“He’s making a list, and checking it twice, gonna find out who’s naughty or nice. Santa Claus is coming to town!”
So, have we been naughty or nice? Will we finish the year with a little Santa rally, or will we end up with a lump of coal? Its hard to say.
In preparing for this annual Christmas Insight I reviewed what I wrote the last few years. While I have promised not to use AI in our writing, it is tempting to cut and paste those previous December Insights. Like 2023, this has been a strange year, especially in the second half. Take small-company stocks in the Russell 2000 index: At the end of the third quarter, stocks of companies in that index that are losing money were outperforming the stocks of companies in that index that make money by more than 30 percent.
This phenomenon led to the narrative that we are in an AI bubble, which in turn has led to a strange quarter where seemingly company after company reported better-than-expected financial results only to watch their stock prices drop as a result. One such example is Duolingo, which grew revenue at 41 percent and earnings at more than 1,000 percent to then see its stock drop 25.5 percent the day they announced these results. Doesn’t seem to make sense? It doesn’t have to make sense. Markets allocate capital over the long term better than any other method, but in any given short-term period, all kinds of crazy things can occur. This is why prudent investing requires patience, which was our theme in 2023.
In both 2023 and 2024 there was lots of talk about the market being expensive. It still is expensive if one simply looks at the top-down index view. There are some differences, however. The S&P 500 has been very top-heavy; the valuation is skewed by the very high price of the largest few companies. In 2023, we were describing these as the Magnificent Seven. In 2024, we talked about large-growth companies in general being very expensive relative to earnings. Based on our proprietary work, they were two standard deviations above average, which in plain English means they reach prices this high only 5 percent of the time.
In both years we pointed out that there are several areas in the market that were not at these really high prices, and that observation has played out over the last few years. As we finish 2025, value stocks have rallied. The stocks portion of our income strategy, which is meant for investors who are either very conservative and/or in retirement and needing income, is up more than 23 percent, net of fees, year to date through December 17. These are the most conservative value stocks that we own and they have outperformed not only the S&P 500 but also our most aggressive strategies. Last year it was the opposite. I have said it before, and it bears repeating: We did not wake up on January 1, 2025, and forget how to invest for growth, nor did we not know anything about income strategies in 2024. This is how markets work; there is a give and take.
One of the companies we own in our income strategy is Rio Tinto, a mining company that mines several different minerals but primarily iron ore. Rio’s stock price is up 19.78 percent over the last three months and 37 percent year to date through December 17. Its stock price alone (not including the sizable dividend) is up 32 percent total over the last three years. In other words, the stock price was down approximately 5 percent going into the year and not even that great until the last three months. This is how stocks actually move and what makes investing so difficult; they stay relatively flat for long periods and then jump. This behavior is what fools investors into believing they can time things that cannot be timed.
In 2023, it was the Magnificent Seven. In 2024 it was technology, more broadly and AI. Now we are seeing value finally get into the act. So, what will Santa bring us this year and how will this play out in 2026? Honestly, I am not sure, but I do know one thing: the market is running out of places where lower prices can be found. Based on this run, large value stocks have joined their large growth cousins in being unusually expensive.
I suspect that the New Year will bring a rally in technology and AI-related stocks, which have been selling off as of late, and perhaps a drop in the value stocks that have rallied. After that, it will depend on the economy. High prices alone do not cause markets to drop, but high prices combined with disappointing results will. Can the economy hold up and allow corporate earnings to grow into these valuations? That is the question of 2026.
In the meantime, we wish you all a very Merry Christmas and a Happy New Year!
Warm regards,
Chuck Osborne, CFA
