Overview and Market Context
As we look ahead to 2025, we see an environment where the bulk of indicators suggest another year of good returns for the financial markets. Indeed, the majority of calls we've seen from market professionals generally agree that the equity markets and to a lesser extent the fixed income markets will continue to rise in the year ahead. But keep in mind, at turning points in a trend, you do not want to be with the consensus. The question then becomes, are we nearing a turning point?
Economic Indicators
Growth Trajectory
The outlook for the US economy suggests that is not the case. The economy grew at a 3% annual rate in both the 2nd and 3rd quarters of 2024 and may come close to that rate in the 4th quarter. A good portion of this growth comes from a healthy consumer. The job market remains solid despite slowing in the second half of the year and wage growth is exceeding the inflation rate. In addition, higher-end consumers have seen large increases in their net worth thanks to gains in both the financial and housing markets. As these consumers feel more comfortable with financial conditions, their spending typically increases. Indeed, all the early indications suggest retail sales were up nicely this Holiday season. These trends look to continue into 2025, with most economists predicting 2% growth for the year. We agree that there does not appear to be a recession on the horizon and that is a plus for equity markets.
Inflation Trends
Absent a recession, the next big concern is the outlook for inflation. The inflation rate peaked in late 2022 and was steadily falling until the latter half of 2024. Since then, it has stabilized around the 2.5% level depending on the indicator used. This is above the Fed target rate of 2.0% but not by a significant amount. The Fed believes inflation is under control for now and has penciled in two more rate cuts for 2025. We agree that the post-pandemic inflation was largely a result of supply chain disruptions and fiscal policies and that we are likely to return to the low inflation environment of the pre-pandemic era absent other disruptions. This backdrop is a good one for both equity and short to intermediate term fixed income markets.
Market Fundamentals
Corporate Earnings Outlook
An economy with low inflation and continued economic growth is a great environment for earnings growth and we are seeing just that. It appears S&P 500 earnings will grow about 10% in 2024, and predictions are for 15% growth in the year ahead. More importantly, while the bulk of earnings growth last year came from the so-called magnificent 7 (Alphabet, Amazon, Apple, Meta, Microsoft, NVIDIA, Tesla), the coming year is expected to see much better growth from the other 493 companies. If growth of this magnitude does occur, the equity markets should remain in good shape.
Monetary Policy Direction
The Fed is still predicting more cuts ahead. The one caveat is that Chairman Powell was much less confident of further cuts at his December press conference than in previous statements. Our take is that given the uncertainties of policies affecting the economy under the new Administration, the Fed did not want to be committed to one path. With the more hawkish tone, Powell has made it possible for the Fed to pause for a long period or even reverse course if needed. Our belief is that the path to lower inflation will likely slowly continue, and the Fed will stay on its gradually easing course.
Risk Factors
Valuation Concerns
At year end, the S&P 500 closed at an earnings multiple of approximately 25 times trailing earnings and 21.6 times forward earnings. These are very high levels by historical standards. Indeed, a host of other valuation methodologies produce the same results. This is understandable since 40% of the S&P 500 is accounted for by the magnificent 7. These are highly profitable companies that have stellar growth rates and should sell for above average multiples. However, all these companies have market capitalizations well over $1.0 trillion dollars making continued high growth rates more difficult. This suggests earnings multiples are not likely to continue to expand from here and further returns in the S&P 500 will be dependent on earnings growth going forward.
Valuation is not a good predictor of one-year returns. It has historically been a good predictor of returns over the next 5 to 10 years. Current levels suggest longer-term equity market returns in the low single digits. There are two problems with this as we enter the new year. One, the markets are very susceptible to a steep decline on any unexpected bad news and two, 5-10-year bond yields become an attractive alternative investment to equities.
Political and Policy Shifts
The new members of Congress take over on January 3rd and the new president on January 20th. Significant changes in policies are likely to occur and it's very difficult to predict the outcome as they relate to financial markets. On the positive side, a continuation of the current low tax policy and possibility of an even lower corporate rate are clearly good for equity markets. In addition, the promise of less regulation could give the economy a nice boost. These are offset by the possibility of high tariffs and a crackdown on all immigration into the country. The latter two could end up being more bargaining chips than actual policy, but it is simply too early to tell, and both need to be watched closely. Another area to watch closely is fiscal policy. A case can be made that the reason the economy is doing so well is the large fiscal deficit. To the extent that the issue is addressed, it will be good for the long-term health of the economy, but clearly cause pain in the short-term.
Market Technical Analysis
There is an old Wall Street saying that "the trend is your friend." The current upward trend began in the Fall of 2022 and remains intact for the S&P 500 and Nasdaq Composite. For the trend to change these averages must begin to break below their long-term moving averages. For now, they are holding well above those averages and that is positive for equity markets. An important point to add here is that markets have not had a 10% correction since the rally began almost 27 months ago. By historical standards, we are past due for such a correction. Given the uncertainties of the new administration's policy changes, such a correction would not be surprising to see in 2025. As such, a change in trend seems a good possibility.
Investment Outlook and Conclusion
As usual, we begin the year with a mix of positive and negative elements heading into the New Year. For the equity markets, we see a year of good earnings growth but stable multiples leading to positive but muted returns. Our year-end target for the S&P is 6,200, which equates to a total return of approximately 7.0%. This is based on S&P earnings of $260.00 in 2025 and $286.00 in 2026. This would result in a year end 2025 trailing multiple of 23.8 and a forward multiple of 21.7, comparable to where we are now. Unlike last year, when technology and consumer services stocks significantly outperformed other sectors, we do not expect a large variance in sector performance. We still see the technology-related companies performing well, but to a much lesser extent than in the previous two years. On the flip side, the four weak sectors from last year, Energy, Health Care, Materials and Real Estate, will likely come closer to performing at the index level.
The above is our best estimate given current information. There are always so-called tail risks as possibilities. On one side, if all goes well with the economy and the policies implemented by the new Administration are more benign than expected, we see 6,800 as a realistic outcome. On the other side, if more problems arise than currently expected affecting economic growth, inflation and employment in a negative way, we could see a retest of the 2024 lows of around 5,000. For now, we see both of these as low probability events.
As for the fixed income markets, we see the Fed following through with their forecast of two rate cuts, taking short-term rates down to the 3.8% level. We expect longer-term bond rates to stay relatively stable with the 10-year treasury in a range of 4.0 – 5.0% during the year. We will continue to keep the fixed income duration short, and that should provide returns in excess of 4.0% for the fixed income portion of portfolios. Finally, we still see a place for gold in the portfolios as we see the dollar weakening during the new year. We believe its return will be less than last year's stellar 27%, but still competitive with returns from financial markets.