Solid Rebound to Begin Year
We have often cited that market pullbacks that are technically driven typically offer excellent buying opportunities. The December pullback granted just that with January posting solid returns. This rally into Inauguration Day was likely not just election euphoria redux. Sparking the dip buying could also be attributed to lower-than-expected nonfarm payroll additions, producer prices and consumer prices. These data points countered the market’s inflation concerns, which had driven interest rates higher. The US 10 Year Treasury yield quickly reversed course falling from 4.8% (a new cycle high) to 4.6% and triggered rebounds in stocks and bonds. Lower interest rates are good for both stocks and bonds.
Within the last few days, the market has experienced a different sort of pullback in AI stocks. The advent of DeepSeek’s R1 AI model that allegedly was produced at a fraction of the cost of OpenAi’s ChatGPT, Google’s Gemini or Meta’s Llama models yet yields similar results, has caused a dramatic rethinking on core investment assumptions. (Please see our research note on the implications of DeepSeek here for details.) The implication of DeepSeek’s supposed accomplishment of using older, slower, cheaper Nvidia chips to obtain similar results to its much more expensively made competition raises the question of future demand for high end Nvidia GPUs and other related hardware. It could mean there is a lower need for AI data centers…or it might not. We believe there is much more to learn about this fluid situation before arriving at a definitive decision. This is an important distinction from a technically driven pullback because the business implications raised by DeepSeek may be real and fundamental. The degree to which fundamentals will change for the worse may change our view on the value of these businesses. So, more to come on that.
Tariffs TBD
With President Trump’s (thankfully peaceful) inauguration in the rear-view mirror, the guessing game on his policies is becoming clearer by the day. Although one area that has generated significant market consternation that remains in flux is tariffs. The market narrative likely became too negative entering the year in terms of the pervasiveness of their use and the anticipated inflation impact from them. We suspect that the Trump Administration is going to use the threat of tariffs as a negotiating stick but will be selective in its application. For instance, the “proposed” 25% tariff on Canadian imports would significantly damage the Canadian economy, and we doubt that is the real goal of these tariffs. In other words, broad application of tariffs seems inconsistent with the specific goals of increasing manufacturing jobs in the US or securing the border.
The mere threat of tariffs seems to be having an impact already. For example, on January 22nd, Stellantis – maker of Chrysler automobiles – announced it will move 1,500 jobs from Canada to its shuttered Belvidere, IL plant[1]. It is reasonable to believe that many companies if faced with a choice between adding production in Canada, Mexico, or China (all potential tariff targets) as an alternative to the US will now need to consider the risk of tariffs. Given President Trump’s prior use of tariffs in his first term, the current threats need to be taken seriously. According to Bloomberg, the term “Tariffs” is being cited more frequently on earnings calls this quarter, which indicates elevated awareness among company executives and investors.
From an investing standpoint, we feel it is best to limit any potential damage by avoiding stocks in industries that may be subject to tariffs. As far as trying to find stocks that will benefit from tariffs, we have historically found betting on prospective policies out of Washington to be a fool’s errand.
Tax Policy Matters
By far the most important political issue for the market this year is the prospective expiration of the Trump tax cuts set forth in the 2017 Tax Cuts and Jobs Act at year end. Treasury Secretary Scott Bessent in his Senate testimony plainly warned of the “devastating” consequences to the economy and to individuals if the tax cuts are not extended, which is President Trump’s intention[2]. He further testified, “Americans are barreling towards an economic crisis at year-end. If Congress fails to act, Americans will face the largest tax increase in history, a crushing $4 trillion tax hike.” During the Q&A portion of his testimony he added, “We will see a gigantic middle class tax increase. We will see the child tax credit halved. We will see the deductions halved, so it will be what we call in economics, it has the potential for a sudden stop.” [3]
With Republican control of both the House and Senate, the most likely outcome is that most of the expiring taxes will be made permanent or extended thereby averting an economic catastrophe. Failure to do so seems like political suicide on top of the dramatically negative economic consequences. The markets would surely experience a dramatic decline as well.
Expectations are for these tax cuts to be addressed in a reconciliation bill as such bills only require a simple majority in the Senate for passage. Nevertheless, this is not going to be easy. We would expect vocal opposition by Democrats and other complicating factors to arise. While the market seems unconcerned about this bill’s ultimate passage that could change. The longer this process takes the more concerned the market may become. The market does not want this to degenerate into a New Year’s Eve standoff.
Portfolio Positioning
The last few months have been chaotic, and markets have been volatile. For all that volatility, the stock market indices are still near record highs. The election, surging interest rates and the AI stock swoon have been a series of distractions away from a still solid economy. The labor market remains strong, and inflation continues to trend downward. Although, few cuts are expected this year from the Fed, their bias is toward easing. This backdrop for markets provides a firm foundation for risk assets. It is easy to become distracted by periodic chaos, which is why we remain keenly focused on business fundamentals.
A key aspect, therefore, to generating attractive returns for investors is finding companies with earnings accelerating faster than the market expects. This is one of the reasons we invest in companies benefiting from strong secular tailwinds. At the individual stock level, we have a lot of confidence that the stocks we own will likely exhibit such earnings growth. On occasion, even the strongest of themes, such as AI, can undergo pullbacks. Big kneejerk moves often create more buying opportunities. We often find oversold stocks that were “guilty by association.” As we sift through the AI rubble, we expect to find a few of those. Importantly, we remain poised to adjust the risk in our portfolios as conditions warrant.
Conclusion
Our optimism for healthy returns this year has not waned. We are in the middle of earnings season as so far companies sound similarly optimistic. The economy is strong, and the pillars are in place for many companies to grow solidly. We discussed last month just how reliant last year’s market performance was on Nvidia and the rest of the Magnificent 7. The DeepSeek revelation reinforces that there are really two markets: AI and the rest. We will continue to maintain exposure to both as the best risk-adjusted way to create wealth for our clients.
Disclosures
LIM is an Investment Advisor based in Dallas, Texas and registered with the Securities and Exchange Commission. Registration does not imply a certain level of skills or training. LIM is a company with purpose, dedicated to creative and unique thinking. We focus on portfolio valuation and research, along with superior client experience. We seek to identify investment opportunities by looking at economic factors, security valuation and human behavior. We start with the fundamentals of portfolio management and valuation. Then we build on these fundamentals with unique thinking and creative intelligence gathering to form a viable investment thesis. We believe this approach leads to dynamic global portfolios with increased return and managed risk. LIM utilizes Charles Schwab & Co. Inc. (“Schwab”), a FINRA-registered broker-dealer, member SIPC, as its custodian of assets. LIM is independently owned and operated and not affiliated with Schwab.
Additional disclosures:
This document may contain forward-looking statements based on LIM’s expectations and projections about the methods by which it expects to invest. Those statements are sometimes indicated by words such as “expects,” “believes,” “will” and similar expressions. In addition, any statements that refer to expectations, projections or characterizations of future events or circumstances, including any underlying assumptions, are forward-looking statements. Such statements are not guaranties of future performance and are subject to certain risks, uncertainties and assumptions that are difficult to predict. Therefore, actual returns could differ materially and adversely from those expressed or implied in any forward-looking statements as a result of various factors.
This material represents an assessment of the market and economic environment at a specific point in time and is not intended to be a forecast of future events or a guarantee of future results.
Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions.
This document is a general communication being provided to you for information purposes only. This communication is educational in nature and not designed to be a recommendation for any specific investment product, strategy, plan design feature or any other purpose. By receiving this communication, you agree with the intended purpose described above. Any examples used in this material are completely hypothetical and for illustration only. The document is for the sole use of the person to whom it is addressed and is privileged and confidential. Use by anyone other than the addressee is strictly prohibited.
Definitions
The S&P 500 Index consists of 500 stocks chosen for market size, liquidity, and industry group representation. It is a market-value weighted index (stock price times number of shares outstanding), with each stock’s weight in the Index proportionate to its market value.
The Nasdaq Composite Index is a market cap-weighted index, representing the value of all stocks listed on the Nasdaq Stock Market. The composition of the Nasdaq Composite is a mix of long-established companies that have been on the exchange since inception, to IPO newcomers, companies that grew from OTC exchanges or switched from other exchanges.
The Dow Jones Industrial Average is a price-weighted average of 30 blue-chip stocks that are generally the leaders in their industry. It has been a widely followed indicator of the stock market since October 1, 1928.
The Bloomberg US Aggregate Index is a broad-based flagship benchmark that measures the investment grade, US dollar-dominated, fixed-rate taxable bond market. The index includes Treasuries, government-related and corporate securities, mortgage-backed securities (agency fixed-rate pass throughs), asset-backed securities and commercial mortgage-backed securities.
The S&P 500 Equal Weighted Index is the equal-weight version of the S&P 500. The index includes the same constituents as the capitalization weighted S&P 500 index, but each company is allocated the same fixed weight at each quarterly rebalance.
The Russell 2000 Index is comprised of the smallest 2000 companies in the Russell 3000 Index, representing approximately 8% of the Russell 3000 Index total market capitalization.