Q1 2025 Commentary
Last quarter’s commentary spent considerable time discussing optimism. In December stocks were at all-time highs, trading at valuation multiples that had only ever been seen during the 2021 tech bubble and the dotcom bubble before that. The price action was largely driven by a combination of optimism surrounding the benefits of AI and the business-friendly potential of the incoming Trump administration.
Some of that optimism faded in the first three months of the year, which concluded with the S&P 500 down 4.6% – the worst quarter for the index since Q3 2022. Several factors contributed to the weak start.
The AI narrative was disrupted by the emergence of the Chinese LLM Deepseek. The cost-efficient AI model shook the narrative of U.S. mega-cap tech dominance and the dependence on top-tier GPUs. We are not AI bears, but have repeatedly stated that competition in the space was underappreciated in excessively high P/E multiples.
This first quarter also saw some signs of emerging economic concerns. January and February showed payroll growth slowing to its lowest level since last summer. Initial jobless claims remained low, but reversed a six-month trend lower. At the same time, there were some signs that inflation was accelerating, with core inflation in February jumping to its highest rate in over a year.
Adding to the inflation concerns was the Trump administration’s aggressive tack on tariffs, beginning with escalating tariffs with our three largest trading partners, and threatening more. Investors hoping for some offsetting relief on the political front were also disappointed by the lack of progress on tax cuts or a new budget.
When drafting this commentary in the days after the quarter-end, I generally like to compartmentalize the previous quarter, but given the market action since April 2nd (Liberation Day), I do feel compelled to shift the focus to the tumultuous start to the second quarter.
Of the concerns above, one has dominated the start of Q2: tariffs.
On April 2nd, markets were stunned by the magnitude of the Liberation Day tariffs. The floor for tariffs on foreign goods was set at 10% (even for those countries with which we have a trade surplus), with new duties rising as high as 50%.
US stocks fell more than 10% over the next two trading days – marking the worst back-to-back equity market sessions since the Covid-19 crash, joining the financial crisis and the 1987 crash as the only similarly rapid declines in post-war history. Losses persisted in the following trading days, bringing the S&P 500 more than 20% from its all time high, and the Nasdaq, 25%.
The disorder spread to treasury and currency markets as well. 10-year yields saw their largest weekly jump since 2001, while the dollar posted its worst week since 2022.
Likely shaken by the market instability, on April 9th, the day that the reciprocal tariff regime was supposed to go into effect, the administration backed away from most of their extreme positions – settling on a 10% additional global tariff for the next 90 days. China, however, was not only excluded from the de-escalation, but saw cumulative tariffs on their goods hiked to 145%. Markets found relief in the pause, posting one of the largest intraday reversals in history, with the S&P 500 closing more than 10% above its morning lows.
As of Friday April 11th, the S&P 500 was down 10.8% for the year.
Our performance for the quarter can be attributed to a few choices. The most significant choice was entering the year with a large cash allocation. The bull market since the 2022 lows had been rather relentless, driving equities to extreme valuations and increasing risks. As with the Covid outbreak in 2021, our defensive posture was not in anticipation of any particular bad news, but mounting downside risks in the face of any bad news.
Our core strategy also benefited from an allocation to higher-quality companies. The worst performance around the tariff announcements came from higher-beta stocks, and the price action included some rotation into more stable, quality names.
Lastly, we benefited by buying into the weakness. We did not make any dramatic allocation shifts, but Time Overlay equity allocations, which began the year below 40%, briefly surpassed 50%.
By many metrics, this is precisely the type of environment that we have historically found appealing. Financial headlines have worked their way into mainstream media, inciting panic. Stock prices are considerably off their highs. Economic data and corporate earnings remain rather resilient. We have even seen signs that corporate insiders are buying stock into the recent weakness. The Federal Reserve appears inclined to lower rates.
Some of these metrics align with historic buying opportunities. To begin with, consider the price action alone. The only two-day 10% crashes in modern history occurred during Covid, the financial crisis, and the 1987 crash. Each saw stocks permanently bottom within 6 months, and with subsequent drawdowns of no more than 10%. Each subsequent rally saw stocks at least 10% higher. That is a very favorable risk-reward setup for investors with a time horizon beyond six-months.
Looking at investor sentiment, the AAII survey has seen bearishness exceed 50% for seven consecutive weeks, surpassing 60% in two of those weeks. We have not seen sustained responses at those levels since 1990 and October of 2022, respectively. Each of those times marked significant, enduring market bottoms. Similarly, the Investors Intelligence survey saw bulls fall to their lowest level since the end of 2008, near the financial crisis lows. There is no ambiguity that this level of panic has historically been bullish.
At the time of publication, markets have shown some renewed calm. Though we do not necessarily believe that the temporary reversal from the administration has set a floor in equity prices, we do believe that the reversal has restored some order to markets, both by scaring away shorts, and proving that there is a political reaction function to adverse market moves.
Our core strategy does not anticipate any imminent changes to our target asset allocations, but as you are likely aware, the environment is changing daily. We will not be afraid to continue acquiring shares of high-quality companies if opportunities arise once again.
Though we find support from historical analogs, we must also note how this market decline is unlike any that has preceded it. The correction exists solely because of abrupt unilateral trade actions. For now, the President has the power to restore or destroy sentiment based on his willingness to facilitate or disrupt global trade. In some ways this creates both more upside and downside risk. There is more upside risk than in past disruptions because we could escape these conditions without lasting drag or damage (see structural unemployment from 2008-2015 or inflation in 2022). There is more downside risk, however, because the government is not coming to support markets. Deficit spending and monetary stimulus are out of style, and if the President remains committed to goals of using trade barriers to realign our economy, we might have to “take our medicine,” and markets may not like the taste.
Because of the rapidity of the moves, we have abstained from being overly aggressive, but if markets deteriorate further, our core strategy has plenty of cash in money market funds that could be put to work. If markets are able to orchestrate a rebound, we will be content with our current level of participation in what remains a rather expensive market environment.
Robert B. Drach
Drach Advisors LLC