2025: Quality Small-Caps Emerge as the Prime Hunting Ground

Setting the Stage: How 2024 Shapes 2025

2024 kicked off with inflation fears grabbing headlines. January’s CPI report showed a 0.1% overshoot, largely driven by inflated shelter costs, which make up a hefty 25% of CPI. Meanwhile, the PPI painted a different picture, with upstream prices holding steady and unchanged since mid-2022. By February, M2 contraction continued, signaling a normalization of monetary policy after the pandemic-era stimulus surge. Demand for cash returned to pre-pandemic trends, and financial markets began pricing in a potential Fed pivot. The SPX surged 10% in Q1, fueled by optimism.

Spring brought momentum to the disinflation narrative as shelter costs, a primary inflation driver, started cooling. Analysts began projecting a reduced CPI contribution from housing by late 2024. March M2 data reinforced these expectations as supply and demand aligned. Yet, the Fed remained cautious, closely monitoring lagging indicators like employment and housing. By summer, shelter-driven CPI distortions eased, with ex-shelter CPI consistently below 2% for eight straight months. At July’s FOMC meeting, the Fed hinted at potential rate cuts before year-end. Markets rallied on expectations of lower borrowing costs.

As 2024 drew to a close, the financial landscape was abuzz with anticipation of a Federal Reserve pivot. The long-awaited cooling of shelter inflation—a significant contributor to overall price pressures—played a pivotal role in narrowing the gap between headline and core CPI figures. This shift provided the Fed with an opportunity to consider easing its monetary stance, a move that seemed increasingly viable without stoking the embers of inflation fears.

Meanwhile, liquidity remained robust across markets, bolstered by tight credit spreads that signaled continued investor confidence in the resilience of the economy. Corporate earnings painted a similarly optimistic picture, with many companies, particularly in the tech and consumer discretionary sectors, exceeding expectations. The tech industry, buoyed by innovations in AI and cloud computing, saw renewed momentum, while consumer discretionary benefited from resilient spending patterns and easing cost pressures. As markets speculated on the timing and scale of the Fed’s potential policy shift, optimism grew, setting the stage for a pivotal moment in the economic cycle.

The Fiscal Overhang

Despite an optimistic macro backdrop, fiscal concerns cast a long shadow over the economic horizon. Interest payments on public debt surged to unprecedented levels as a share of GDP, reflecting a fiscal trajectory that increasingly seems unsustainable. The U.S. debt-to-GDP ratio crossed a staggering 120%, with annual deficits running at 7% of GDP—troubling figures, particularly in a strong economic environment. Adding to the alarm, annual interest payments on the national debt neared the $1 trillion mark, underscoring the structural challenges that, while unlikely to trigger an immediate crisis, pose significant threats to long-term economic stability.

This brewing fiscal storm has fueled a growing narrative about the risks of rising bond yields and ballooning deficits destabilizing financial markets. The crux of the concern lies in the upward march of the 10-year Treasury yield, which many fear could breach 5%—a threshold that could shake the very foundations of the global financial system. Skeptics highlight the fallout from regional bank failures in 2023, when the 10-year yield surpassed 4%, as a cautionary tale of what might happen if yields climb even higher. The implications extend beyond banks. Higher yields could reverberate across credit markets, pressuring corporate balance sheets, raising borrowing costs, and spooking investors. Critics argue that, unlike past crises, the Federal Reserve might find its hands tied. With bond market dynamics dictating terms, the Fed’s ability to inject liquidity into a strained financial system could be severely constrained, leaving policymakers with fewer tools to manage turbulence. As these tensions simmer, they serve as a stark reminder that even in periods of economic strength, underlying vulnerabilities can threaten to reshape the landscape.

Counterpoint: The Banking System’s Resilience

This narrative, while compelling, misses critical nuances in how banks manage risk and value their assets. MTM losses on Treasuries are largely theoretical unless banks are forced to sell these securities before maturity. In reality, most Treasuries held by banks are classified as held-to-maturity, meaning they’re recorded at par value on balance sheets as long as they’re retained until maturity. These securities, virtually free of credit risk, will pay out in full barring a U.S. government default—a scenario with an exceedingly low probability.

The regional bank failures of early 2023, such as SVB, weren’t solvency crises but rather liquidity mismatches. These banks faced concentrated depositor bases, which triggered mass withdrawals and forced them to sell HTM securities at a loss. In contrast, larger financial institutions benefit from more diversified depositor bases and stronger capital buffers, making them far less susceptible to similar runs. Additionally, the Federal Reserve has introduced tools like the Bank Term Funding Program, which allows banks to pledge HTM securities at par value for liquidity. This effectively eliminates the need for forced asset sales at a loss, significantly reducing systemic risk. Taken together, these factors highlight the resilience of the broader banking system. While liquidity concerns may linger at the margins, fears of a widespread solvency crisis appear overblown and disconnected from the fundamentals of modern bank risk management.

Expectations for 2025: A Pause, Not a Crash

While fiscal challenges will inevitably require attention, the tipping point doesn’t appear to be on the immediate horizon. In 2025, the economy is likely to keep grinding forward, with GDP growth slowing modestly but staying positive. Inflation may stabilize in the 3-4% range, signaling a steady yet elevated interest rate environment. Corporate earnings should remain resilient, buoyed by a strong labor market and steady consumer spending amidst the ongoing divide between the upper and lower end consumers. What’s more pressing is the intensifying wealth divide. By 2023, the top 10% of U.S. households controlled nearly 70% of the nation’s wealth, while the bottom 50% held just 3%. Rising interest rates disproportionately impact debt holders—primarily non-asset owners—while asset owners continue to benefit from higher nominal GDP and inflation-fueled gains in asset prices. Housing affordability, already strained, is worsening, with median home prices at 7.6x median household income—far above the historical norm of 3-4x. This imbalance is poised to widen further, exacerbating long-term socioeconomic concerns.

For 2025, the most likely scenario is a year of consolidation. Asset prices could hold steady or even post modest gains(albeit with increased intra-year volatility), but the underlying economic storm—fueled by structural fiscal and social divides—is unlikely to erupt just yet. Instead, this could be a year where the cracks deepen, setting the stage for more significant challenges into ‘26.

The Magnificent 7

The S&P 500 has delivered two consecutive years of 20%+ returns, driven almost entirely by the Magnificent 7, AAPL, MSFT, AMZN, NVDA, GOOG, META, and TSLA. Bolstered by robust earnings and early dominance in AI adoption they now make up nearly 30% of the index's total weight. As we head into 2025, their performance will be the critical driver of broader market trends. Consensus estimates peg SPX EPS at $240 for 2024 (10% growth) and $275 for 2025 (14.5% growth), with bullish outliers like Yardeni forecasting as high as $285 (19% growth). At 5,900, the SPX trades at 21.5x forward earnings for 2025, well above the historical 18-19x range. Revenue is projected to grow only 6% hence much of this growth hinges on earnings outpacing revenue, with ~200 basis points of margin expansion pushing profit margins to record highs of ~14%.

The Magnificent 7 have now become the index and their valuations now appear stretched, offering what I think is limited upside given the risks. AAPL, the most valuable company globally, trades at 30x 2025 FCF, up from 24x a year ago. This market premium assumes 14% FCF growth in 2025 driven by margin expansion, while revenue is forecasted to grow just 7%. Beyond 2025, FCF growth is expected to slow to single digits, reflecting challenges in finding new growth drivers given the massive base. Even if AAPL compounds FCF at 10% annually, it still trades at 21x 2029 FCF, not exactly a bargain. Its current valuation assumes ongoing flawless execution, including maintaining its dominance in the NA smartphone market, sustaining its lucrative app store fees, and most importantly navigating geopolitical risks in key markets like China and India. NVDA was up almost 200% for the year and trades a 35x FCF multiple, faces similar pressures. While its growth is powered by the AI boom, sustainability is uncertain. Major customers are actively diversifying their suppliers, which could weigh on long-term growth. MSFT, trading at 42x FCF, benefits from its enterprise dominance and high-margin recurring revenues and while its premium valuation may be justifiable, it leaves no margin for execution missteps. GOOG and META, at 26x and 28x FCF respectively, appear more reasonably priced but are far from undervalued. Bulls argue that heavy AI-related capital expenditures are temporarily suppressing FCF and that profitability will expand as capex normalizes. However, much of this optimism seems baked into current prices, capping further upside. In sum, while the Magnificent 7 are exceptional companies, their current valuations demand perfection in execution to sustain gains. These are great businesses, but they are not great stocks at these levels. With the SPX so heavily influenced by these mega-caps, the broader index may struggle in 2025 as fundamentals work to catch up with lofty valuations. For investors, this could mean tempered returns and heightened risks in the year ahead.

The Case for Small Caps

While mega caps dominate, 2025 could mark a turning point for small caps, which have been overlooked for years. Many small caps trade at deeply discounted valuations, with the Russell 2000 significantly lagging large-cap indices. Years of underperformance have left many high quality constituents priced well below intrinsic value. Small caps are also fundamentally stronger now. Many have deleveraged and are positioned to benefit from steady domestic growth. Their reliance on localized economic drivers makes them more resilient to global macro volatility. With large caps trading at historically high multiples, quality small caps could offer a better risk/reward profile.

I’m less bullish on the index overall because it reflects broader market trends, many of which are driven by macroeconomic factors or sector-wide dynamics that can dilute potential upside. Instead, I’m focused on idiosyncratic opportunities within its constituents—those individual companies that, due to unique growth drivers, mispricing, or underappreciated fundamentals, may outperform regardless of broader market conditions. Underestimating margin upside is often one of the best catalysts for positive returns. When this is combined with multiple expansion, it can create a powerful combination that drives robust returns, making these company-specific opportunities very attractive. This is where I’ll focus my energy in 2025. While mega caps take a breather, quality small caps could see a leadership shift, driven by improving fundamentals and undervalued opportunities. I’ll be hunting for high-quality, fundamentally strong small caps with clear growth drivers as that’s where I see the best risk/reward setups for the year ahead.