Day Hagan Smart Value Strategy Update January 2025
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Summary
The DH Smart Value Portfolio continues to invest in companies producing excess returns through positive economic profitability, supported by solid balance sheets (quality), significant cash generation (profitability), and trading with considerable margins of safety (valuation). We believe these factors will continue to provide rational opportunities for the foreseeable future.
Strategy Update
2024 was another strong year for U.S. equities, with the S&P 500 posting back-to-back 20% gains for the fifth time in history. However, the U.S. equity markets faced challenges in December 2024, leading to weaker performance across major indices. Several key factors contributed to the market’s cautious tone at the end of the year, ranging from Federal Reserve policy to mixed economic data and seasonal trends. While the Fed continued its rate-cutting cycle, long-term bond yields stayed elevated, reflecting strong economic fundamentals and inflation settling at 2.5%, above the central bank’s 2% target. This dynamic created headwinds for interest-sensitive sectors such as real estate and utilities, with the S&P Real Estate sector declining 9.6% and Utilities down 8.1% during the month. Elevated fixed-income yields underscored market concerns about the pace of monetary easing and its impact on economic activity.
As 2024 commenced, investors were concerned about economic growth (recall all of the discussions around the prospects for a “soft landing”), high inflation (“higher for longer”), geopolitical tensions with Russia and China, broadening tensions in the Mideast, and various global political upheavals. Yet, despite these challenges, the U.S. economy likely achieved a moderate 2.5% to 2.8% GDP growth rate for the year (advanced estimate due on January 30). For 2025, U.S. GDP growth estimates range from 1.9% (CBO) to 2.5% (Goldman Sachs/Bank of America). This modestly optimistic outlook is supported by the potential increases in earnings stemming from tax reforms, deregulation efforts, and significant investments in artificial intelligence (AI).
Importantly, Wall Street analysts predict a notable 12% rise in earnings per share (EPS) for 2025, a substantial increase from the anticipated 8% growth for 2024. However, as we look ahead to 2025, the financial landscape presents a myriad of uncertainties. One pressing question arises: Can stock valuations sustain their current levels? The S&P 500 trades at a price-to-earnings (P/E) ratio of 22.4, raising concerns about sustainability should economic growth begin to wane.
Another vital consideration is whether the U.S. economy can thrive amidst stagnation in Europe and China. With the specter of trade wars looming and projections of low growth in both China and the Eurozone, sustaining momentum in the U.S. becomes increasingly challenging. Furthermore, lingering concerns regarding the sustainability of AI infrastructure investment have come to the forefront. While recent performance from major semiconductor companies indicates a solid demand for AI technologies, the market’s heavy concentration in a few mega-cap technology firms raises doubts about future returns and overall market stability. The valuations of technology stocks and the S&P 500 appear increasingly stretched, raising alarms about the durability of current growth trends—especially if advancements in AI technology experience a slowdown.
Investors face a complex environment characterized by potential growth and ongoing uncertainties as we navigate another year for financial markets. Despite these challenges, the resilience of the U.S. economy remains evident, buoyed by a favorable earnings outlook in the face of moderating inflation. The Federal Reserve’s pivot toward an easing cycle, which began in 2024, bolsters expectations for modest rate cuts in 2025. This monetary landscape offers opportunities for stock price expansion, driven by increased spending and investments in AI, alongside pro-growth policy expectations. Nevertheless, it is crucial to remain vigilant. Disappointing economic and earnings projections could unsettle this dynamic, particularly if inflation reignites or the Federal Open Market Committee (FOMC) commits a policy misstep.
Currently, U.S. economic conditions display modest strength, largely due to personal consumption growth at a solid 3.7% (contributing to the Q3 2024 real GDP growth rate of 2.8%), well above the 50-year average of 3%. This robust growth and heightened consumer confidence will likely sustain the anticipated GDP growth trajectory.
The “Magnificent 7,” a select group of significant technology stocks, have been key drivers of S&P 500 earnings in recent quarters. However, this growth is likely to plateau as the broader market trends upward, with smaller-cap stocks that previously lagged anticipated to lead, with earnings growth projected at over 18% entering 2026.
In conclusion, earnings growth is anticipated to be more pivotal in driving equity returns in 2025 compared to 2024. Given elevated valuations that complicate P/E expansion, the emphasis will shift toward achieving substantial EPS growth. A resilient consumer outlook, projected to maintain a steady 2.0%+ GDP growth, is expected to support EPS growth of around 10% for 2025. If interest rates and inflation remain contained, a stable or slightly expanding P/E multiple could further enhance market conditions, setting the stage for continued investment opportunities.
Below, we list the bullish and bearish factors that we view as likely to be the broader influences for 2025:
Bullish (positive):
Fed is past peak hawkishness—it’s only been 3½ months since the first rate cut!
Most global central banks are also lowering rates
Employment is strong in the U.S.
Economic growth is positive in the U.S.
Corporate earnings growth (profitability) is solid
Inflation is trending lower
The U.S. and global service economy is expanding
Credit spreads remain below long-term averages (indicates lower risk of a major financial dislocation)
Potential for a more business-friendly tax and regulatory environment
AI theme remains attractive
Economic liquidity is positive, including consumer and business lending outlets
Bearish (negative):
Valuations
Interest rates have risen since the first rate cut
Lower-income consumers under pressure
Election risk—an unintended consequence of the new administration’s efforts to streamline government
U.S. Fiscal policy is a wildcard (can make the argument that changes could be inflationary or disinflationary). Markets tend to price uncertainty negatively.
Rates higher for longer (real yields increasing as inflation retreats)
The strong U.S. dollar is a headwind for U.S. export industries (we expect the dollar to weaken)
Economic weakness in Europe (France and Germany GDP)
Sovereign debt levels
Japanese yen-based carry trade under pressure
Manufacturing still weak in the U.S. and across the globe
China’s growth prospects are being dialed down
Based on the weight of the evidence, our models and indicators acknowledge that inflationary pressures have increased slightly, global economic activity is waning (especially in manufacturing), valuations are extended, and geopolitical risks are elevated. But U.S. companies are profitable and growing, and the Fed is past peak hawkishness. Until the models shift negative, we will continue to hold the course. We expect our technical indicators to turn first should the supporting backdrop deteriorate. As of this writing, the evidence continues to portray an uptrend that remains intact.
Turning to equity sectors for a moment, our largest sector allocations are to Financials, Information Technology, Communication Services, and Industrials. In our recent Smart Sector update, we reviewed the operating environment backdrop and model readings for each, as shown below.
For each sector, we highlight 1) current valuation conditions (Forward Price/Earnings ratio), 2) expected earnings growth expectations (expected percentage gain for 2025), and 3) levels of overbought or oversold (based on trailing 1-year returns expressed as the standard deviation of the returns vs. history. SD above +1.0 = overbought, below -1.0 = oversold, between +1 and -1 = neutral), along with our sector model readings and outlooks.
Information Technology: Forward P/E 29.2x, Price/Cash Flow 30.1x, 2025 earnings growth estimate +22.2%, overbought by +0.54 SD.
Global IT spending is anticipated to rise 8% from 2023 to 2024, reaching around $5 trillion. This growth is largely driven by companies investing in emerging technologies, notably generative AI, to advance their digital transformation efforts. As of December 30, 2024, the U.S. Information Technology sector boasted a market capitalization of $18.7 trillion and a price-to-earnings (P/E) ratio of 51x, reflecting strong investor confidence in its long-term growth. Companies that successfully integrated AI saw significant stock value increases; for instance, AppLovin’s advertising revenue surged by 66%, resulting in a staggering 740% rise in its stock price. Palantir Technologies experienced a 360% increase in stock value by leveraging AI to enhance customer outcomes. The “BATMMAAN” stocks—Broadcom, Nvidia, Tesla, Amazon, Microsoft, Meta, Apple, and Alphabet—played a critical role in market gains, collectively adding over $1.9 trillion in market capitalization since the November 2024 election. The IT sector exhibited strong performance, with Nvidia’s stock soaring 180% and Broadcom’s 110%, fueled by strong demand for AI-related technology. Analysts noted that the top five tech companies account for an impressive 63% of the market capitalization among the leading 20 firms, highlighting the significant influence held by these major players. The sector’s technical indicators improved slightly this month, as reversals from oversold conditions showed improving demand.
Financials: Forward P/E 15.3x, Price/Cash Flow 15.1x, 2025 earnings growth estimate +9.5%, overbought by +0.54 SD.
The interest rate landscape is shaped significantly by the Federal Reserve’s monetary policies, which held the policy rate at 4.25% to 4.50% as of December. Projections suggest a reduction to around 3.75% by the end of 2025, potentially impacting net interest margins for banks and financial institutions. Analysts also foresee a rebound in U.S. GDP growth, estimating a rise to approximately 1.4% in 2025, propelled by government fiscal stimulus. This outlook typically favors the Financial sector by enhancing lending and investment activity. Furthermore, the KBW Nasdaq Bank Index demonstrated a robust 10.5% monthly rise and a 37.2% increase in 2024, attributed to undervaluation and favorable regulatory expectations. Earnings growth is another positive indicator for the sector, with estimates of a 39.8% year-over-year increase in Q4 2024, primarily due to easier comparisons with weaker Q4 2023 earnings. However, the overall market performance remains tenuous, as concerns about potential overvaluation linger, particularly in the face of disappointing earnings or shifting economic conditions. Our model shows a positive interest rate environment, steady GDP growth, and low unemployment rates bolstered consumer confidence, promoting increased borrowing and financial activity. Overall, U.S. financial stocks exhibited strength, fueled by better-than-expected earnings and favorable economic conditions. The composite model declined due to higher volatility, some deterioration in credit quality, and concerns about global economic growth.
Communication Services: Forward P/E 20.0x, Price/Cash Flow 13.9x, 2025 earnings growth estimate +13.8%, overbought by +1.26 SD.
The performance of the advertising sector tends to increase during periods of economic growth and decrease during downturns. As of December, advertising revenue exhibited stability, highlighting consistent consumer expenditures and a robust sense of business confidence. This steady performance can be partly attributed to household spending on communication services, including subscriptions to streaming platforms and internet connectivity. Such expenditures have become significant drivers of growth within the sector. Moreover, these spending patterns are largely shaped by the prevailing economic climate—when disposable income rises, consumption of communication-related services typically follows suit. The U.S. Bureau of Economic Analysis shows an upward trend in disposable personal income (DPI). DPI rose 0.3% in November following a 0.7% increase in October, marking a 5.3% year-over-year growth, outpacing inflation. Although this suggests a boost in consumer spending during the holiday season, lower-income households are struggling, with reports indicating they are delaying purchases and seeking more affordable options. These disparities highlight that increases in disposable income are not felt equally across all income levels. The composite model is mixed, with trend, overbought/oversold measures, momentum, and earnings revisions leaning positive. Valuations, sales growth trends, and higher relative volatility are negative.
Industrials: Forward P/E 21.4x, Price/Cash Flow 17.9x, 2025 earnings growth estimate +14.8%, oversold by -1.46 SD.
The U.S. manufacturing sector is showing signs of recovery, with the Purchasing Managers’ Index (PMI) rising to 49.3 in December, its highest level since March. Nonetheless, it remains under the expansion threshold of 50 and marked the ninth consecutive month of contraction. In December, the Federal Reserve lowered interest rates to a target range of 4.25%-4.50% to stimulate economic activity; this decrease in borrowing costs aims to benefit industrial companies by reducing expenses and encouraging capital investment. The election of President Donald Trump brought hopes of tax cuts and deregulation that could favor industrial sectors. However, there are concerns about possible tariffs on imports from Mexico, Canada, and China, which could increase the costs of imported raw materials, potentially affecting manufacturing expenses. Meanwhile, the industrial sector is entering a stabilization phase after a previous period of rapid growth, as the supply surge began to taper off in 2024. This is attributed to declining construction starts and rising borrowing costs. Lastly, global economic uncertainties, the strong dollar, and trade tensions are impacting the demand for U.S. industrial goods, particularly with worries about slowdowns in major economies like China, affecting export orders and revenue forecasts. The model held steady with the January update. Measures of momentum declined, partially offset by increasing commodity pricing reflecting improving demand.
Next month, we will once again begin featuring earnings results for companies within our portfolio to confirm or disprove our investment thesis for each holding.
The Smart Value portfolio strategy utilizes measures of economic profitability, balance sheet sustainability, cash flow generation, valuation, economic trends, monetary liquidity, and market sentiment to make objective, rational decisions about how much capital to put at risk and where to put that capital.
Sincerely,
Donald L. Hagan, CFA®
Regan Teague, CFA®, CFP®
Rob Herman, MBA
Jeffery Palmer, CIPM
Steve Zimmerman, MBA
Steven Goode, CFA®
Disclosure: The aforementioned positions may change at any time.
Disclosure: *Note that individuals’ percentage gains relative to those mentioned in this report may differ slightly due to portfolio size and other factors. Returns are based on a representative account. The data and analysis contained herein are provided "as is" and without warranty of any kind, either express or implied. Day Hagan Asset Management, any of its affiliates or employees, or any third-party data provider shall not have any liability for any loss sustained by anyone who has relied on the information contained in any Day Hagan Asset Management literature or marketing materials. All opinions expressed herein are subject to change without notice, and you should always obtain current information and perform due diligence before investing. Day Hagan Asset Management accounts that Day Hagan Asset Management or its affiliated companies manage, or their respective shareholders, directors, officers, and/or employees, may have long or short positions in the securities discussed herein and may purchase or sell such securities without notice. Day Hagan Asset Management uses and has historically used various methods to evaluate investments which, at times, produce contradictory recommendations with respect to the same securities. The performance of Day Hagan Asset Management’s past recommendations and model results is not a guarantee of future results. The securities mentioned in this document may not be eligible for sale in some states or countries nor be suitable for all types of investors; their value and income they produce may fluctuate and/or be adversely affected by exchange rates, interest rates, or other factors.
There is no guarantee that any investment strategy will achieve its objectives, generate dividends, or avoid losses.
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Day Hagan Asset Management, 1000 S. Tamiami Trail, Sarasota, FL 34236
Toll-Free: (800) 594-7930 | Office Phone: (941) 330-1702
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