December thirtieth, two thousand twenty-four to January third, two thousand twenty-five
I. Foundation
resistance to change and hence greater dependability for the results shown in the past.
Inflation catch-up in macroeconomic data: consumer prices and input costs
Actual wage growth is not as concerning as the headline data suggest.
Historically, Union wage growth is typically a lagging indicator of labor-market conditions, because union contracts are adjusted less frequently, so they reflect the inflation peak over a longer period.As shown in the chart at lower right, over the past three years, wage growth for union workers consistently lagged that of nonunion workers, only beginning to catch up in the past few quarters.
Chart: Lag between union and nonunion wages
When labor-market tightness measures continue to decline or remain stable, some wage growth will reflect delayed compensatory increases and does not indicate renewed heating in the labor market.Lagged union-wage pressures will 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 by similar reasoning:
The components with the largest increases in current inflation may look overheated, but they are actually the result of lagged compensation 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 gradually narrows, price increases will gradually slow.
Take housing as an example: official shelter-inflation measures will catch up with higher market prices:
Chart: 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 by 24%, while the official shelter-price measure has risen by only 22%.Market prices—that is, rents paid by new tenants—typically adjust faster than rents paid by existing tenants, while official shelter-inflation measures include rents for both new tenants and renewals.
The latter usually adjust more slowly, because leases are renewed infrequently and landlords are also 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 compensatory price increases.
In health care, consumer prices also catch up with higher input costs.Health-care prices typically adjust slowly, mainly because contract terms are longer, especially in the hospital sector.
As shown in the chart at lower left, since the first quarter of 2020, health-care service costs have risen by 15%, reflecting increases in supply and labor costs (for example, hospital wages rose by 13% during 2021-2022), while consumer prices have risen by only 11%:
Chart: Contract terms 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.
As shown in the chart at lower left, since the first quarter of 2020, auto-insurance costs have risen by 51%, while consumer prices have risen by 43%:
Chart: Auto insurance also requires price coordination with regulators, leading to catch-up inflation
These cost increases have a long lag before affecting prices because auto insurers must negotiate price adjustments with state regulators based on recent costs and profitability.
As a result, when analyzing macro inflation, the components related to inflation catch-up can be excluded when assessing forward-looking trends and turning points, when the prices of components in the inflation basket that are not clearly affected by lagged compensation effects slow to the previous cycle’s range high, we can expect the disinflation trend to stabilize,
At present, as prices catch up, catch-up inflation is nearing its end.
Chart: Catch-up inflation ends naturally as prices converge
Currently, officially measured rents 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. Catch-up in government-regulated categories such as auto insurance also appears to be nearing its end.
Chart: Wage growth has tended to fall below 4%, and catch-up wage growth for union members 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 far less to PCE than to CPI, mainly for two reasons. First, the PCE index captures changes in insurance premiums net of “normal losses” paid to consumers, whereas the CPI index captures premiums alone.Therefore, auto insurance accounts for about 3.7% of core CPI, but only 0.6% of core PCE.
Auto insurance contributes far 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, while 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 a year for auto insurance, and the insurance company pays 600 dollars a year in claims to the consumer:
1) CPI directly counts 1000 dollars as the cost of insurance.
2) PCE counts only 400 dollars (premiums minus claims), because the remaining 600 dollars are compensation paid by the insurer under 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 is therefore a more intuitive measure of the spending pressure they perceive.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 come up for renewal, whereas CPI reprices half the sample on a rotating basis every two months. The measurement differences between PPI and CPI are mainly due to differences in the sample-update mechanism and frequency.PPI uses dynamic sample adjustments and renewal-based repricing; it has a greater lag but better represents actual changes in market revenue; CPI, in contrast, is based on a fixed sample, reflects price trends more promptly, but is less adaptable to changes in market structure.
[Effect of policy-renewal mechanisms]
1) PPI reprices policies in the sample only when they are renewed. This means price changes are reflected only after renewal. If the renewal cycle is long (for example, a year or longer), price adjustments will be delayed.
2) By contrast, CPI updates prices by resampling some policies every two months, so price changes are captured more frequently and promptly.
3) Why occasional jumps occur: when a group of policies in the sample expires and is renewed all at once, the price adjustment is reflected in a concentrated way in PPI, producing a clear “jump” in the price curve. With CPI, more frequent price updates make the curve smoother and such jumps less common.
Therefore, PPI’s measurements show occasional jumps when policies are renewed and sometimes lag behind CPI. In addition, PPI uses a “targeted replacement” adjustment, periodically updating the policies in the sample so they better represent the company’s revenues, while CPI has priced the same group of policies since 2004. As insurance costs rose over the past few years, consumers may have changed the types of policies and coverage they purchase, 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 rise in auto-insurance premiums mainly reflects a lagged catch-up with rising costs, as pandemic-related supply-chain disruptions drove used-car prices sharply higher, and those increases later pushed up repair and maintenance costs. Medical and legal expenses have also risen significantly over the past few years, reflecting higher medical costs per claim as accidents became more severe and lawsuits more numerous.
However, the effect 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 in the chart below, In the fourth quarter of 2023, companies’ losses as a share of revenue were still about 8 percentage points above their 2019 levels, in which case premiums will rise later to catch up with costs:
Chart: In the fourth quarter of 23, auto insurers’ losses as a share of premiums collected remained about 8 percentage points above the 19 level
Costs rise faster than prices can be adjusted on the profit side, so profitability declines 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
An investment-research report Buffett wrote at age twenty: Investment thesis and framework for the auto-insurance industry
The original text comes from an article Buffett published in 1951, “The Security I Like Best,”the GEICO mentioned in the article marked the beginning of Buffett’s path to building an insurance cash cow, and its chairman at the time was his teacher Benjamin Graham.Davis, then vice president of finance at GEICO, had intended to send him away, but ended up talking with Buffett for more than four hours.
Full employment, sharply rising profits, and record dividends clearly do not go with a depressed stock market.
For the past 5 years, most industries have enjoyed this prosperity, and a few minor fluctuations have done nothing to diminish this powerful wave.Yet the auto-insurance industry did not share in this prosperity.After suffering huge losses just after World War II, the auto-insurance industry finally improved in 1949. But in 1950, casualty insurers were hit hard again, making it the insurance industry’s second-worst year in 15 years.
The share prices of some casualty insurers, especially those with a large auto-insurance business, performed very poorly.Many of these stocks seem undervalued based on profitability and asset factors. 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 costs, which had a negative effect during the price-inflation period of 1945-1951, but if the economy enters a deflationary phase, it should be an advantage.
Other advantages of the industry include no issues involving inventory, collections, labor, or raw materials, as well as 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 who received this benefit during their service; 4) former policyholders; 5) teachers and staff at primary, secondary, and postsecondary schools; 6) employees of government contractors engaged specifically in defense work; 7) the company’s shareholders.
The company has no agencies or branches, so policyholders can obtain a standard auto-insurance policy at discounted annual rates of up to 30%. The company handles claims nationwide through about 500 agents, with a very fast response.
“Growth companies”generally refers to those after excluding price increases and easing commercial competition, whose sales have nevertheless grown over the past few years companies.
Based on the performance below, GEICO is clearly a bona fide growth company:
Image 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 nation’s 50 states (including the District of Columbia and Hawaii).At the beginning of 1950, the company had fewer than 3000 customers in New York State.
For potential customers, the 25% discount on a 125-dollar policy in New York should seem more appealing than the 25% discount on premiums of 50 dollars in less developed regions.As cost competition becomes more important during recessions, the appeal of GEICO’s rates should help it take business from comparable companies more effectively.
Because insurance rates rise with prices, the gap in rates of 25% becomes larger in 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 an imperfect rate structure, the company may suspend promotion.
GEICO’s greatest appeal may lie in its profit margin.In 1949, the company's insurance profit-to-premium income ratio was 27.5%, while the average profit margin of the 135 casualty insurance companies surveyed by Best's was only 6.7%. In 1950, business conditions deteriorated, and the average profit margin calculated by Best's fell to 3%, while GEICO fell to 18%. GEICO does not operate in every casualty insurance business. Although personal injury and property insurance are both important business lines for GEICO, they have the lowest profit margins.
GEICO also has a sizable automobile insurance business, which was a highly profitable line in 1950. In the first half of 1951, nearly all insurers posted losses in casualty insurance; personal injury and property insurance were especially unprofitable. GEICO’s margin fell to slightly above 9%, compared with losses of 16% for Massachusetts Insurance, 8% for New Amsterdam Casualty, and 9% for Standard Casualty.
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 (a 1-for-25 split) increased 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.
Since 1948 Benjamin Graham’s investment fund acquired a large block of GEICO shares and took it public, Graham has been chairman of the board. Leon Goodwin is the company’s president, an exceptionally capable executive who has guided GEICO since taking office. At the end of 1950, the 10 directors together held about one-third of GEICO’s outstanding shares. The company earned 3.92 dollars per share in 1950, and 4.71 dollars per share in 1949 (when its overall business was smaller). These figures exclude unearned premium reserves, which were substantial in both years. Profits in 1951 were lower than in 1950, but the broad rate increases this summer will be reflected in profits in 1952. Between 1947 and 1950, the company’s investment income quadrupled, reflecting the growth in its assets. At the current share price, At the current valuation, the company trades at 8 times earnings from 1950 (a poor year for the industry)., which seems to leave the company’s enormous growth potential entirely unreflected.
2024.12.31
II. Insights
Our Viewpoints and ideas on market.
Artificial intelligence: a disconnect between the investment cycle and adoption rates
The AI investment cycle continues to run smoothly, market interest in cutting-edge technologies such as generative AI remains strong, and there are clear signs of capital inflows as the potential for adoption gradually emerges across multiple industries.However, the adoption rate is still quite low, especially in traditional industries and small and medium-sized businesses, where adoption has not yet reached scale.
This suggests that the transformational impact of AI on overall labor productivity may take several years to emerge.
Chart: The artificial intelligence investment cycle is progressing smoothly
Chart: But adoption remains 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 for AI could also be hindered by 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
At the end of 2024, markets showed unexpected volatility, and 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 implied volatility (compartmentalize)
SPX: the volatility market is learning to compartmentalize quickly; that is, After a brief risk-off episode in the market, volatility rises quickly, then falls even faster.This phenomenon has been very rare over the past three years.
This rapid change in volatility is likely due to pressure from the structural supply of index gamma in the market. In other words, there are many 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 (prolonged period of weakness), short-dated option prices are likely to fall “too quickly” to low levels as a result 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.
Market conditions over the past year show that, Gamma’s influence on market price fluctuations 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 a need limited to options traders; it has become essential for investors across the market.
The black line on the chart is SPX gamma at spot, which represents 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, the market is more volatile, and negative gamma amplifies price movements.
Given gamma’s direct effect on market volatility, it has now it has become a central topic of daily 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 when gamma supply changes.
3）Another notable phenomenon is the marked weakening of market breadth
In 12, on 70% of the trading days in the S&P 500 index, more stocks fell than rose; the monthly average SPXAD was -100.Such negative breadth usually means the index could fall 10-15%, but SPX has shown resilience.
In addition, SPX equal-weighted indices have substantially underperformed market-cap-weighted indices, indicating that a handful of large-cap stocks are providing exceptionally strong support for the overall market.
From a market-structure perspective, the performance gap between equal-weighted and market-cap-weighted indices has reached a record, with their relative performance diverging by a full 6 percentage points in 2024.In other words, the gap between “stocks” and “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 equal weight over market-cap weight and would be more inclined to use equal-weighted rather than market-cap-weighted indices to guide subsequent positioning.
4）Fading enthusiasm
In 2024, retail investors’ speculative sentiment briefly surged at certain points, but today their speculative call-option trading volume in mega-cap technology stocks has fallen significantly.Data show that trading volume in these options is down 75% from its peak.
Mega-cap technology stocks have shifted from their past pattern of “surging and plunging” to “rising slowly,” inevitably making them less attractive to speculators; at the same time, lower implied volatility has reduced the potential payoff from call options.
5) The implied cost of 1-year at-the-money calls/puts is near a historical high
At current interest rates and dividend levels, even with a year-end target price of 6500 for 2025, the return on these call options would be only about 20%.
The breakeven for the call is quite high.
6) 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 marked increase in market concerns about volatility and tail risk.
7) Systematic fund behavior is being triggered
Systematic traders are participants who rely on quantitative models, rules, or algorithms to trade (for example, trend-following strategies, risk-parity funds, or momentum strategies). These strategies typically make automated buy and sell decisions based on prices, volatility, or market signals, with a significant effect on market liquidity and volatility.
At present, short-term price momentum in the Russell 2000 and S&P 500 indices has fallen below a key threshold, causing systematic strategies to have net sold about 280 hundred million dollars’ worth of equity positions over the past week.
If market prices remain at current levels or fall further, these strategies could trigger another round of selling, potentially totaling another 280 hundred million, Even if the market moves sideways (with no significant price increase), systematic funds 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 of 2024 was objectively a high valuation level.
However, this did not impede the market’s advance; on the contrary, the market richly rewarded investors willing to “add to their positions at high levels.”
The market’s rewards for risk-takers have been highly differentiated, for example, the basket of unprofitable technology companies rose only 1% for the full year in 24, while the unprofitable biotech sector also rose only 1% for the year, significantly underperforming and reflecting market investors’ focus on earnings quality.Moreover, although some areas faced bubble risks in 2024, there was no market-wide speculative excess like NFT in 2021, SPAC, or the cannabis sector.
2025’s 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 11% in 2025
3) To some extent, markets tend to place too much emphasis on the P/E ratio and too little on PEG (the price/earnings-to-growth ratio). From the perspective of PEG, comparing the U.S. market overall, especially technology stocks, with other investment choices shows that it is not so expensive. This is an indicator to keep watching.
2025.01.02
1.7%
Although market yields have fallen significantly, the 7-day repo fixing remained firmly above 1.80% in 2024. It may edge lower as year-end effects fade, but is expected to remain high in 1, with funding conditions still tight.
Liquidity is expected to remain balanced but not abundant 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, taking advantage of low financing costs to increase issuance.Historical data show that policy bank bond issuance usually peaks in the second to third quarters, with the full-year quota of 80% concentrated in the first three quarters.
The 7-day repo fixing reflects the financing costs of financial institutions in the market, The central bank may want to keep the fixing elevated to curb excessive buying of fixed-income products and prevent bond-market yields from falling too quickly; the channel for lowering financing costs in the real economy lies in the monetary-policy transmission mechanism mainly through OMO/LPR and lending rates。
Chart: Monetary-policy transmission mechanism
There is a high likelihood of a reserve requirement ratio cut before the Spring Festival (1 month 28). The lower bound of the 7-day repo fixing may be adjusted to OMO+20bp, meaning that without a rate cut, the fixing may fall within 1.7%-1.8%.If it falls below 1.7%, that could mean the central bank is truly changing the rules of the game and supporting looser liquidity.
Chart: The spread between 7-day repo fixing and the 7-day OMO policy rate
It is currently about 30 basis points; the fixing floor may stabilize at around 20 basis points above the OMO policy rate.
2025.01.02
III. Market Pulse
Our latest Comments on the economic and market environment
An unhealthy long end and indicators that may not be effective
Long-term U.S. interest rates have fluctuated sharply since the Fed meeting, and not in a healthy way.
The move reflects both an increase in real interest rates and a rise in the term premium.The market is clearly concerned about certain factors, perhaps the large volume of debt supply coming in 2025, or persistent fiscal deficits (for example, the near government shutdown some time ago may foreshadow the difficulty of advancing major legislative changes), or the view that the Fed believes the neutral rate needs to rise structurally.
Whatever the reason, interest rates have risen, and the Fed has also made clear that it will place greater emphasis on its inflation target going forward.
Since the 12 meeting in FOMC, markets have been volatile, and equities have struggled to reach new highs despite very favorable seasonality, The main problem is still the Fed.
Chart: Term premium of 10-year zero-coupon bond
In fact, the technical picture for U.S. equities is quite unusual at present. Generally, the start of a new year brings fresh inflows.
In particular, positioning suggests there is some room for the market to add exposure, but that increase in positioning has not occurred. The year-end hedging activity of the past two weeks drove the fastest increase in U.S. ETF short positions since 2021 2. Across various measures of market sentiment, overall levels are already low.
The January effect is generally traded on the premise that “sectors that previously lagged may perform better, all else being equal.”And now, the ratio of the equal-weighted S&P 500 (Equal Weight SPX) to the S&P 500 index has nearly returned to its lows.
In this context, the market breadth indicators discussed previously may not necessarily be reliable leading signals, it may reflect something else—the short-term vulnerability in market momentum strategies(for example, greater clarity on tariff policy, larger-scale fiscal stimulus from the East, or a sharp rise in oil prices could all be triggers), market breadth indicators may reflect changes in short-term capital flows more than they signal whether the market as a whole is becoming healthier.
If the interest rate market remains stable, U.S. equities may perform somewhat better, but Given current valuation levels, interest rate movements, and the Fed’s policy shift, it is difficult to see what could support equities in breaking through to further highs，At least until inflation data clearly show that the Fed can prioritize growth (the 12 core PCE data support this trade).
2025 may begin on a cautious note. Capital flows are a powerful driver, and it is unwise to move recklessly against them. In some respects, market sentiment and positioning may point to a rebound in risk assets, but it is important to respect the signals from the bond market; waiting on the sidelines may be the wiser choice.
2025.01.03
Note: All content herein is for reference only and does not constitute investment advice or a basis for any laws, regulations, or regulatory policies. Investors should not use or rely on this information as a basis for making decisions.