it is “the best of times.”
THE MARKETS. Do we dare say this is “the worst of times” section? Not in an absolute sense, but in a relative sense, perhaps. We have outlined a very promising picture for the economy and gone so far as to at least raise the question of a new paradigm of growth. The bad news is that the stock market has recognized this and has been factoring it into valuations. It has done this to the extent that the broad stock market is priced very high, historically so by some measures. We can cite numbers: price-to-earnings ratio 22 times expected 2025 earnings, price-to-sales 3.15 times, almost record stock market valuation as a percent of GDP. Admittedly, some of these measures can be distorted by the very high prices of a few large, dominant companies, but it is almost impossible to escape the conclusion that the stock market is richly priced.
By pointing to elevated stock prices, we are not suggesting a doomsday scenario. On the contrary, we retain our optimism about the possibilities that come with long-term investment in high-quality stocks. Nor are we implying that high prices for stocks mean that they must endure a period of serious losses. What we do suggest is the possibility that because the stock market has produced such well above-average returns recently, that in the next few years, more pedestrian returns could be the result, even in the face of strong economic growth. Our advice: don’t lose your faith in the long term, just be prepared for a more normal return environment for a while.
It is one thing to be prepared for a period of relatively low returns. It is something else to be prepared for one of those periods when it truly is the worst of times. These we call bear markets. They almost always occur around recessions, something hardly anyone is predicting amidst all the optimism over the economic growth we describe above. However, recessions have a way of appearing when no one expects them; therefore, investors need to be prepared for the worst of times as well as the best of times. We believe our way of investing is an excellent way of being prepared for both. We have often referred to it as investing for all seasons, both good and bad. Because of our focus on quality as the starting point, and income from dividends as a key element in our approach, we believe we have been able to participate on the upside in the best of times and preserve capital on the downside in the worst of times. This combination of upside participation and downside protection helps smooth out investment returns over time and enabled clients to enjoy the benefits of compounding investment returns.
A few words about bonds. Last year investors were forced to take a few roller coaster rides as yields moved up and down, sometimes in dramatic fashion. Recently, the yield on the 10-year Treasury has risen to 4.50% from a low of 3.65%. At least two factors are at work: a change in Fed policy to slow the pace of interest rate reductions, which disappointed investors, and fears that if president-elect Trump imposes tariffs, they will be inflationary. We retain our belief that the eventual level of longer maturity yields is lower, since the Fed cycle of reducing rates is still in place, just at a slower pace. Achievement of the 2% target for inflation should result in lower short-term and long-term interest rates.
We are not sure if we are in a new paradigm of growth for the economy, but for now things are moving in the right direction. This is good. However, we must deal with a stock market that is richly priced by historical standards and a bond market that is uncertain. As always, there is uncertainty in the future. We really don’t know how things economic or marketwise will turn out over the near term. What we can do is maintain our faith in the reliability of the U.S. economy over the longer term and steadfastly keep our focus on quality in the investments we make. This you can count on us to do.
We conclude by wishing you all the best in the New Year, especially happiness and good health. And we express our heartfelt appreciation for the ongoing opportunity to work with you toward the attainment of your investment goals.
Crawford Investment Counsel (“Crawford”) is an independent investment adviser registered under the Investment Advisers Act of1940, as amended. Registration does not imply a certain level of skill or training. More information about Crawford, including our investment strategies, fees, and objectives, can be found in our Form ADV Part 2and/or Form CRS, which is available upon request.
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