Federal Reserve’s hawkish rate cut a signal for investors

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As we enter 2025, we think there was a recent development over the past two weeks that investors really should start paying attention to, especially those aiming for a repeat of last year’s market results.

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The U.S. Federal Open Market Committee meeting (a branch of the Federal Reserve System that determines the direction of monetary policy) on Dec. 18 was a real doozy. The 25 basis point rate cut came in as expected but there was some disagreement among members as to whether to hold rates steady. As a result, the Fed’s dot-plot (the central bank’s projection for its key short-term interest rate) is now projecting another 50 basis points of rate cuts next year, taking rates to 3.9 per cent, which is down by half of the previously expected 100 basis points in cuts.

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This sudden hawkish positioning sent shockwaves mostly through very expensive U.S. equity markets that have been depending on more liquidity coming out of the U.S. Federal Reserve to justify current sky-high valuations. More so, we saw this in those certain pockets of excessive speculation, like cryptocurrencies, that appear to be simply levered-beta strategies, meaning the volatility of their returns are high compared with the broader market. Interestingly, it was also impactful to those companies that have benefited from Donald Trump winning the U.S. presidential election, such as MicroStrategy Inc. and Telsa Inc.

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For the majority of us professional investors, who typically don’t participate in these areas of the market, we are more concerned about the price investors have been willing to pay for the U.S. mega cap stocks that have been leading the charge and dominating indices.

For example, take one of the largest U.S. companies by market cap, Apple Inc., which has recently been trading as high as 41 times earnings, its highest price-to-earnings (P/E) ratio since 2007 when the first iPhone was released. This is despite moderate forward revenue and earnings growth projections and no major new product launches expected.

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It has now reached the point that the share of stocks with an enterprise value to sales multiple greater than 10 times has increased to levels not seen since the 2021 mania and the 2000 tech bubble.

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The big question is if the Federal Reserve has taken away half of the punchbowl and is no longer going to continue at its previous pace of easing, then how are these companies going to backfill in financial results to support such high multiples?

Fidelity Global Macro Strategist, Jurrien Timmer, sums it up perfectly in a recent X post: “By my math, trailing EPS for the S&P 500 index would be $211 instead of $251 were it not for financial engineering (buybacks and M&A). That means that the P/E ratio is higher by a similar magnitude. The five-year cyclically adjusted P/E ratio (CAPE) would be 38.3x instead of 32.4x, which is even higher than the peak of the dot.com bubble in 2000. It gives me pause.”

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This is something that really deserves a lot more attention and leaves us thinking that perhaps we’re back to the scenario where bad economic news is good news for these companies because it increases the likelihood of the Fed resuming its previous path of easing?

Being a market participant prior to the introduction of quantitative easing post-2008, this really does not sit well with us. Markets have become liquidity addicts and this is unfortunate as it is masking some really good companies generating some excellent free cash flow that get labelled as “yesterday’s trade” and therefore do not get the attention they deserve.

Instead, it’s all about borrowing at low rates and buying up stock to financially engineer boosted earnings growth. Maybe one day we will return to the good old days of Benjamin Graham and start handing out his famous book, The Intelligent Investor, to read instead of kids taking pictures of throwing it in the trash can.

Until then, we must all become experts on monetary policy, as our portfolios depend on it.

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Martin Pelletier, CFA, is a senior portfolio manager at Wellington-Altus Private Counsel Inc., operating as TriVest Wealth Counsel, a private client and institutional investment firm specializing in discretionary risk-managed portfolios, investment audit/oversight and advanced tax, estate and wealth planning. The opinions expressed are not necessarily those of Wellington-Altus.

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