LIZ ANN SONDERS: I'm Liz Ann Sonders.

KATHY JONES: And I'm Kathy Jones.

LIZ ANN: And this is On Investing, an original podcast from Charles Schwab. Each week, we analyze what's happening in the markets and discuss how it might affect your investments.

LIZ ANN: Well, Kathy, welcome back to the podcast. It is nice to be back, or at least I'll speak for myself after a few weeks off. So how were your holidays? How was the beginning of the new year for you?

KATHY: Great, yeah, thanks, Liz Ann. Holidays were nice, quiet, family, and New Year, as usual, quiet. We don't do a lot of partying these days on New Year's Eve, but it has been good. Yeah, how about you, Liz Ann?

LIZ ANN: It was good. As you know, I had total knee replacement surgery the second week in December. So I was literally and figuratively not running around a lot, but that was actually not bad for the setup to be for fairly quiet days during that period of time. And like you, I sometimes find New Year's Eve itself to be sort of amateur hour. And I was, as is often the case, in bed by 10:00 on New Year's Eve blissfully. Didn't wait for the ball to drop, but it's good. But it also feels good to kind of be back in and in the throes of things. I'm glad we're back on this together. It seemed like a long break, but it's nice to chat with you again and see you again. And as always these days, there's a lot to talk about.

KATHY: There's no shortage of news, that's for sure. We've got lots going on here to catch up on after a couple of weeks off.

LIZ ANN: One of the last pairs of episodes that we did was our 2025 market outlooks. And your side of the world, the bond market, last year was where a heck of a lot of the action and volatility took place in some measures more so than what we saw in the equity market. So give us a little lay of the land right now in terms of Treasury yields, the yield curve, Fed policy.

What are your thoughts as we start this new year?

KATHY: Yeah, we have continued to be pretty cautious on the fixed income markets. And I'm glad we became cautious late last year, in the fall, because yields have just continued to climb. I think the outstanding issue is that we have a lot of these unknowns out there. So on the one hand, we have right now inflation is down, but it's not continuing to fall. So it's kind of stuck right around 2.5 to 3%, which is above the Fed's target. So that opens the question of "Well, will the Fed actually ease again anytime soon, or are they on hold for a long time?" We know that they're on hold for the time being, and they're waiting for more information, but we really don't have a great clue as to when that information will come in. So expectations about what the Fed's going to do have really been moving around. Right now, the market seems to be pricing in two rate cuts of 25 basis points each in this year in 2025, but that could shift very, very quickly depending on the data. So one factor is simply being reflected as the shift in expectations about the Fed policy, and that's driven by what inflation's doing, how economic growth seems to be holding up quite well.

And then you throw in this combination of policies that could prove to be inflationary in 2025, possibly beyond, and raise the deficit. So I'm starting to call it the year of the term premium. And for people who aren't familiar with that terminology, the term premium is just the extra yield you get for buying a longer-term bond versus buying short-term bonds and rolling them over.

So you could buy three-month T-bills and just hold them for five years, or you could buy a five-year note or a 10-year note, but you have this uncertainty about, "Where does policy go over the next five to 10 years? And do I get compensated for that uncertainty?" And the more volatile the market is, the more unknowns there are, the higher the term premium. And that has accounted for most of the increase in longer-term yields.

And I think that that's going to be the case this year. We're looking at probably 5% now as the next target on the 10-year Treasury. And barring any real significant change in the economic outlook, the driver is likely to be this concern about inflation and growth exceeding levels that are sustainable in the economy without generating more inflation and causing the Fed to just stay on hold for the time being.

I've even heard a few people talk about possible hikes. I don't think that's likely. Still penciling in one to two rate cuts this year, but really not a lot of confidence around that prediction. We could be stuck where we are for quite a while. So Liz Ann, I'll kick it back to you in terms of equities. Still a bull market. 2024 looked pretty good, as I saw you write. What do you think about 2025?

LIZ ANN: I mean, it was a great year, but I think the fuller story of what happened in 2024 got told at least slightly below the surface of the cap-weighted indexes. So the S&P 500® was up more than 23% last year, NASDAQ was up almost 29%, the NASDAQ 100 up 25%. So on the surface, that was an incredibly strong year. In fact, in the case of the S&P 500, it was the second year in a row of 20%+ gains, and you have to go back to the late 1990s to find the last time that that happened. I don't think it's the setup for something ominous like what followed that period of time because I think there's more differences than similarities, but it's more of a "for what it's worth," but those gains were in large part driven up the capitalization spectrum by the mega-cap tech, tech-related names, Magnificent Seven has been the grouping of stocks that tends to get most of the attention. The moniker was attached to them when they were, and not far off now, are the seven largest stocks in the S&P 500. Tesla did drop off that top seven and was replaced by Berkshire for a little while, but it's been toggling in and out. But they're certainly within the 10 largest stocks in the S&P, which, by the way, the 10 largest stocks in the S&P now account for just under 40% of the index, which is by far a record high, well above what we even saw back in that 1999-2000 period of time. 

But that really propelled the indexes. But again, the fuller story, I think, can be told under the surface to some degree. It's not the truer story. It's just a fuller story—because with a 23% performance for the year for the S&P 500, the average member within the S&P 500 had a maximum drawdown on average of 21%. So that's just into bear market territory. Maybe even more surprising, that same metric was −49% for the NASDAQ. So the average member throughout the course of the year had almost a 50% decline, and it was 38% for the Russell 2000. Now, I think any investor, any investor that I know, would prefer a backdrop like that, where via churn and rotation and sporadic weakness that rotates into different segments of the market at different times, even though those declines were extreme, is much more appealing than if the NASDAQ were to go down all at once to the tune of 49 or 50%. So it's certainly a more beneficial backdrop, particularly for index investors.

And that's just both on the individual investor side and the professional side. It does make it a more difficult environment for professional active managers because if they don't own some of those stocks, the mega-cap stocks in a similar size as what they're represented in the index, they almost by default have very little ability to outperform the indexes. 

But one of the things I always say on this subject to, what is probably for the most part our audience, what is for the most part Schwab's client base, which are individual investors, is, "Don't feel compelled to fall into that trap of having that same amount of concentration in your own portfolio." Because what I think exists out there as a misperception is that the Magnificent Seven, let's just use that as the category, that they're the best performing stocks. They're the biggest contributors to index gains by virtue of their size. 

So the contribution is a function of price times their size. And it's the size component that has been driver of the contribution. In fact, one of the things I pointed out in a recent report that we just published, which was a look back at 2024 performance, is the top 10 best performing stocks in the S&P, only one is in the Magnificent Seven. Maybe no surprise, it's Nvidia. But it's not the best performer. The best performer is actually Vistra, which is a utility stock. There's another utility stock. Four industrials are on the list of top 10 performers. If you go to the NASDAQ and look at top 10 best performers, none of them are in the Magnificent Seven. In fact, none of them are mega-cap stocks or even large-cap stocks. So the point is that there's still has been and will continue to be opportunity potentially to make money and find good investments within the equity market without feeling compelled to take on that same kind of concentration risk that many institutional investors might feel forced to do. 

The last thing I'd say to tie in my world with your world is bond yields matter a lot. They always do, but I think to a heightened degree in this past year or so, given the fact that the Fed lowered rates by 100 basis points, yet longer-term bond yields went up by a similar amount. And as you know, there's been some interesting phases just in the last year. We went through a few-month period where bond yields going up and/or down, didn't, in the case of bond yields going up, didn't hurt the stock market, that they were positively correlated. That has reversed now. We're back into that bond-yield/stock-prices negative correlation. And I think that is something that will continue to be a force in 2025. Particularly really sharp moves up in bond yields would in particular hurt down the capitalization spectrum. Smaller-cap companies that have more variable-rate debt, they're more at the mercy of moves up and down in interest rates. Larger companies are a little bit more insulated, certainly the ones that are earning a lot of interest on their cash. But I think that bond-yield/stock-price relationship continues to be an important one in 2025. 

And then last thing, because you asked about sentiment, there is still some signs of froth. We've seen fund flows. The last two months of fund flows are near a record, inflows into large cap, in particular, large-cap equities. But attitudinal measures of sentiment have come off the boil a bit. AAII, which is American Association of Individual Investors, does a weekly survey of all their members. And it's about an even percent right now that call themselves bulls versus bears. And I think December's weakness might have just eased some of that attitudinal frothiness, but behaviorally we're still seeing it. So as a backdrop, that maybe would fall more on the risk side of things, even though sentiment is a terrible market-timing tool in the short term. It's always sort of the PSA[1] that's important with any kind of sentiment analysis.

KATHY: Yeah, you know, I'm glad you brought up the bond-stock relationship because it brings me around to a couple of questions about the economy that I'd love to get your thoughts on. So you know, as I mentioned, bond yields have been moving up, but real bond yields have been moving up even more sharply. So we're looking at, if you use the Treasury Inflation-Protected Securities Market, TIPS market, and you look at where real yields are, they're in the 2.25, 2.5% region, which is like a 15-year high. We haven't seen real yields at these levels in a really long time. And yet, the economy continues to grow at a pretty healthy rate. The unemployment rate is up from its lows, but it's hovering right around a little above 4%, which is where we used to consider full employment. There's not a lot of signs that the economy's truly slowing down. 

There are certainly cohorts and segments of the economy not doing well and certainly people not doing well. I want to acknowledge that. But in aggregate, the economy is growing 2.5 to 3%, and we're still pretty close to a very low unemployment level. And the credit markets are wide open. If you want to go to the corporate bond market—and you're a company—to borrow money, you know, no problem, capital markets on the equity side, wide open. If you want to go there, you can access money, private equity, plenty of money going around. And so it begs the question that I've been trying to figure out here is, "Have we just reached a higher potential growth rate in the economy that we can tolerate higher real interest rates?" And I'm leaning, you know, yes, it seems the evidence suggests, "Yeah, it's true." We continue to grow with higher nominal and real rates, and nothing seems to be slowing us down. Maybe that's the result of all the investment and supply side that we've had. We've got a big influx into the labor market. We've had some productivity gains. We've had a lot of investment in the economy, both from the public sector and the private sector. 

Are we able to continue this way? And if we do, there's not really a lot of reason for the Fed to be cutting rates anytime soon. And so I'd love to get your thoughts on that.

LIZ ANN: Yeah, I couldn't agree more. I think the potential growth rate of the economy is probably a little bit higher. And that has a lot to do with the shift in our economy over the past many, many years away from manufacturing a little bit more toward the services side. And there's less of a spread between the two, as there were in the early part of the pandemic, the lockdown phase, you initially had the surge on the goods side of the economy because services were completely locked down. That's where the inflation problem began. But then that rolled over, and we had pent-down demand at a time where services opened up, and we had pent-up demand on the services side, fueled by a lot of the stimulus. I think now looking forward, it's less about this idea that the economy is going to slow. I think part of the resilience of the economy in the face of what the Fed did with short-term interest rates is based on what corporations did during this part of the cycle that preceded the Fed's tightening campaign, which was again the second big move to 0% interest rates, second to the global financial crisis.

And many corporations, particularly the larger corporations, took advantage of that, and they termed out their debt, and they've been earning more interest on cash in many cases than they're paying interest on debt. You also saw it with homeowners, mortgage holders that locked in fixed-rate mortgages at very low rates. It's such that when, I don't remember, did the peak in this stated mortgage rate ever get to 8%? I think it was maybe just shy of that. High sevens.

KATHY: Yeah, I think it was in the sevens. Yeah, but I don't think it got to eights.

LIZ ANN: But when it was there, you still had a three handle on what the average mortgage holder was paying. So it didn't eliminate the impact on the economy of what was a pretty aggressive tightening cycle, but it had a muted impact. I think as we think about 2025, it's less about, "The economy isn't really slowing." I think there had been a hope that we would see some catch-up in those more interest-sensitive areas. Manufacturing would pick up. Housing would pick up and play catch-up to services that have continued to be strong. I think that has just been delayed a little bit, not stalled altogether. I think there's tariff-related uncertainty—that's very clear—and monetary-policy-related uncertainty. But I think we do have a very resilient economy. And I think the labor market really holds the key to that. That's where resilience has been significant, notwithstanding the move up in the unemployment rate.

And I think that that really holds the key to the strength of consumption, even to a large degree, monetary policy. And if we can hang in there with a decent labor market, I think that filters through continuing pretty decent performance in the economy.

KATHY: Yeah, and we had those productivity gains. Always such a hard thing to predict and even to measure in real time. But you know, over the last couple of years, had tremendous gains in productivity for a very mature economy with an aging workforce, which has not aged as much because we had this influx of new people. And that could be the key to the fact that we've had such a resilient economy. 

LIZ ANN: But that's also important looking forward because, of course, basically GDP is a function of labor force growth multiplied by productivity. We've got that strong productivity side. The big unknown is what happens on the labor force growth side because of immigration. So I'm glad you brought that up.

KATHY: Yeah, we have those unknowns, tariffs, immigration, tax policy. We've got a lot of unknowns on the horizon. And that, I think, is the big driver here on the bond market side in the long end of the yield curve. It's just, you know, people want to get paid more for tying up their money because they're just not sure how these policies are going to play out. Unfortunately the crystal ball isn't real clear either here or at the Fed.

They acknowledge that they're still operating under cloudy skies, so we'll have to see how that plays out. But for now, we're being pretty cautious on duration. We don't want to extend beyond a benchmark amount just to take that kind of risk. It just doesn't make a lot of sense right now.

LIZ ANN: Yeah, and that ties into what our perspective has been on the equity side of things. As you know, we and many listeners know, we have been very factor-focused investing based on characteristics of companies and still think you want to stay up in quality. And that tends to at least dampen some of the volatility that can kick in, in light of a lot of this policy-related uncertainty.

KATHY: So let's pivot now and look at the week ahead.

We're recording this just prior to the unemployment report as usual. So we've got that. What else are you keeping an eye on for next week?

LIZ ANN: Yeah, so next week we get two of the biggest inflation numbers. We get both CPI, that's the Consumer Price Index, and PPI, which is the Producer Price Index. And then the Fed's preferred measure which is PCE, which is the Personal Consumption Expenditures index, but Fed increasingly cites a pretty wide variety of inflation data, and it's the PPI and CPI tend to be the ones that the market can often react to.

If you get an outlier report on either of those, you can see a bigger market reaction. Once you get CPI and PPI, if you're a really good economist from a math perspective, you can map the data you get with CPI and PPI into what PCE is going to be, and that's why it doesn't tend to be an outlier relative to consensus expectations. So I think that's important. And then maybe one that has garnered a little bit more interest just because of the inflation backdrop, but also the trade backdrop, would be the differential between import and export prices. That comes out next week as well. 

Claims is a weekly metric for what's going on in the labor market, is important. As you and I are doing this, we got claims a day earlier than we normally would this week because of the market being closed on the 9th for remembrance of former President Jimmy Carter. But I think claims is important because the most recent reading showed another big drop down to just a little over 200,000, which again is testament to the relative strength of the labor market. 

We also get the Housing Market Index, which was put out by the National Association of Home Builders, NAHB for short. Those are metrics that I like to watch and some of the subcomponents of that and also related to housing we get starts and permits and then we also get industrial production, which is a feeder into recession models. What about you?

KATHY: Well, we've got some minutes of the Fed's last meeting coming out, which I'm going to be interested in, because we did get our first dissent in years. And clearly there were some, when we look at the dot plot where they all estimate where policy rate is going, there was a huge dispersion from the highs to the lows for the next, not just now, but for the next several years and for the ending terminal rate as well.

So it'll be very interesting to me to see any detail on that conversation to understand who's coming from what direction in terms of Fed policy. So I'm looking forward to a good nerdy read of the minutes. And then of course that ushers in a rotation at the Fed, the annual rotation of voting members. So we'll kind of be paying attention to various speeches from the voting members now to see where they stand on things. I think that's going to be my focus and of course on any of the new policy discussion coming out of Washington. It's too early obviously to have conclusive policy decisions, but that's increasingly driving expectations in the market, so I have to keep an eye on all that.

So that's it for this week. Thanks for listening. As always, you can keep up with us in real time on social media. I'm @KathyJones—that's Kathy with a K—on X and LinkedIn.

LIZ ANN: And I'm @LizAnnSonders on X and LinkedIn. I am only on those two platforms right now. I'm not on Facebook, not on Instagram. I'm not maybe yet on BlueSky or WhatsApp. I have a lot of imposters, and lately they have been generating AI videos, which look like me and sound like me, but they're not me. They've actually scammed quite a few people, including some of our clients. So be really mindful of that. You can also read all of our written commentary under the Learn tab of Schwab.com. So don't forget about that. 

And back to our podcast. If you've enjoyed the show, we would really be grateful if you would leave us a review on Apple Podcasts, a rating on Spotify, or feedback wherever you listen. And you can follow us for free in your favorite podcasting app. And we will be back in a short week for another episode. So stay tuned.

For important disclosures, see the show notes or visit schwab.com/OnInvesting where you can also find the transcript.

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