From December thirtieth, two thousand twenty-four, to January second, two thousand twenty-five

I. Foundation 

resistance to change and hence greater dependability for the results shown in the past.

Inflation catch-up in macro data: consumer prices and input costs

Actual wage growth is not as concerning as the headline data suggest.

Historically, union wage growth is usually a lagging indicator of labor market conditions, because union contracts are adjusted less frequently, so they reflect the inflation peak for a longer period.As shown in the lower-right chart, over the past three years, wage growth for union workers consistently lagged that of nonunion workers until it began to catch up only in the most recent quarters.

Figure: A lag between union and nonunion wages

With measures of labor market tightness continuing to decline or remaining flat, some wage growth reflects delayed catch-up increases and does not indicate that the labor market is heating up again.Lagged union wage pressures temporarily push up prices in labor-intensive categories, thereby delaying the return of core PCE inflation to target.

Many stories about price inflation can be explained with similar logic:

The components with the largest increases in current inflation appear overheated, but are actually the result of delayed catch-up effects, rather than renewed heating in the labor market or accelerating demand. This phenomenon is most evident in housing, health care, auto insurance, and other regulated prices.

In these areas, market prices or input costs rose sharply over the past few years, but their growth has slowed recently, while consumer prices are in a catch-up phase. As the gap between prices and costs narrows, price increases will gradually slow.

Take housing as an example: the official shelter inflation measure will catch up with higher market prices:

Figure: Official shelter inflation measures lag market price measures

The chart on the left shows that since the first quarter of 2020, rents for new tenants have risen 24%, while the official shelter price measure has risen only 22%.Market prices—that is, rents paid by new tenants—usually adjust faster than rents for existing tenants, while the official shelter inflation measure includes rents for both new tenants and lease renewals.

The latter usually adjusts more slowly, because leases are renewed less frequently and landlords are reluctant to lose tenants by raising rents too quickly. In addition, regulations limit rent increases in some cases.

It takes time for the data to reflect the gradual adjustment in the rental market and the fading of the catch-up effect.

In health care, consumer prices also catch up with higher input costs.Health care prices usually adjust slowly, mainly because longer contract terms, especially in the hospital sector.

As shown in the lower-left chart, since the first quarter of 2020, health care service costs have increased 15%, reflecting higher supply and labor costs (for example, hospital wages rose 13% during 2021-2022), while consumer prices rose only 11%:

Figure: Contract durations in health care cause consumer prices to catch up with input costs later

Similarly, in the auto insurance sector, consumer prices are also catching up with higher input costs.

The chart on the lower left shows that since the first quarter of 2020, auto insurance costs have risen 51%, while consumer prices have risen 43%:

Figure: Auto insurance also needs to coordinate prices with regulators, creating an inflation catch-up effect

These cost increases have a long lag because auto insurers must negotiate price adjustments with state regulators based on recent costs and profitability.

Therefore, when analyzing macro inflation, the portions involving inflation catch-up can be excluded when assessing forward-looking trends and turning points, when the prices of the components in the inflation basket that are not significantly affected by lagged compensation effects slow to the previous cycle's range high, the disinflationary trend can be expected to stabilize,

At present, as prices catch up, catch-up inflation is nearing its end.

Figure: Catch-up inflation naturally ends as prices catch up

At present, official rent measures have fully caught up with market prices, and owners' equivalent rent has almost caught up with market rents for new tenants, continuing to converge toward the low growth rates of the past two years. The catch-up in government-regulated categories such as auto insurance also appears to be nearing its end.

Figure: Wage growth has tended to fall below 4%, and the catch-up in union members' wages has ended; they often sign multiyear contracts, and those contracts are now nearing expiration.

Further reading:

GS：Continued Catch-Up Means the Latest Wage and Inflation Readings Are Lagging Indicators

GS：Shelter Inflation: A Longer Lag for OER

GS：Car Insurance: Another Case of Catch-Up Inflation

GS：10 Questions for 2025

2024.12.30

Why does auto insurance contribute far less to PCE than to CPI?

Auto insurance contributes much less to PCE than to CPI, mainly for two reasons. First, the PCE index captures changes in insurance premiums after deducting “normal losses” paid to consumers, whereas the CPI index captures premiums only.Therefore, auto insurance accounts for about 3.7% of core CPI, but only 0.6% of core PCE.

Auto insurance contributes much less to PCE than to CPI, for two main reasons.

First, The PCE index reflects changes in insurance premiums after deducting “normal losses” paid to consumers, whereas the CPI index reflects premiums alone. Therefore, Auto insurance accounts for about 3.7% of core CPI, but only 0.6% of core PCE.

Example:Suppose a consumer pays 1000 dollars per year for auto insurance, and the insurer pays the consumer 600 dollars per year in claims:

1) CPI will directly calculate 1000 dollars as the insurance cost.

2) PCE will count only 400 dollars (that is, the premium minus claims), because the remaining 600 dollars are compensation paid by the insurer to fulfill the contract, not the cost of the insurance service.

PCE focuses on the net cost of insurance services by deducting “normal losses,” making it a more precise measure of insurance prices. CPI is more direct: it reflects the full premiums paid by consumers and therefore more intuitively represents the spending pressure consumers feel.This difference means that auto insurance has different weights and price-change patterns in PCE and CPI.

Second, the PCE index measures auto insurance prices using PPI, while CPI uses insurance premium data directly.

In PPI, prices are reset only when sampled policies expire and are renewed, whereas CPI rotates the pricing of half the sample every two months. The measurement differences between PPI and CPI stem mainly from differences in the sample update mechanisms and frequency.PPI uses dynamic sample adjustments and renewal-based pricing, resulting in greater lag, but better representing actual changes in market revenue; by contrast, CPI is based on a fixed sample, reflects price trends more promptly, but is less adaptable to changes in market structure.

[Impact of the Policy Renewal Mechanism]

1) PPI reprices only when policies in the sample are renewed. This means price changes are reflected only after renewal takes place. If the renewal cycle is long (for example, a year or more), price adjustments will be delayed.

2) By contrast, CPI updates prices by resampling a portion of the policies every two months, so price changes are captured more frequently and promptly.

3) Cause of occasional jumps: When a group of policies in the sample expires and renews at the same time, price adjustments are reflected all at once in PPI, causing a noticeable “jump” in the price curve. By contrast, with more frequent price updates, CPI has a smoother curve and fewer such jumps.

Therefore, PPI’s measurements can show occasional jumps due to policy renewals and may sometimes lag behind CPI. In addition, PPI uses “directed replacement” adjustments, periodically updating the policies in its sample so they better represent the company’s revenue, whereas CPI has priced the same group of policies since 2004. As insurance costs have risen over the past few years, consumers may have changed the types of policies they buy and their coverage, which has also contributed to differences between the measurements of CPI and PPI.

Further reading:

GS：Car Insurance: Another Case of Catch-Up Inflation

Market Notes 240729: PCE and the Fed’s inflation target; PCE is more relevant to the monetary policy path

2024.12.30

Inflation and the auto insurance industry’s profit cycle

The increase in auto insurance premiums mainly reflects a lagged catch-up with rising costs, as pandemic-related supply-chain disruptions caused used-car prices to rise sharply, and these increases later drove up repair and maintenance costs. Medical and legal expenses have also risen significantly over the past few years, reflecting more serious accidents and more lawsuits that have increased medical costs per claim.

However, the impact of these cost increases on prices is subject to a long lag, partly because auto insurers must negotiate rate increases with state regulators based on recent costs and profitability.

As shown below, In the fourth quarter of 2023, companies’ losses as a share of revenue were still about 8 percentage points higher than the 2019 level, in which case premiums will subsequently rise further to catch up with costs:

Chart: In the fourth quarter of 23, auto insurers’ losses as a share of premiums collected were still about 8 percentage points above the 19 level

Costs rise faster than the rate adjustments on the profitability side, so earnings decline during the first half of the inflation cycle, while auto insurers’ earnings improve to some extent during the second half.

Further reading:

GS：Car Insurance: Another Case of Catch-Up Inflation

2024.12.31

The research report Buffett wrote at age twenty: The investment rationale and framework for the auto insurance industry

The original text comes from Buffett’s article “The Security I Like Best,” published in 1951, The GEICO mentioned in the article marked the beginning of Buffett’s insurance cash-cow journey; its chairman at the time was his teacher, Benjamin Graham.At the time, GEICO’s vice president of finance, Davis, initially wanted to send him away, but ultimately spoke with Buffett for more than four hours.

Full employment, sharply rising profits, and record dividends clearly do not go hand in hand with a sluggish stock market.

For the past 5 years, most industries have enjoyed this kind of prosperity, and a few minor fluctuations have done nothing to weaken this powerful wave.Yet the auto insurance industry has not shared in this prosperity.After suffering huge losses in the period just after World War II, the auto insurance industry finally recovered in 1949. However, in 1950, casualty insurers were hit hard again, making it the insurance industry’s second-worst year in 15.

Some casualty insurers’ stocks, especially those with a large auto insurance business, performed very poorly.Judging by profitability and assets, many of these stocks seem undervalued. The auto insurance industry itself has characteristics that smooth cyclical fluctuations. Most car buyers consider auto insurance necessary.Insurance contract rates must be adjusted each year to reflect conditions at the time. Rate adjustments lag behind costs, had a negative impact during the inflationary period of 1945-1951, but if the economy enters a deflationary phase, that should be an advantage.

Other advantages of this industry include having no inventory, collections, labor, or raw-material problems, and no risk of products becoming obsolete or related equipment being phased out.

GEICO was founded in the mid-30s and provides comprehensive automobile insurance services nationwide to eligible groups,

including:

1) federal, state, and municipal government employees; 2) active-duty and reserve commissioned officers, as well as noncommissioned officers in the top three pay grades; 3) veterans eligible for this benefit during their service; 4) former policyholders; 5) teachers and staff at primary, secondary, and higher-education institutions; 6) government contractors’ employees who work specifically on national defense; 7) the company’s shareholders.

The company has no agencies or branch offices, so policyholders can obtain a standard auto insurance policy at a discounted annual rate of up to 30%. The company handles claims nationwide through about 500 agents, with a very fast turnaround.

“Growth companies”generally refers to those excluding price increases and easing business competition, whose sales have still grown over the past few years companies.

Based on the performance below, GEICO is undoubtedly a bona fide growth company:

 Chart source: Horizon Global Strategy

Of course, yesterday’s growth does not generate profits for today’s investors. In the case of GEICO, we have reason to believe there is still ample room for growth. As of 1950, the company was registered in only 15 of the 50 states nationwide (including Washington, D.C., and Hawaii).At the beginning of 1950, the company had fewer than 3000 customers in New York State.

For prospective customers, the 25% discount on a 125-dollar policy in New York should seem more attractive than the 25% discount on 50 dollars of premiums in less developed areas.As cost competition becomes increasingly important during recessions, the appeal of GEICO’s rates should enable it to take business from other similar companies more effectively.

As insurance rates rise with inflation, the gap in rates of 25% becomes larger in absolute dollar terms. The company also faces no pressure from agents to accept questionable applications or renew policies for high-risk policyholders. In some states with inadequate rate structures, the company may suspend marketing.

GEICO’s greatest appeal may lie in its profit margin.In 1949, the company’s insurance profit-to-premium revenue ratio was 27.5%, while the average profit margin of the 135 casualty insurers surveyed by Best’s was only 6.7%. Conditions worsened in 1950: Best’s calculated that the average margin fell to 3%, while GEICO fell to 18%. GEICO does not operate in every casualty insurance line. Although personal injury and property insurance are both important business lines for GEICO, their profit margins are the lowest.

GEICO also has a substantial collision insurance business, which was very profitable in 1950. In the first half of 1951, nearly all insurers lost money on casualty insurance, with personal injury and property insurance being the least profitable lines. GEICO’s profit margin fell to just above 9%, whereas Massachusetts Insurance Company lost 16%, New Amsterdam Casualty Company lost 8%, and Standard Casualty Company lost 9%.

Because GEICO was in a rapid growth phase, its cash dividends remained relatively low. From 1948 6 1 to 1951 11 10, stock dividends and stock splits (1-for-25 split) expanded the number of shares outstanding from 3000 shares to 25 ten-thousand shares. The company also issued warrants to subscribe for shares in an affiliated subsidiary.

Benjamin Graham’s investment fund acquired a large stake in GEICO and took it public in 1948; Graham has been chairman of the board ever since. Leon Goodwin is the company’s president, an outstanding executive who has guided GEICO ever since taking office. At the end of 1950, the 10 directors on the board collectively held about one-third of GEICO’s outstanding shares. The company’s earnings per share reached 3.92 dollars in 1950 and were 4.71 dollars per share in 1949 (when total business volume was smaller). These figures exclude unearned premium reserves, which were substantial in both years. Profits in 1951 were lower than in 1950, but the across-the-board rate increases this summer will be reflected in profits for 1952. Between 1947 and 1950, the company’s investment income quadrupled, reflecting the growth of its assets. At the current share price, At the current share price, the valuation is 8 times earnings for 1950 (a poor year for the industry), which seems to give no account at all of the company’s enormous growth potential.

2024.12.31

II. Insights 

Our Viewpoints and ideas on market.

Artificial Intelligence: A Gap Between the Investment Cycle and Adoption Rates

AI’s investment cycle continues to run smoothly, market attention to cutting-edge technologies such as generative AI remains high, signs of capital inflows are clear, and application potential is gradually emerging across multiple industries.However, the adoption rate remains relatively low, especially in traditional industries and small and medium-sized enterprises, where adoption has not yet reached scale.

This suggests that the transformational impact of AI on overall labor productivity may take years to become apparent.

Chart: The artificial intelligence investment cycle is proceeding smoothly

Chart: Adoption remains very low, suggesting that a major impact on overall labor productivity is still years away

Once the training began, researchers discovered a problem in the data: It wasn’t as diversified as they had thought, potentially limiting how much Orion would learn..The problem hadn’t been visible in smaller-scale efforts and only became apparent after the large training run had already started. OpenAI had spent too much time and money to start over...

Expectations of a major leap forward in AI may also be hindered, as reflected in the forced shift from training to reasoning models:

In a recent TED talk, one of OpenAI’s senior research scientists played up the advantages of reasoning.  “It turned out that having the bot think for just 20 seconds in a hand of poker got the same boost in performance as scaling up the model by 100,000x and training for 100,000 times longer,” said Noam Brown, the OpenAI scientist. "

Further reading:

GS：Global Economics Analyst-Top 10 Charts of 2024

WSJ：The Next Great Leap in AI Is Behind Schedule and Crazy Expensive

TED：AI won't plateau — if we give it time to think

（https://www.ted.com/talks/noam_brown_ai_won_t_plateau_if_we_give_it_time_to_think?subtitle=en）

2025.01.01

Rethinking Market Structure

As 2024 draws to a close, markets have shown unexpected volatility; the structural features of trading and participant behavior are our focus.

1) The most important lesson of 24 was the “compartmentalized” nature of SPX’s surface volatility (compartmentalize)

SPX volatility markets are learning to compartmentalize rapidly; in other words, After the market experiences a brief risk-off mood, volatility rises rapidly and then falls even faster.This phenomenon has been very rare over the past three years.

This rapid volatility shift is likely due to the pressure from structural index gamma supply in the market. In other words, there are large numbers of short-dated options in the market, and these contracts trigger sharp price adjustments when markets fluctuate.

​

This means that if the market enters a more prolonged period of weakness, short-dated option prices may fall back to low levels “too quickly” because of this characteristic, creating attractive buying opportunities.

When short-dated options become cheap as volatility falls (that is, when implied volatility is undervalued), but overall market risk has not fully dissipated, this creates an “asymmetric risk-reward” opportunity for option buyers.

​

2）Gamma is not only important; its importance is increasing.

The market environment over the past year shows that Gamma’s impact on market price volatility has shifted from a “technical variable” to one of the core market indicators of market dynamics.Understanding and paying attention to gamma is no longer just a need for options traders; it has become essential knowledge for investors across the market. ​

The black line on the chart is SPX gamma at spot, indicating the market’s gamma supply. When gamma supply is high, the market may be more stable (because positive gamma dampens volatility); when gamma supply is low, market volatility will be greater, and negative gamma amplifies price fluctuations.

Given gamma’s direct impact on market volatility, now it has become a daily focus of discussion among Wall Street investors and traders.For example, trading flows in short-dated options and hedging demand from market-neutral funds can trigger chain reactions as gamma supply changes.

3）Another noteworthy phenomenon is the significant weakening of market breadth

During 12, on 70% of the trading days in the S&P 500 Index, more stocks declined than advanced; the monthly average SPXAD was -100.Such negative breadth usually suggests that the index may decline 10-15%, but SPX has shown resilience.

In addition, the equal-weight index SPX has significantly underperformed the market-cap-weighted index, indicating that a handful of large-cap stocks are providing substantial support to the overall market.

From a market-structure perspective, the performance gap between equal-weighted and market-cap-weighted indices has reached a new high; in 2024, their relative performance was lower by a full 6 percentage points.In other words, the true gap between “stocks vs. the stock market has never been this pronounced.

The strength of a few heavily weighted stocks is masking the weakness of the broader market.

Looking ahead, we favor eq weight vs mkt cap weight and would be more inclined to use equal-weighted indices rather than market-cap-weighted indices to guide subsequent trading decisions.

4）Fading enthusiasm

In 2024, retail investors’ speculative sentiment briefly surged at certain points, but by now, retail investors’ speculative call-option trading volume in mega-cap tech stocks has fallen significantly.Data show that trading volume in these options has fallen 75% from its peak.

The trajectory of mega-cap tech stocks has shifted from “surging and plunging” to “climbing slowly,” inevitably reducing their appeal to speculators; at the same time, lower implied volatility has also reduced the return potential of call options.

5) The implied cost of at-the-money calls/puts with a 1-year term is at a historical high

At current interest and dividend levels, even with a year-end target price of 2025 set at 6500 points, the return on these call options would be only about 20%.

The breakeven for the call is quite high.

6) As for volatility indices, VIX and related indicators show rising stress

The Vol Stress Index rose to 7.5; even after excluding some hedging positions, it still reflects a significant increase in market concerns about volatility and tail risk.

7) Systematic flows are being triggered

Systematic traders are participants who trade based on quantitative models, rules, or algorithms (for example, trend-following strategies, risk-parity funds, or momentum-trading strategies). These strategies typically make automated buy and sell decisions based on prices, volatility, or market signals, and have a significant impact on market liquidity and volatility.

At present, short-term price momentum in the Russell 2000 Index and the S&P 500 Index has fallen below a key threshold, meaning that over the past week, systematic trading strategies have net sold approximately 280 hundred million dollars’ worth of equity positions.

If market prices remain at current levels or fall further, these strategies may trigger another round of selling, potentially offloading another 280 hundred million, Even if the market moves sideways (with no significant price gains), systematic flows may continue selling.

2025.01.01

Valuations, corporate earnings, PE & PEG

At the beginning of 2024, the S&P 500 Index’s forward P/E was 19.5; by year-end, it was 21.5. Whether measured by P/E, ERP, CAPE, or other traditional valuation metrics, the starting point in 2024 was objectively a high valuation level.

However, this did not hinder the market’s advance—on the contrary, the market delivered generous returns to investors willing to “add to positions at high levels.”

The market’s rewards for risk-takers are highly differentiated, for example, a basket of unprofitable tech companies rose only 1% over all of 24, and the unprofitable biotech sector likewise rose only 1% for the year, significantly underperforming and reflecting the market’s focus on earnings quality.In addition, although there were bubble risks in some areas in 2024, there was no market-wide speculative excess like NFT in 2021, SPAC, or the cannabis sector.

In 2025, market momentum will depend more heavily on corporate earnings growth:

1) In 2024, earnings growth contributed more than half of the S&P 500 Index’s return

2) The market expects U.S. corporate earnings to grow by 11% in 2025

3) To some extent, the market tends to place too much emphasis on the P/E ratio and too little on PEG (the price-to-earnings-to-growth ratio). Viewed from the perspective of PEG, the U.S. market overall, especially tech stocks, is not that expensive compared with other investment options. This is also an indicator to keep monitoring going forward.

2025.01.02

1.7%

Despite the significant decline in market yields, the 2024-year 7d repo fixing remains firmly above 1.80%. Although it is expected to edge down slightly as the year-end effect fades, it is expected to remain elevated in 1, and liquidity conditions will remain tight.

Liquidity is expected to remain balanced but not ample going forward; without rate cuts, 1.70% may be the floor.

Policy bank bond supply is expected to accelerate in the first quarter of this year, as issuers take advantage of lower financing costs to increase issuance.Historical data show that policy bank bond issuance usually peaks in the second to third quarters, with the annual 80% quota concentrated in the first three quarters.

The 7-day repo fixing reflects financial institutions’ financing costs in the market, The central bank may want to maintain a relatively high fixing to curb excessive purchases of fixed-income products and prevent bond-market yields from falling too quickly; the way to lower financing costs for the real economy lies in the monetary policy transmission mechanism mainly through OMO/LPR and lending rates。

Figure: Monetary policy transmission mechanism

There is a high likelihood of a reserve requirement ratio cut before the Spring Festival (1 month 28 day). The lower bound of the 7-day repo fixing rate may be adjusted to OMO+20bp; without a rate cut, the fixing may remain between 1.7% and -1.8%.A drop below 1.7% could mean that the central bank is truly changing the rules of the game and supporting looser liquidity.

Figure: The spread between 7d repo fixing vs 7d OMO policy rate

It is currently about 30 basis points; the floor for the fixing may stabilize at about 20 basis points above the OMO policy rate.

2025.01.02

III. Market Pulse 

Our latest Comments on the economic and market environment

Note: All content in this article is for reference only, does not constitute investment advice, and is not a basis for any laws, regulations, or regulatory policies. Investors should not use or rely on this information as a basis for decision-making.